From time to time a Seller of an appreciated business or property, who is interested in the Deferred Sales Trust (DST) will comment that the legal costs associated with setting up the DST are too high. But are they?
In my experience “Cost” is a relative term that should only really be defined in terms of the “Value” received for the cost. Is the cost for an operation that can save the life of your child too high? How about a quality pair of shoes that will last you 10 years, vs a cheaply made product that you will have to replace every 6 months?
Take the DST, there is a fairly standard fee schedule for setting up the legal structure and helping manage the closing of the transaction equal to 1.5% of the first $1,000,000 in selling price and 1.25% of the sales price which exceeds $1,000,000.
Take a hypothetical sale for $1,000,000 where the seller/taxpayer would be exposed to $250,000 in capital gains and related taxes in a pure direct and taxed sale, without tax deferral.
The legal and set up costs for creating the DST would be about $15,000. Let’s further assume that the seller/taxpayer intended to reinvest his or her proceeds to generate a 5% annual income stream.
If he or she had paid all their taxes in the year of sale, he or she would generate $750,000 x 5% = $37,500 in annual income on the invested proceeds.
If instead the seller/taxpayer were able to defer the capital gains taxes until many years down the road, he or she would generate $1,000,000 x 5% = $50,000 in annual income.
If the legal and set up costs were $15,000 the seller/taxpayer would break even at the end of the first year. In future years they would continue to generate an additional $15,000 per year than if they had paid all their taxes up front. Over say 10 years, that puts $150,000 more in the seller’s pocket than would a direct and immediately taxed transaction. It may also be important to recognize that receiving your sales proceeds in installments over time (plus interest) can help you lower the tax brackets you will pay tax in, resulting in further net income gains.
Think of your installments like you would your IRA. Most people choose to withdraw from their IRA from year to year, only the amounts necessary to meet their obligations or maintain their preferred lifestyle. Who in their right mind would cash out their IRA if they had no need to consume the entire proceeds in a given year?
Relative to the breakeven point, most business owners and entrepreneurs will make a value decision related to investments in their companies, such as in equipment or technology. Often the business owner will want that new investment to generate additional value in terms of revenue or cost savings to have a breakeven point of 18 months to 2 years in order to justify the investment. Anything beyond the breakeven point is pure profit.
The DST as well should be evaluated not strictly on the cost, but on the value it can generate for you, as yes perhaps part of the analysis is the breakeven point.