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An “installment sale” is a disposition of property in which at least one “payment” is to be received after the close of the taxable year in which the disposition occurs. IRC §453(b)(1).
The “installment method” is the default method prescribed by the Code to report income from installment transactions unless the taxpayer elects not to use the installment method. This election must be made no later than the due date of the tax return (including extensions) for the taxable year in which the disposition occurs. IRC §453(d)(1).
Under the installment method, a fraction of each installment payment constitutes a return of capital and a fraction constitutes capital gain. That fraction is defined as the “gross profit ratio.” The gross profit ratio is equal to the “gross profit” over the “contract price.” The gross profit is the gain reported on the transaction, while the total contract price is the total consideration to be paid, reduced by the amount of any “qualifying indebtedness” assumed or taken subject to by the buyer, to the extent of the seller’s basis in the property. IRC §453(c); Temp. Treas. Reg. §15A.453-1(b)(2)(ii).
If any or all of the installment payments under an installment sale are not made, and either (i) the debtor declares bankruptcy or (ii) a judgment is obtained against the debtor, then the uncollected amounts may be written off as a bad debt. The amount of the deduction would be equal to the installment obligation’s adjusted basis.
If a business consisting of multiple assets is sold, an allocation of the selling price and the payments received must be made in the year of sale to (i) inventory, whose gain may not be reported on the installment method; (ii) loss assets, whose loss must be reported in the year of sale; (iii) real property, whose gain may be reported on the installment method; and (iv) personal property, the gain on which may also be reported on the installment method. Treas. Reg. §1.453-5(a).
B. Limitations on IRC § 453 Reporting
1. Accrual Method Taxpayers
Under IRC § 471(a), the IRS may require any taxpayer to use inventories, and therefore the accrual method, if necessary to clearly reflect the taxpayer’s income. In 1999 Congress amended IRC §453(a) to provide that accrual basis taxpayers could no longer use the installment method. This provision adversely affected partnerships and C corporations selling assets on the installment basis, since these entities are constrained in their ability to use the cash method. The profoundly unpopular enactment also adversely affected the ability of small business owners to sell their business on the installment basis. The unpopularity of the statutory change resulted in some administrative leniency; the IRS had stated that taxpayers with average annual gross receipts of $1 million or less could use the cash method of accounting and, therefore, the installment method. Rev. Proc. 2000-20 I.R.B. 1008.
However, the Tax Relief Extension Act of 1999, which imposed the ban on installment basis reporting by accrual-method taxpayers was itself retroactively repealed by the Installment Tax Correction Act of 2000 (HR 3594). The bill was passed by the unanimous vote of both houses, and signed into law by President Clinton on December 28, 2000. For purposes of the Code, the earlier legislation is treated as if it had never been enacted.
In general, partnerships may not use the cash method if (i) the partnership has as a partner a C Corporation and (ii) the partnership’s average annual gross receipts for the three-year period before the taxable year in issue exceeded $5 million, or (iii) the partnership is a “tax shelter.” IRC §448(a), (b)(3), (c); see also Treas. Reg. §1.448-1T(a), (b), (f). A C corporation may not use the cash method of accounting unless the corporation’s average annual gross receipts for the three-year period before the taxable year in issue did not exceed $5 million. IRC §448(a)(1), (b)(3).
With proper planning, it may be possible in certain factual circumstances for partnerships to avoid the full impact of the rule:
1. An installment sale by an accrual method partnership will generally result in immediate gain recognition to the partnership. However, if cash method partners instead sell their partnership interests, that gain could be reported on the installment method. IRC §453(a)(2). Rev. Rul. 99-6, 199-6 I.R.B. 6, Situation 2, states that a sale of all interests in a limited liability company is treated as a sale of partnership interests for purposes of determining the tax consequences to the seller, but is treated as a purchase of assets for purposes of determining the tax consequences to the buyer; and
2. If an accrual method partnership distributes assets to cash method partners, a later sale by the partners may be respected if the partners themselves negotiated the later sale. See U.S. v. Cumberland Public Service Co., 338 U.S. 451 (1950). However, if the partnership negotiated the sale, the step transaction doctrine may warrant treating the distribution and later sale as one transaction for tax purposes. See Commr v. Court Holding Co., 324 U.S. 331 (1945).
