Draft:537 Installment Sale Trust

Installment Sale Trust

Overview

The Installment Sale Trust (IST) is a combination of an estate and tax planning strategy designed to defer capital gains taxes on the sale of highly appreciated assets such as investment properties, personal residences, businesses, and more.

It combines a Revocable Business Purpose Trust with Installment Sales, allowing sellers to receive payments over time rather than in a lump sum. By structuring a sale this way, sellers can maximize income by deferring taxes, compound their growth on the untaxed principal, and pass it down to heirs with a step up in basis to keep in the family for generations to come.

This strategy was first developed by Ernst & Ernst (now Ernst & Young) in 1971 for internal clients and has been refined over decades. The IST is fully compliant with the IRS, operating under Section 453 of the Internal Revenue Code (IRC) and IRS Publication 537 that tie into Installment Sales and the Installment Method of Reporting.

Unlike some other installment sale programs, the IST is not classified as a Deferred Sales Trust (DST) or a Monetized Installment Sale, both of which have been flagged by the IRS as potentially abusive tax schemes.

Legal Basis and Compliance

The Installment Sale Trust is structured around Section 453 of the Internal Revenue Code (IRC), which governs installment sales. This section allows sellers to recognize income over time rather than at the moment of sale, deferring capital gains taxes accordingly. Key compliance points include:

• No constructive receipt: Since the seller does not receive the full proceeds immediately, the sale does not trigger an immediate taxable event.
• Taxation upon withdrawal: When the seller withdraws funds from the trust, taxes are due based on income classification (capital gains, ordinary income, or return of basis).

Third-party trustee management: To ensure compliance, an independent trustee oversees the trust's operations to avoid the issues that can arise with step doctrine.

How a Installment Sale Trust Works

The structure of a Installment Sale Trust typically follows these steps:

1. Creation of the Trust – The seller establishes the IST with a third-party trustee.
2. Asset Sale – The seller plans to sell the appreciated asset in exchange for a Secured Promissory Note that collateralizes the IST.
3. Asset Sells to the End Buyer – The business or real estate transaction will remain the same without modifications to language. The only difference is the IST will receive the funds at close of escrow similar to a 1031 exchange rather than the seller.
4. Investment and Growth – The IST invests the sale proceeds in approved investments, allowing tax-deferred growth and production of dividends or income to pass through to the Note Holder.

Installment Payments – The IST makes scheduled payments to the seller, distributes income, and allows for additional withdrawals or modifications to the income stream at any time over the Note term.

Because the funds within the IST continue to grow tax-deferred, sellers can benefit from compounded interest on untaxed gains, generating additional income over time.

Key Benefits of the Installment Sale Trust

An IST provides several advantages, including:

• Full IRS Compliance – Unlike some other installment sale strategies, the IST follows IRS guidelines.
• Liquidity and Flexibility – Sellers can withdraw funds or refinance the promissory note for additional liquidity.
• Investment Control – Sellers approve trust investments, ensuring alignment with their financial goals.
• Generational Wealth Planning – The IST can be passed on to heirs with a step-up in basis, providing long-term income benefits.

Profit from Deferred Taxes – Because taxes are deferred, funds that would have been paid in taxes remain invested, generating additional returns.

Installment Sale Trust as a Safety Net for 1031 Exchanges

An Installment Sale Trust can also serve as a backup plan for a failing 1031 Exchange.

A 1031 Exchange, under Section 1031 of the IRC, allows sellers of investment properties to defer capital gains taxes by reinvesting proceeds into a "like-kind" property within a strict 45-day identification period and 180-day closing period. However, if the exchange fails—whether due to deal complications, market conditions, or failed reinvestment options—the seller could be stuck with an immediate tax bill.

In such cases, an IST can step in as a safety net by:

• Deferring taxes even if a 1031 Exchange falls through – Instead of paying capital gains taxes immediately, the seller places the proceeds into an IST, keeping funds tax-deferred.
• Providing liquidity without 1031 constraints – Unlike a 1031 Exchange, which requires reinvestment in another property, an IST allows investment diversification without strict timelines.
• Extending tax deferral into future tax years – Even if the 1031 Exchange fails late in the year, the IST can defer income recognition until the following tax year, providing greater financial planning flexibility.

For this reason, an Installment Sale Trust is a viable alternative or backup to a 1031 Exchange, especially for investors who want tax deferral without being restricted to real estate reinvestment.

Risks and Considerations

While an IST provides numerous benefits, sellers should be aware of potential risks:

• IRS Compliance Requirements – While fully legal, ISTs must be structured properly to avoid tax penalties.
• Investment Risks – The trust’s performance depends on investment choices, so working with experienced trustee services and financial advisors is essential.

Limited Immediate Access – While the IST provides liquidity, accessing large withdrawals at once may trigger tax consequences.

Comparison to Other Tax Deferral Strategies

An Installment Sale Trust is often compared to:

• 1031 Exchange – Requires reinvestment into similar real estate but avoids capital gains tax indefinitely.
• Charitable Remainder Trust (CRT) – Offers tax deferral while contributing assets to charity.

Each option serves different needs, making it crucial for sellers to consult tax professionals when selecting a strategy.

Conclusion

The Installment Sale Trust is a powerful, IRS-compliant tax deferral tool that allows sellers of appreciated assets to spread out capital gains tax liability while maximizing investment growth. It provides flexibility, liquidity, and estate planning benefits, making it an attractive alternative to a 1031 Exchange—or a safety net when a 1031 fails.

Properly structured, an IST ensures tax efficiency while generating long-term financial benefits for both individuals and future generations.