Benefits of Asset Exchange Structure

The purpose of this discussion is to define the possible benefits of the Asset Exchange structure as well as its mechanics. This discussion is intended to provide you with a legal take on the methodology and design of the transaction—it is not intended to be a reliance opinion with respect to any specific results nor is it intended to guaranty specific results for any seller, real or hypothetical.

There are two primary benefits to the Asset Exchange transaction. First and foremost, this transaction provides an asset protected entity that will hold liquid assets resulting from a sale transaction. For context, if an individual seller receives cash at the closing of the sale of an asset (whether that asset is real property, an active business, etc.), that cash immediately becomes subject to the creditors of the individual. If, instead, the individual receives the right to payment in the future from an asset protected entity at closing, only the payments the individual actually receives are subject to her creditors. Because an Asset Exchange transaction does not involve gifts or transfers for less than adequate consideration, there are no fraudulent convenance issues that would create exception creditors who could place liens on the assets of the trust.

The second benefit of this transaction is tax deferral for deferrable capital gains. This is the benefit that sellers tend to focus on. However, because the IRS can argue (whether or not successfully) that transactions engaged in for the sole purpose of tax mitigation can be undone, we always emphasize that the Asset Exchange transaction is an asset protection structure that also throws off very significant tax benefits.

ASSET EXCHANGE MECHANICS

From a transactional perspective, the Asset Exchange utilizes a very straightforward installment sale. Unlike other esoteric tax structures, this structure does not rely on a private letter ruling, revenue ruling, or tax court opinion interpreting whether a benefit should be applied under a particular set of facts. This structure falls firmly within provisions of the U.S. Tax Code and the Regulations thereunder (similar to tax deferred exchanges, charitable remainder trusts, etc.).

Section 453 of the Tax Code deals with the timing of the tax trigger on installment sales. For deferrable capital gains, the tax on any portion of the gain is payable in the year a principal payment is received from the sale of the asset.

To achieve this installment sale treatment, the seller sells her appreciated asset to a Nevada Asset Protection Trust that we have established solely to purchase assets for resale. As payment for its purchase, the Nevada Asset Protection Trust pays with a promissory note (the design of which can be negotiated by the seller. Additionally, each Nevada Asset Protection Trust that we establish is used only for a single sales transaction.

Because the Trust is purchasing the assets with an intention to resell them to an ultimate buyer, the purchase agreement is written to require the seller and its principals to acknowledge and subscribe to the representations, warranties and restrictive covenants in any purchase agreement between the Trust and an ultimate purchaser. We think this step is crucial in ensuring that a future purchaser takes title to the assets with the same security that it would receive had it purchased them directly from the seller.

The trustee we use is completely independent of the seller. Therefore, many of the concerns about related parties, controlled parties, etc., in a purchase and sale transaction do not apply. The only relationship the seller and the Trust have is contractual—the seller holds a promissory note reflecting the installment payments on the sale and the Trust is a debtor on the note.

Once the Trust is the owner of the assets, it sells them to an ultimate purchaser (who is often determined prior to us commencing the sale from the seller to the Trust), usually with cash as a primary form of consideration.

Timing is important with respect to the sale by the seller to the Trust. The tax law concept of assignment of income will treat the original seller as receiving the cash at closing from the sale by the trust if the seller sells her assets to the Trust after giving another buyer a legal right to purchase them. This would result in all of the gains being triggered at closing. We do not allow an Asset Exchange trust to purchase assets from a seller who has signed an asset purchase agreement giving a purchaser the right to close on the assets. However, we can use our Asset Exchange structure even if a Letter of Intent is in place from an ultimate purchaser to purchase the assets from the seller as long as the LOI is not binding (which is the case with most LOIs). If there is any type of legally enforceable agreement to purchase the assets in place between the seller and the ultimate purchaser, it is often too late to use the Asset Exchange structure (and we believe this is true even if all of the parties consent to a change of the identity of the seller in the purchase agreement or an assignment of that purchase agreement to the Trust). One notable exception to this rule is where the seller is an entity and one of its owners wants to use an Asset Exchange structure—in this case it is often possible for the owner to sell her shares or membership interests to the Asset Exchange Trust prior to the entity selling the underlying assets.

The sale by the seller to the Trust is at full market value. As a result, the Trust takes a full market value “purchase price” income tax basis in the asset. When the Trust sells the asset to the ultimate purchaser (at about the same price if its sale is shortly after its purchase), the transaction is a fully taxable sale, but the Trust’s income tax basis is equal to the amount it realizes on the sale, resulting in no gains. The overall result of this is that the gains are recognized by the seller as she receives payments from the Trust on the promissory note it used for payment.