2. Dealer Dispositions
Installment reporting is also not available with respect to “dealer dispositions.” IRC §453(b)(2)(A). Dealer dispositions include dispositions of real property held by the taxpayer in the ordinary course of business. IRC §(1)(l)(B). However, an exception permits sales of timeshares or residential lots to be reported on the installment method provided (i) in the case of a timeshare, the interest involves a right to use a timeshare ownership interest in residential real property for not more than six weeks per year; and (ii) in the case of residential lots, the taxpayer or related persons do not make improvements. IRC §453(l)(2), (3). Taxpayers who avail themselves of these exceptions must agree to remit an interest payment with respect to the deferred tax liability. IRC §453(k)(2).
3. Related Party Dispositions
The purpose of IRC §453(e) is to prevent related persons, as a unit, from accelerating the receipt of cash — but not tax liability — by means of a sham intermediate sale which nominally resembles an installment sale. Therefore, a taxpayer making an installment sale to a related person (“first disposition”) may be required to accelerate all or a portion of the installment gain if the related person impermissibly disposes of the property within two years (“second disposition”).
A “related person” is one who bears the relationship to the taxpayer described in IRC §§ 318(a) or 267(b). IRC §453(f)(1). Acceleration of gain will not result where avoidance of tax was not a principal purpose of the second disposition. IRC §453(e)(7); see also S. Rep. No. 96-1000, 96th Cong., 2d Sess. 16 (1980). The amount of accelerated gain is the lesser of (i) the amount realized on the second disposition or (ii) the total contract price, reduced by the aggregate amount of payments received (or treated as having been received) by the taxpayer making the first disposition before the close of the taxable year. IRC §453(e).
The rule requiring acceleration of gain does not apply if the related person waits at least two years prior to reselling the property. IRC §453(e)(2). The two-year cut off rule does not, however, apply to marketable securities. IRC §453(e)(2). If property other than money is received by the related seller after the resale, the first seller, for purposes of the rule, is treated as receiving cash equal to the fair market value of the property received by the related person. IRC §453(e)(4).
The related-party rules do not apply to (i) reacquisitions of stock by an issuing corporation; (ii) involuntary conversions; (iii) dispositions at death; or (iv) transactions in which tax-avoidance was not a principal purpose. For purposes of IRS enforcement, the statute provides that the period for assessing a deficiency shall expire no earlier than two years after the date on which the person making the first disposition furnishes a notice to the IRS advising of the occurrence of a second disposition to which the section may have applied. IRC §453(e)(8).
4. Depreciation Recapture
The general rule with respect to installment sales is that gain is reported ratably, as payments are received. However, an installment sale of depreciable property may result in recaptured gain in the year of sale. IRC § 453(i)(1). The recaptured amount treated as ordinary income in the year of sale is any amount that would be treated as ordinary income under IRC §§ 1245 or 1250 if all payments were made in the year of disposition. IRC § 453(i)(2).
Ordinary income recapture occurs under IRC §§ 751, 1245 and 1250 occurs notwithstanding any other provisions of the Code. IRC § 1245(d); 1250(h). Accordingly, recapture income may not be reported on the installment method. IRC §453(i). Recapture potential under IRC §§1245 and 1250 must be reported immediately, notwithstanding that cash proceeds may not be received until later years under the installment agreement.
It is therefore possible that the seller could be required to report ordinary recapture income in the year of an installment sale despite having received no payments that first year. This may create a severe cash-flow problem to the seller, unless this problem is addressed during negotiations. Since only recapture gain is treated as received in the year of disposition, the balance of the gain is spread over the remaining payments.
The amount recaptured cannot, however, exceed the realized gain. Moreover, if realized gain exceeds the recapture amount, that amount may reported under the installment method. IRC § 453(i)(1)(B). The amount recaptured as ordinary income is added to the adjusted basis in order to determine the gross profit.
When computing gain recognized with respect to each installment payment, the adjusted basis of the property sold must be increased by the amount of recapture income recognized in the year of sale for purposes of determining the gross profit ratio and calculating the amount of each installment payment is included in income. IRC §453(i); see also S. Rep. No. 169, 98th Cong., 2d Sess. 466 (1984); IRS Pub. No. 537.
C. Unrecaptured IRC §1250 Gain
Unrecaptured IRC §1250 gain should not be confused with ordinary income recapture under IRC §1250. Unrecaptured section 1250 gain is actually that portion of long-term capital gain that corresponds to the straight-line depreciation deductions which have been taken. Such gain is taxed at 25 percent. IRC §1(h)(1)(D)(i). Regulations provide that unrecaptured section 1250 capital gain may be reported on the installment method provided the taxpayer is otherwise entitled to use the installment method. Treas. Reg. §1.453-12(a).
