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What is Constructive Receipt?

What is Constructive Receipt?

January 24, 20243 min read

In the complex world of asset sales, particularly for high-value items like businesses or real estate, the concept of constructive receipt plays a pivotal role in determining tax liabilities. This blog post aims to shed light on what constructive receipt entails, its implications for sellers of assets, and how an Installment Sale Trust (IST) can strategically circumvent this issue, leading to a more tax-efficient sale process.

What is Constructive Receipt?

Constructive receipt is a tax principle that considers income as received by an individual as soon as it is made available to them, without any substantial restrictions. This means that if you have the ability to access income, the IRS views it as if you have already received it, regardless of whether you physically have the money. This concept becomes crucial when you're dealing with the sale of assets that result in capital gains.

For example, selling a business or real estate property typically incurs capital gains tax on the profit. However, if the entire sale amount is immediately accessible to you, even if you choose not to receive it all at once, you might be liable for taxes on the entire gain in that tax year due to constructive receipt.

How Does an Installment Sale Trust (IST) Help?

An Installment Sale Trust offers a savvy approach to managing and deferring capital gains taxes. It does so by structuring the sale of an asset through an arms-length transaction with an "interest-only" secured note, effectively steering clear of constructive receipt.

Here’s the breakdown:

  1. Arms-Length Sale: The asset is sold to the trust in an arms-length transaction, ensuring the sale reflects fair market value as it would between unrelated parties.

  2. Secured Note: The seller receives an "interest-only" secured promissory note from the trust, outlining the payment terms over a specified period. This note signifies the seller's right to future proceeds.

  3. Trust Holds the Asset: The IST holds the asset and the proceeds from its eventual sale to a third party. Since the seller doesn’t directly access the sale proceeds, they avoid constructive receipt and defer capital gains taxes.

  4. Withdrawals and Tax Implications: The IST is structured to generate an income stream, typically around 6%, by investing and growing the principal inside the trust. The seller can withdraw this income without capital gain obligations but still pays income tax. However, if the seller wishes to withdraw amounts above the principal (minus the basis), capital gains taxes are incurred on a pro-rata basis.

With an IST, all the money is secured in a trust bank account under the name of a 3rd party trustee, but collateralized by the interest-only secured note. This gives you control over any assets being moved, but not complete ownership, allowing you to avoid constructive receipt.

Example to Illustrate:

Consider Jane, who sells her business with a basis of $100k for $1 million using an IST. She receives an "interest-only" secured note and the trust invests the principal. This investment generates a 6% income stream, amounting to $60,000 annually, which Jane can withdraw without triggering capital gains tax.

Suppose, after a few years, Jane decides to withdraw an additional $100,000, exceeding her principal amount (minus the basis). This withdrawal is not subject to capital gains tax. If she decides to make another withdrawal of $100k, this excess withdrawal is subject to capital gains tax, calculated on a pro-rata basis based on the total gain and the proportion of the total sale proceeds she has received.

Get Started With The Installment Sale Trust:

An Installment Sale Trust is an effective strategy for managing and deferring capital gains taxes on the sale of high-value assets. By understanding the nuances of arms-length sales, "interest-only" secured notes, and the implications of withdrawals, sellers can navigate the intricacies of constructive receipt. This approach not only facilitates tax deferral but also offers financial planning flexibility, making it an invaluable option for asset sellers.

To get started with your own Installment Sale Trust, schedule a quick phone call here:

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