A Deferred Sale Trust is a special purpose legal entity managed by an independent trustee, set up to spread out or defer your tax impact after a sale of stock.
Let’s imagine that your journey with ESO is coming to a happy ending where you have bunch of publicly traded stock available to sell any time you want. Monetizing your shares by selling will instantly trigger a lot of state and federal taxes. Even if you are eligible for long-term capital gains, selling a large block of shares may worsen your pain by triggering the higher Alternative Minimum (AMT) rate. But if you need the money, want to diversify into other investments, or simply want to capture a precariously high valuation before it collapses, then you need to sell and face the tax man. Unfortunately, even at the lower long term capital gains rates, the taxes are so high that you only have a fraction of your wealth left after selling. Then you have to invest successfully to even get back to where you were before selling.
This is where the use of Deferred Sale Trust (DST) can be very valuable. The precise problem is why opportunity zone real estate funds became so popular. They allow you to defer and reduce your taxes if you roll all the gains into a qualified opportunity zone investment. However, opportunity zone investments can be dicey which is why they needed a tax incentive to attract capital in the first place. Moreover, real estate deemed eligible for opportunity zone treatment instantly increased in price by amounts that essentially wiped out the tax benefit. That leaves investor capital stranded in a mediocre investment for up to 10 years and with only tax benefits to show for it. Instead, what if you could sell your valuable stock, get the tax deferral benefit, and invest nearly all of your principal in attractive opportunities that you can control? That would be like having your cake and eating it too!
This is where the use of Deferred Sale Trust can be very valuable. This irrevocable trust is a special purpose legal entity set up to buy your valuable stock from you at fair market value in exchange for a an agreement to be repaid by an installment sale. The trust can then sell your stock at FMV but not have to pay any taxes because it purchased the stock from you at the FMV. An independent trustee will manage this trust and file an annual tax return on its behalf. The trust can have a wealth management firm designated to make investments to create compounded gains for you. The typical term limit for the repayment of the principal to you is 10 years, but the trust can last as long as 20 and be crafted to meet your tax objectives. It can be periodic to spread out your tax impact and avoid AMT or a simple deferral to give you the maximum delay albeit for a large lump sum tax bill down the road. Note that you will eventually pay the taxes that were due anyway as well as pay taxes on the additional investment gains, but the tax deferral will give you the potentially huge benefit of compounding the full original value instead of starting your new investment portfolio 1/3 or 1/2 smaller than it could have been.
Deferred Sale Trusts generally compete with Exchange Funds, also known as Swap Funds. Exchange Funds allow shareholders who have a concentrated position in a single stock to diversify their risk by pooling their stock with a group of other individuals trying to do the same thing. This diversification is achieved without executing a sale and triggering the associated taxes. The group will share in the diversified returns from all the stock and taxes are deferred until the individual contributors sell their ownership units of the Exchange Fund. Exchange Funds usually have lower minimums than a DST but are tainted by adverse selection issues. In other words, the participants tend to contribute stocks that are already overvalued which is why they wanted to diversify in the first place. As such the overall pool of stocks in an Exchange Fund tend to do poorly. Although a DST has a high amount of administrative overhead, it offers nearly unlimited flexibility in its investment diversification strategy. However, the repayment schedule of a DST will be constrained by the terms of its underlying installment sale contract whereas Exchange Funds generally offer more flexible redemptions.
The fees for this arrangement are typically as follows:
- $1 million - $5 million minimum depending on the type of asset that is initially being sold.
- A onetime set up fee of 1.5% for the first $1 million of the original principal and 1.25% for all amounts above $1 million.
- 0.5% ongoing annual trustee fee based on the portfolio value over time. When the initial proceeds are re-invested, the portfolio value can deviate over time. The trustee will file annual tax returns for this trust.
- An ongoing management fee by the financial advisor (wealth management firm) that you designate the trustee to hire. These fees vary considerably but range from 0.25% to 1.5% annually depending on the size of the portfolio and the level of complexity of your investment strategy. If you have a small portfolio and/or a particularly complex investment strategy in mind, you may want to look into hiring a robo-advisor to execute your investments at lower rates.