In 1999, final regulations were issued governing the timing of the recognition of unrecaptured IRC §1250 gain. Treas. Reg. §1.453-12, T.D. 8836, 64 Fed. Reg. 45,874 (Aug. 23, 1999). Those regulations provide that with respect to sales on or after May 7, 1997, if gain from an installment sale consists of both unrecaptured section 1250 gain and adjusted net capital gain, the unrecaptured section 1250 gain is reported first.
With respect to installment payments from sales prior to May 7, 1997, taxpayers receive a modest benefit: the amount of unrecaptured section 1250 gain with respect to an installment payment is determined as if, for all payments properly taken into account after the date of sale but before May 7, 1997, unrecaptured section 1250 gain had been taken into account before regular capital gain. Treas. Reg. §1.453-12(b). The effect of this rule is to reduce the portion of gain from pre-1997 installment sales which are subject to the higher 25 percent capital gains tax rate.
D. Sales of Partnership Interests
IRC §453(a) provides that income from an installment sale shall be taken into account under the installment method. Under IRC §741, the sale or exchange of a partnership interest generates capital gain or loss, except as provided in IRC §751. Under IRC §751(a), amounts received in exchange for all or part of a partnership interest are treated as ordinary income to the extent attributable to unrealized receivables or inventory items. Thus, a partner may recognize both ordinary income and capital gain from the sale of a partnership interest. IRC §§ 741, 751.
Rev. Rul. 89-108 (1989-2 C.B. 100) states that although the sale of a partnership interest is generally treated as the sale of a single capital asset without regard to the nature of the underlying partnership property, IRC §751 operates to prevent the conversion of ordinary income into capital gain upon the sale of a partnership interest. IRC §751 in effect “severs” certain income items from the partnership interest, and to the extent a partnership interest represents substantially appreciated inventory or unrealized receivables described in IRC §751, the tax consequences to the transferor partner are identical to the tax consequences that would be accorded to an “individual entrepreneur.” H.R. Rep. No. 1337, and S. Rep. No. 1622, 83d Cong., 2d Sess. 99. Since the installment method of reporting would not be available on a sole proprietor’s sale of inventory, the installment method is not available for reporting income on the sale of a partnership interest to the extent attributable to substantially appreciated inventory which constitutes inventory within the meaning of IRC §453(b)(2)(B).
E. Assumption of Liabilities
A buyer taking property subject to an indebtedness, or who assumes the indebtedness of the underlying property, may or may not be deemed to have received a “payment” with respect to the indebtedness. If the indebtedness constitutes a “qualified indebtedness,” then the assumption will not be treated as a payment, except to the extent that the amount of the debt exceeds the seller’s adjusted basis in the transferred property. Treas. Reg. §15A.453-1(e)(1).
Qualifying indebtedness includes (i) mortgages, liens, overdue interest, or back taxes; and (ii) debts not secured by the property, but incurred by the purchaser in the ordinary course of business or investment. Temp. Treas. Reg. §15A.453-1(b)(2)(iv). Qualifying indebtedness does not include (i) an obligation of the taxpayer incurred incident to the disposition of the property; (ii) an obligation functionally unrelated to the acquisition, holding or operation of the property; and (iii) an obligation incurred in contemplation of the disposition of the property if the arrangement results in accelerating the taxpayer’s recovery of basis on the sale. Id. When calculating the gross profit ratio (i.e., gross profit over total contract price), the total contract price is reduced by only that portion of the indebtedness not exceeding the seller’s basis in the property. Temp. Treas. Reg. §15A.453-1(b)(2)(ii), (iii).
F. “Wraparound” Mortgages
Note that in the foregoing examples, the assumption of the mortgage by the purchaser reduces the total contract price. This in turn increases the gross profit ratio, and ultimately the tax liability. However, if the purchaser were not to assume an existing mortgage, a reduction in the total contract price, and the corresponding increase in the gross profit ratio, might be avoided. Mortgages which are not assumed by the purchaser are termed “wrap-around” mortgages. Temp. Treas. Reg. § 15A.453-1(b)(3)(ii).
In the case of a wrap-around mortgage, the seller remains fully liable on the mortgage. The buyer neither assumes nor takes the property subject to the mortgage or other indebtedness encumbering the property. Instead, the buyer issues to the seller an installment obligation the principal amount of which reflects the “wrapped” indebtedness. Treas. Reg. § 15A.453-1(b)(3)(ii). Payments made by the purchaser to the seller will be used to satisfy the holder of the “wrapped” indebtedness. However, if the purchaser defaults on the installment note, the seller will remain legally obligated to make the payments under the note. While the IRS initially challenged the tax treatment of wrapped indebtedness in temporary regulations, the Tax Court invalidated those regulations. See Professional Equities, Inc. v. Comr., 89 T.C. 165 (1987), acq., 1988-2 C.B. 1.
