Death-Terminating Installment Notes Held to Generate Taxable Income

The Court of Appeals for the 8th Circuit, affirming the decision of a divided Tax Court, has found that installment notes which terminate upon the death of the obligee generate taxable income to his estate. Frane v. Commissioner, 93-2 USTC 50,386.  Prior to this decision, “Death terminating installment notes” were thought by some to be possessed of favorable income tax consequences.

[Ed. Note: When an installment sale is made, the seller agrees to accept payment for the property over period of years. If the installment sale meets criteria specified in Code Sec. 453, the seller must report gain on the “installment method” unless he affirmatively elects otherwise. Under this method, the seller reports gain ratably, according to a statutorily defined formula which ensures that once all payments have been received, all realized gain will have been reported. According to Code Sec. 453B, if an installment obligation is disposed of “other than at its face value,” the portion of the gain that had been deferred by reason of the installment sale provisions becomes immediately taxable.]

The estate had argued that the cancellation of an installment note by reason of the seller’s death would not constitute a taxable disposition under Code Sec. 453B(a), since the cancellation of the note was predicated upon express contractual language, rather than being the result of an extraneous event.

Its analysis presaged with the admonition that the taxpayer faced an “uphill battle,” the Court found that the statute, as well as the clearly articulated Congressional intent, left no doubt that Congress did not intend for the unreported tax to forever escape taxation. Thus, cancellation of the note at death was held to constitute a taxable disposition pursuant to Code Sec. 453B(f)(1), which in turn caused all of the unreported gain to become immediately taxable.

The Court was, however, vague with respect to the basis of the purchasers in the note. Normally, the purchasers of a note would be entitled to a full cost basis. The Court noted, however, that the obligors of this type of note might not be permitted to take a cost basis because the death-terminating feature made the note “contingent or indefinite.” Yet, if the obligors were not allowed a full cost basis, the gain might be taxed twice.

The Court suggested that  injustice would occur only if the tax treatment accorded to the obligor and obligee were “inconsistent,” and then appeared to suggest that  contingent or not, the obligor would take a full cost basis in the note if the obligee’s estate were required to report gain on the disposition. Nevertheless, the Court shed no light on the crucial issue of the timing of the basis adjustment:  Should the obligor’s basis be “stepped-up” in unison with the estate’s recognition of gain, or should the obligor be entitled to take a full cost basis at the time of the initial sale?

The Appeals Court disputed the Tax Court’s finding with respect to the proper taxable entity, holding that the “unambiguous language” in Code Sec. 691(a)(5)(iii) provides that cancellation occurring by reason of death of the obligee is taxable to the estate, rather than to the decedent.

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