WHY DON’T MORE PEOPLE USE THE CAPS TRUST STRUCTURE?
Although trusts have been around since 1066 A.D. and Installment Sales have been around for many years, few people have thought to combine the two tax savings strategies for the sale of a business. Real Estate professionals have been using tax deferment for years and it is becoming more common for business and asset sales. Due to the complexity of the transactions and general lack of knowledge about the availability of these important tools, many people unknowingly over pay their taxes. The CAPS Trust structure is becoming more popular and mainstream as information about it is disseminated and people become more educated about the tax saving strategies available to them.
1031 EXCHANGE ALTERNATIVE OR 1031 RESCUE
A unique benefit of the CAPS Trust is the ability to rescue a failed 1031 exchange in the event of an acquisition target falling out or the transaction failing to meet the IRS requirements. With a 1031 transaction, the investor's sale proceeds from the disposition of an asset go to a qualified intermediary (QI). The QI holds these proceeds on behalf of the Seller in order to close on a replacement property to complete the tax-deferred exchange. In the event of exchange failure, whereby the funds cannot be reinvested into a property according to IRS guidelines, the funds held at the QI are subject to capital gains and depreciation recapture taxes once released from the QI to the Seller. The CAPS Trust provides a solution to the problem because the funds can be released to the Trust and the taxes deferred. This has the potential for putting millions of dollars more in Seller's pockets. Click HERE to download a free calculator. The Seller is saved from taking constructive receipt of the funds which would trigger a taxable event. It is important to note that the Seller would not be able to reinvest in real estate with the proceeds from the sale immediately, but would put his money into stocks, bonds, mutual funds, and investment grade securities. He could invest in real estate at a future time by taking a loan out against the assets of the Trust. This works well when the Seller does not want to own and have the responsibility of owning real estate.
Internal Revenue Code Section 453
What are Installment Sales?
Number 705 - Installment Sales
An installment sale is a sale of property where you'll receive at least one payment after the tax year in which the sale occurs. You're required to report gain on an installment sale under the installment method unless you "elect out" on or before the due date for filing your tax return (including extensions) for the year of the sale. You may elect out by reporting all the gain as income in the year of the sale on Form 4797.pdf, Sales of Business Property, or on Form 1040, Schedule D.pdf, Capital Gains and Losses, and Form 8949.pdf, Sales and Other Dispositions of Capital Assets.
Situations Where the Installment Method Isn't Permitted
Installment method rules don't apply to sales that result in a loss. You can't use the installment method to report gain from the sale of inventory or stocks and securities traded on an established securities market. You must report any portion of the capital gain from the sale of depreciable assets that's ordinary income under the depreciation recapture rules in the year of the sale. For additional situations and information about when you can't report payments on the installment method, see Publication 537, Installment Sales.
Determining Your Total Gain
Your total gain on an installment sale is generally the amount by which the selling price of the property you sold exceeds your adjusted basis in that property. The selling price includes the money and the fair market value of property you received for the sale of the property, any of your selling expenses paid by the buyer, and existing debt encumbering the property that the buyer pays, assumes, or takes subject to.
Reporting the Sale on Your Tax Return
Under the installment method, you include in income each year only part of the gain you receive, or are considered to have received. You don't include in income the part of the payment that's a return of your basis in the property. Use Form 6252.pdf, Installment Sale Income, to report an installment sale in the year the sale occurs and for each year you receive an installment payment. You'll need to file Form 1040.pdf, U.S. Individual Income Tax Return, and may need to attach Form 4797.pdf, Sales of Business Property, and Form 1040, Schedule D.pdf. You must also include in income any interest as ordinary income. For details, see Reporting Interest below.
You generally report interest on an installment sale as ordinary income in the same manner as any other interest income. If the installment sales contract doesn't provide for adequate stated interest, part of the stated principal may be recharacterized as unstated interest or original issue discount for tax purposes, even if you have a loss. You must use the applicable federal rate (AFR) to figure the amount of stated principal recharacterized as unstated interest or original issue discount. The AFRs are published monthly in the Index of Applicable Federal Rates (AFR) Rulings.
For additional information, refer to Publication 537, Installment Sales.