In holding Temp. Treas. Reg. §15A.453-1(b)(3)(ii) invalid as inconsistent with IRC § 453, the Tax Court in Professional Equities, Inc. v. Comm., 89 TC 165 (1987) held that the denominator should not be reduced by the amount of the underlying mortgage, since the buyer neither “assumed” the mortgage nor took the property “subject to” the mortgage. Accordingly, the smaller gross profit ratio is used to calculate the portion of each installment payment received that is subject to tax. The Tax Court noted that a reduction in the denominator of the gross profit ratio was not appropriate in the context of a wraparound sale, since the entire profit on the sale would be reached without any adjustment of the proportion through reduction of the contract price in the denominator. However, if the buyer is required to discharge the underlying mortgage, or if the seller has little control over the disposition of the payments made by the buyer, then the transaction will be treated as if the buyer had, in substance, taken the property subject to the underlying mortgage. The Service acquiesced to the Professional Equities, Inc., holding in 1988-2 CB 1.
G. Escrow Arrangements
Escrow arrangements often used in connection with installment sales of real property. Disputes have arisen over whether funds held in escrow are actually disguised payments. In Oden v. Commissioner, 56 TC 569 (1971), certificates of deposit held in escrow were held to constitute payment, and use of the installment method was denied. To use the installment reporting in connection with an escrow account, three requirements must be satisfied: First, the escrow arrangement must be the result of an arm’s-length agreement; second, the seller must have no beneficial interest in the escrowed funds; and third, the escrowee must not be acting under the exclusive authority of the selling taxpayer. Reed v. Commr, 723 F2d 138 (1st Cir 1983), rev’g. ¶82,734 P-H Memo TC.
H. Computation of Gain
1. Determine the gross profit. This is the excess of the selling price over the sum of the adjusted basis, selling expenses, and any depreciation recapture. The selling price is the total amount that the purchaser must pay, including any mortgages the purchaser assumes.
2. Compute the total contract price. The total contract price is the greater of (i) the gross profit or (ii) the selling price reduced by any “qualified indebtedness”.
3. Determine the “gross profit percentage”. This is the ratio of the gross profit to total contract price.
4. Apply the gross profit ratio to the payments received during the taxable year. The product is the taxable gain.
5. Determine depreciation recapture under sections 1245 and 1250. All income reported shall be deemed to consist of recapture amounts until all such gain has been reported. Treas. Reg. § 1.1245-6(d), 1.1250-1(c)(6).
6. Determine gain to be reported in year of sale, allocating recapture gain first.
7 Determine gain to be reported in subsequent years.
I. Disposition of Installment Notes
A taxpayer may dispose of one or more installments of an installment obligation in advance of having received all payments thereunder. Certain types of these dispositions may trigger a taxable event. Some dispositions of installment obligations that trigger a taxable event, such as the gift of an installment obligation, would not otherwise constitute a taxable event. IRC § 453B(a). In general, gain or loss recognized on the disposition is equal the difference between the fair market value of the obligation and its adjusted basis. The adjusted basis of an installment obligation is the face amount of the installment, reduced by the gross profit that would be realized if the holder collected the face amount of the obligation.
In the case of a gift, gain recognized equals the face amount of the obligation less its adjusted basis. A primary purpose of the disposition rules is to prevent income-shifting. For example, the distribution by a corporation of an installment obligation will result in immediate gain recognition. IRC § 453B(a). Some dispositions of installment obligations will not result in acceleration of gain or loss. Those situations include (a) certain corporate reorganizations and liquidations; (b) IRC § 351 transactions; (c) transfers incident to death or divorce; (d) distributions by a partnership; and (e) contributions to capital of a partnership. IRC § 453B.
J. Receipt of Installment “Boot”
in Nonrecognition Transactions
Proposed regulations address problems arising when a taxpayer engages in a nonrecognition transaction under IRC §§ 1031, 351, 356 or 721, and receives “boot” in the form of an installment obligation. Prop. Treas. Reg. §1.453-1(f).
1. IRC §1031 Exchanges
Under the installment sale rules, a seller is deemed to receive payment when cash or cash equivalents are placed in escrow to secure payment of the sales price. However, certain safe harbor provisions in the section 1031 regulations provide that cash placed in a qualified escrow account will not result in constructive receipt of the funds. Regulations under IRC § 1031 address this conflict by permitting the rules of IRC § 1031 to trump those of IRC § 453 in certain circumstances. Therefore, the installment sale rules under IRC § 453 will not necessarily hinder the application of IRC § 1031.