Because the Trust is entering into the transaction with the intent to sell the assets purchased, and is determining its purchase price based on its expectation of the price it will be able to sell the asset for, the purchase agreement between the seller and the Trust contains a standard purchase price adjustment that adjusts the purchase price up between the seller and the Trust if the Trust makes more on the transaction than expected. We use these types of post-closing purchase price adjustments all the time to deal with variables in regular M&A deals. However, by using one in the Asset Exchange transaction, the result is that at the end of the note period, the original purchase price is adjusted, which will work to sweep out the returns of the pre-tax investments over the term of the note. This is how the seller is able to participate in these returns. The economics of the tax deferral and participation in the investment returns is often very compelling.

It is important to note that because we establish a new Trust for each seller, there is never a possibility of one seller’s assets being at risk to another seller’s investment choices. Because the seller is a debtor of the Trust, the Trust’s investment advisor can consult with the seller with respect to the design of an investment portfolio that takes into account the preferences and risk tolerance of the seller (even though these investments are being made inside of a trust that is unrelated to the seller).

WHY WE BELIEVE THE ASSET EXCHANGE WORKS

The above description is focused on how the transaction provides asset protection and capital gains tax deferral. As mentioned above, this transaction falls squarely within section 453 of the Tax Code and the Regulations thereunder. Versions of this transaction similar to ours have been favorably discussed at various tax seminars, continuing education programs, and have been included in programs presented by at least one state bar association.

There are a number of ways that this type of transaction may not provide the benefits above even though it clearly falls within the installment sales rules of the Tax Code (just like any other structure can fail if designed or managed poorly). The fact that our Trustee is a true third party (not related or subordinate to the seller) alleviates many of the concerns around the possibility for failure of this transaction. If the Trustee were found to be related or subordinate to the seller, the IRS could argue that this transaction is not, if fact, an installment sale for one of the following reasons:

• Substance over Form: This is the IRS’s go to argument to undo an otherwise valid transaction. If the Trustee were not independent with an independent economic benefit from the transaction, the IRS could argue that the relationship was custodial instead of a sale (which would result in a deemed sale by the seller directly to the ultimate purchaser).
• Step Transaction Doctrine: If the Trustee is related and does not receive real economic benefit from this transaction, the IRS could argue that the transaction was a single sale directly between the seller and the ultimate purchaser.
• Sham Trust Doctrine: If we cut corners on the design and implementation of the Trust in Nevada, the IRS could argue that the trust is not real, giving the same result as above.

Additionally, the fact that the Asset Exchange team does not offer this transaction to sellers who have an already-established contractual obligation to sell their asset avoids the previously discussed Assignment of Income Argument, whereby the IRS could deem the gains triggered to the seller immediately.

The fact that this transaction defers but does not eliminate tax is beneficial to keep in mind. Many arguments around the avoidance of tax are focused exclusively on tax elimination—a result this transaction does not provide.

A FEW CLOSING THOUGHTS

This transaction was developed twenty years ago by a large southeast tax law firm. Once it became clear that it worked and that there was a need for it, other providers came into the picture and offered the transaction with ever-increasing seller accommodations to make the transaction easier, faster, etc. Many of those providers still work in this space.

We have seen and even reviewed many of these other structures. We will be happy to provide our thoughts (whether they are positive or negative) on other similar structures that are out there, and how to move forward with them with the least amount of risk.

This type of structure will simply not work if the seller receives both cash and tax deferral at the time of the sale of the assets. For instance, when a seller sells assets in return for a promissory note but then borrows 95% of face value of that note from the provider of the structure, the transaction is no, in actuality, an installment sale for which capital gains tax deferral will apply.

Similarly, if the seller is given a “put option” on the note allowing her to require the trust to prepay it, the tax will not be deferred to the extent that the seller can require early payment (and the time of the tax trigger is based on the earliest time the seller can exercise her put option).

If the seller is in direct control of the investments inside the trust, the investor control doctrine may be used to deem those assets to be owned by the seller, resulting in an immediate trigger of all of the deferred tax.

Finally, an escrow relationship cannot be used to defer capital gains taxes. Anyone considering this type of transaction should not be comfortable if the design centers on an escrow fund.

We hope this explanation is helpful. We are always happy to answer questions about this structure.

Russell Lombardy II, Esq. LL.M.

Russ currently serves as a managing member and lead exchange attorney at The Asset Exchange. He is also owner and founder of Monarch Wealth Attorneys. Russ built his legal career in New York where he worked for a well known international tax law firm designing large estate plans. He was then recruited by one of the Big Four accounting firms as a federal tax manager to service their largest corporate clients. Russ has a significant amount of international planning experience as he has transacted business in well over 50 countries.

Russ has extensive experience working with wealthy families and successful business owners. His practice centers on asset protection, wealth transfer, complex estate planning and legal services for entrepreneurs (with the related corporate and partnership taxation planning).