It is a Secured Note with a Security Agreement securing the Note with the Assets within the Trust. The Note specifies an interest rate (Chosen by the Seller and agreed to by the Trustee if commercially reasonable), usually one close to the AFR (anything above current long term AFR and below approximately 14% should be Commercially Reasonable). Notes can be amortized as Interest only or Interest plus Principal (this is determined by the Seller's individual needs). The Seller has flexibility of terms in setting up their Note.
What are trusts? A trust is a legal arrangement used to protect assets, such as cash, stocks, mutual funds,land, buildings or other types of assets for the benefit of the “beneficiaries” to the trust. Such assets are referred to as “trust property”. When a trust is created “trustees” are appointed. The trustees are legally responsible for the assets held in the trust and are required to manage the trust and carry out the wishes of the person whose assets were placed into trust. The person whose assets were placed into trust is known as the “settlor”.
How long have Trusts been used? Trusts (aka Holding Companies) have been around since 1066 in England and the concept was adopted in the US, although not popular until the late 1880’s. Trusts are utilized for estate planning, tax reduction and asset protection strategies.
History of Trusts
“A HISTORY OF TRUSTS AND THEIR COMMON USES"
- Contributed by MontereyTrust.com
History of Trusts: We can trace trust history as far back as Norman Conquest of England in 1066. Prior to the Norman Conquest, English law was different, but with the Norman Conquest William decreed that he, as King, owned all the land. From time to time he gave control to others to administer his lands – that ownership was known as tenure – this is where our common term, tenant, originated.
Tenures were granted in exchange for a variety of goods or services such as knight services, farming services or maintenance of hunting grounds. A tenured resident could pass on his interest to an eldest son, but the King was entitled to an estate tax – the birth of our estate tax system.
The Magna Carta, which was adopted by England in 1215, further laid the foundation for Trust Law as we know it today. Under the Magna Carta an earl, baron, other person who was holding land, still had the right to pass his land directly to an heir. Again, it provided for an estate tax upon inheritance. If an heir was under age at the time his father died, a guardian of the land of an heir was appointed until “he became of age”.
The guardian was charged with the guardianship of such land and he was to maintain the houses, parks, fish preserves, ponds, mills, and everything else pertaining to it… and when the heir became of age, the land was restored back to him.
In trust law today, trustees are held to the “Prudent Person Rules” (See Trustee Duties in this Sidebar) in managing estates for others. The Magna Carta stated that the land shall be entrusted to prudent men who shall be answerable to the King for revenues and other guardianship issues of such land.
As an aside, the word “he” was used above because women were not allowed to hold title to land. In fact, the Magna Carta provides that “At her husband’s death, a widow may have her marriage portion [dowry] …returned to her”.. And “She may remain in her husband’s house for forty days after his death…”
Most of our current trust laws came over on the Mayflower from England – although far-reaching changes have been made since their adoption in the U.S. Prior to the 1970’s trusts were used mostly by wealthy families to move assets from one generation to another in an orderly manner and to take advantage of tax benefits. Trusts were also used to keep money out of the hands of a child that perhaps fancied fast racehorses and even faster women and would certainly have spent an entire inheritance in a very short time (See Spendthrift Protection in this Sidebar). A parent could set up a trust to benefit that spendthrift child, helping with educational expenses, funds needed to establish a business or buy a home, all the while keeping most of the funds away from the racetrack. Paul Getty was once quoted as saying “I want to leave my children enough money so that they can do anything, but not so much that they do nothing”
Trusts and Their Common Uses: Generally speaking, there are three parties involved in a Trust agreement:
-A Grantor or Trustor is the person who establishes the trust
-The Trustee is the person appointed to administer the trust upon the Grantor’s incapacity or death
-The beneficiary is the person(s) who receives the benefits of the trust
There are many types of trusts and trusts can be used to accomplish different objectives. Trusts are written documents, or Agreements, which are normally prepared by individuals during their lifetimes wherein they write an agreement which outlines what the individual (grantor) wants done with their assets upon their incapacity or death. The trust is usually part of the grantor’s overall estate plan and, subject to an individual’s personal situation, a complete estate plan could contain a Will, Trust Agreement, Power of Attorney for Finances, and Power of Attorney for Health Care (Advance Health Care Directive).
You may hear of Trusts being called living trusts or inter vivos trusts, marital trusts, by-pass trusts, charitable trusts, dynasty trusts, testamentary trusts.
Overall, Trusts are an important part of an estate plan and, if you have an estate of even $300,000, they should be considered. Trusts can protect a person from the need for a Court initiated Conservatorship, they can protect assets from being wasted in the capricious actions of an irresponsible child and they keep your estate out of Probate. “
CAPS uses an Irrevocable Trust. Unlike a revocable trust, an irrevocable trust is treated as an entity that is legally independent of its grantor for tax purposes. Careful considerations are made to ensure that constructive receipt and arms-length requirements are met with a CAPS Trust. The trustee must file a tax return on behalf of the trust annually. If income is distributed to trust beneficiaries or if a charitable deduciton is claimed, additional tax documentation is required. A irrevocable Trust is utilized in a CAPS structure to ensure compliance with Constructive Receipt and Arms Length Transaction IRS rules.
WHAT CHANGES FOR THE BUYER?
To a Buyer there are minimal changes including:
The Buyer will be buying from "XYZ Trust" instead of "AB Seller".
The Seller(s) as an individual will give the usual reps and warrants, training, and non-compete terms.
All remedies and obligations under the Contract will be available to the Buyer. The Buyer's remedies and obligations will remain and will not be impaired by using a CAPS Trust structure. The Trust, however, does protect the Seller against third-party creditors.
What is Constructive Receipt? Constructive receipt is an accounting concept that determines when income must be taken, for accounting purposes. Usually constructive receipt comes into question the end of an accounting period. Constructive receipt is determined by when the recipient of the income had control over it. An individual or company is considered to have control over income when it is credited to that person or company.
Constructive Receipt in Business Taxes.
According to IRS (Publication 538), income is constructively received when an amount is credited to your account or made available to you without restriction, even if you don't have possession of it. For example, if an agent is holding the money for you, it has been considered to be received by you, even if the money is not in your bank account. The IRS goes on to note that, "Income is not constructively received if your control of its receipt is subject to substantial restrictions or limitations."
(a)General rule. Income although not actually reduced to a taxpayer's possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions. Thus, if a corporation credits its employees with bonus stock, but the stock is not available to such employees until some future date, the mere crediting on the books of the corporation does not constitute receipt. In the case of interest, dividends, or other earnings (whether or not credited) payable in respect of any deposit or account in a bank, building and loan association, savings and loan association, or similar institution, the following are not substantial limitations or restrictions on the taxpayer's control over the receipt of such earnings:
(2) The fact that the taxpayer would, by withdrawing the earnings during the taxable year, receive earnings that are not substantially less in comparison with the earnings for the corresponding period to which the taxpayer would be entitled had he left the account on deposit until a later date (for example, if an amount equal to three months' interest must be forfeited upon withdrawal or redemption before maturity of a one year or less certificate of deposit, time deposit, bonus plan, or other deposit arrangement then the earnings payable on premature withdrawal or redemption would be substantially less when compared with the earnings available at maturity);
(3) A requirement that the earnings may be withdrawn only upon a withdrawal of all or part of the deposit or account. However, the mere fact that such institutions may pay earnings on withdrawals, total or partial, made during the last three business days of any calendar month ending a regular quarterly or semiannual earnings period at the applicable rate calculated to the end of such calendar month shall not constitute constructive receipt of income by any depositor or account holder in any such institution who has not made a withdrawal during such period;
(4) A requirement that a notice of intention to withdraw must be given in advance of the withdrawal. In any case when the rate of earnings payable in respect of such a deposit or account depends on the amount of notice of intention to withdraw that is given, earnings at the maximum rate are constructively received during the taxable year regardless of how long the deposit or account was held during the year or whether, in fact, any notice of intention to withdraw is given during the year. However, if in the taxable year of withdrawal the depositor or account holder receives a lower rate of earnings because he failed to give the required notice of intention to withdraw, he shall be allowed an ordinary loss in such taxable year in an amount equal to the difference between the amount of earnings previously included in gross income and the amount of earnings actually received. See section 165 and the regulations thereunder.
(b)Examples of constructive receipt. Amounts payable with respect to interest coupons which have matured and are payable but which have not been cashed are constructively received in the taxable year during which the coupons mature, unless it can be shown that there are no funds available for payment of the interest during such year. Dividends on corporate stock are constructively received when unqualifiedly made subject to the demand of the shareholder. However, if a dividend is declared payable on December 31 and the corporation followed its usual practice of paying the dividends by checks mailed so that the shareholders would not receive them until January of the following year, such dividends are not considered to have been constructively received in December. Generally, the amount of dividends or interest credited on savings bank deposits or to shareholders of organizations such as building and loan associations or cooperative banks is income to the depositors or shareholders for the taxable year when credited. However, if any portion of such dividends or interest is not subject to withdrawal at the time credited, such portion is not constructively received and does not constitute income to the depositor or shareholder until the taxable year in which the portion first may be withdrawn. Accordingly, if, under a bonus or forfeiture plan, a portion of the dividends or interest is accumulated and may not be withdrawn until the maturity of the plan, the crediting of such portion to the account of the shareholder or depositor does not constitute constructive receipt. In this case, such credited portion is income to the depositor or shareholder in the year in which the plan matures. However, in the case of certain deposits made after December 31, 1970, in banks, domestic building and loan associations, and similar financial institutions, the ratable inclusion rules of section 1232(a)(3) apply. See § 1.1232-3A. Accrued interest on unwithdrawn insurance policy dividends is gross income to the taxpayer for the first taxable year during which such interest may be withdrawn by him.
ARMS LENGTH TRANSACTIONS
What is an 'Arm's Length Transaction? An arm's length transaction is where the buyers and sellers of a product (asset, business, stock, etc.) act independently and do not have any relationship to each other. The concept of an arm's length transaction assures that both parties in the deal are acting in their own self-interest and are not subject to any pressure or duress from the other party. It also assures third parties that there is no collusion between the buyer and seller.
Breaking Down Arm's Length Transactions
Arm's length transactions commonly come into play in the real estate market and when dealing with tax authorities. In general, family members and companies with related shareholders are said not to be transacting at arm's length.
Arm's Length Transactions and Real Estate. Arm's length transactions help determine the fair market value of a piece of property. To properly set fair market value, the price for the property must be obtained through a potential buyer and seller operating through an arm's length transaction. Otherwise, the agreed-upon price is likely to differ from the actual fair market value of the property.
For example, if two strangers are involved in the sale and purchase of a house, it is likely that the final agreed-upon price is close to market value, assuming that both parties have equal bargaining power and equal information about the situation. The seller would want a price that is as high as possible, and the buyer would want a price that is as low as possible.
This contrasts with a situation in which the two parties are not strangers. For example, it is unlikely that the same transaction involving a father and his son would yield the same result, because the father may choose to give his son a discount.
Whether the parties are dealing at arm's length in a real estate transaction has a direct impact on financing by a bank of the transaction, stamp duty, or other municipal or local taxes, as well as the use of the transaction to set comparable prices in the market.
Arm's Length Transactions and Taxation
Tax laws throughout the world are designed to treat the results of a transaction differently when parties are dealing at arm's length and when they are not. Using the same example as above, if the sale of the house between father and son is taxable, tax authorities may well force the seller to pay taxes on the gain he would have realized had he been selling to a neutral third party and disregard the actual price paid by the son.
In the same way, international sales between non-arm's length companies, such as two subsidiaries of the same parent company, must be made for arm's length prices. This practice, known as transfer pricing, assures that each country collects the appropriate taxes on the transactions.” Source: Divestopedia
Read more: Arm's Length Transaction Definition | Investopedia https://www.investopedia.com/terms/a/armslength.asp#ixzz5JV5zl5Rx
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IRS Code Sections regarding Arm’s Length Transactions can be found in Title 26, IRC, CFR 1.482-1, (a) (3) (b) Arm’s length standard;
(3) Taxpayer's use of section 482. If necessary to reflect an arm's length result, a controlled taxpayer may report on a timely filed U.S. income tax return (including extensions) the results of its controlled transactions based upon prices different from those actually charged. Except as provided in this paragraph, section 482 grants no other right to a controlled taxpayer to apply the provisions of section 482 at will or to compel the district director to apply such provisions. Therefore, no untimely or amended returns will be permitted to decrease taxable income based on allocations or other adjustments with respect to controlled transactions. See § 1.6662-6T(a)(2) or successor regulations.
(b) Arm's length standard -- (1) In general. In determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer. A controlled transaction meets the arm's length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm's length result). However, because identical transactions can rarely be located, whether a transaction produces an arm's length result generally will be determined by reference to the results of comparable transactions under comparable circumstances. See § 1.482-1(d)(2) (Standard of comparability). Evaluation of whether a controlled transaction produces an arm's length result is made pursuant to a method selected under the best method rule described in § 1.4821(c).