Under IRC § 453 a direct or indirect receipt of cash or cash equivalent is treated as the receipt of payment, Treas. Reg. § 1.1031(k)-1(j)(2) provides that a transferor is not deemed to have received an installment payment under a qualified escrow account or qualified trust arrangement, nor is the receipt of cash held in an escrow account by a qualified intermediary treated as a payment to the transferor under the rules, provided the following two conditions are met: (i) the transferor has a bona fide intent to enter into a deferred exchange at the beginning of the exchange period (IRC § 1.1031(k)-1(j)(2)(iv)); and (ii) the relinquished property does not constitute “disqualified” property. In general, disqualified property is property excluded from the purview of IRC § 1031. See Temp. Reg. § 15A.453-1(b)(3)(i). The relief from the otherwise operative installment sale rules ceases upon the earlier of the end of the exchange period or when the taxpayer has an immediate right to receive, pledge, borrow, or otherwise obtain the benefits of the cash or the cash equivalent. Treas. Reg. § 1.1031(k)-1(j)(2)(vi).
The like-kind property received in the exchange would not constitute “payment”. Prop. Treas. Reg. § 1.453-1(f)(2)(ii). The proposed regulations allocate the taxpayer’s basis in the relinquished property, to the extent of its fair market value, to the like-kind property received in the exchange. To the extent the taxpayer’s basis in the relinquished property exceeds the fair market value of the like-kind property received in the exchange, that excess is referred to as “excess basis.”
For the purpose of making installment method calculations, the taxpayer is treated as having made an installment sale of appreciated property whose basis equals the “excess basis,” and in which the consideration received is the installment obligation in addition to any other boot received. Prop. Treas. Reg. § 1.453-1(f)(1)(iii). Therefore, although the notes received are not considered boot at the time of the exchange, as the taxpayer receives payments on the installment obligation, a portion of each payment will constitute gain, and a portion will constitute a recovery of basis.
2. IRC §351, §356
or § 721 Transactions
Proposed regulations treat boot received in a section 351 exchange similar to manner in which boot is treated in a section 1031 like-kind exchange. An installment obligation received in a section 351 exchange that is not a security within IRC § 351(a) is treated as boot. The taxpayer reports gain with respect to the installment obligation on the installment method, and any other boot received will be treated as payment made in the year of the exchange. Prop. Treas. Reg. § 1.453-1(f)(3)(ii).
A taxpayer receiving installment boot in a transaction governed by IRC § 354 or § 355 would, to the extent the installment boot is not treated as a dividend, report the gain in a manner similar to the method in which installment boot gain would be reported in a section 1031 like-kind exchange or in a section 351 transaction.
A taxpayer does not recognize gain or loss on a contribution of property to a partnership in exchange for an interest in the partnership. IRC § 721(a). However, if a transfer of property to a partnership is followed by a direct or indirect transfer of money or other property to the partner, the disguised sale rules may treat the transaction as a sale or exchange of the property. IRC § 707(a)(2)(B). Under the treasury regulations, if in exchange for the transfer of property the partner receives both a partnership interest and other property, the transaction is treated as a partial sale. Treas. Reg. § 1.707-3(f). If an installment note were to constitute payment instead of cash, the transaction would presumably be treated as a partial sale of the property in exchange for an installment obligation.
K. Interest and Pledge Rules
IRC § 453 allows gain on an installment sale to be reported on a deferred basis. It permits the spreading of the income tax over the period during which payments of the sales price are received,” and thus “alleviates possible liquidity problems which might arise from the bunching of gain in the year of sale when a portion of the selling price has not actually been received.” H. Rept. 96-1042 at 5 (1980); S. Rept. 96-1000, at 7 (1980), 1980-2 C.B. 494, 497.
Laudable as these objectives are, the installment sale rules also permit the taxpayer to obtain an interest-free loan from the government until tax has actually been reported. There is also no bar to the taxpayer pledging the installment obligation for a loan. The taxpayer could in this manner extract cash from an installment sale without incurring any immediate tax.
In response to these concerns, Congress enacted IRC § 453A, which applies to installment obligations of $150,000 or more arising from any nondealer installment sale after December 31, 1988. IRC § 453A(b)(1). If an obligation to which IRC § 453A applies is outstanding at the close of the taxable year, a taxable interest charge is imposed; that charge is equal to the product of the “applicable percentage of the deferred tax liability” and the underpayment rate.
If an installment obligation is used as security for a loan, the net proceeds of the loan will be considered as payment of the installment obligation on the later of the time when (i) the indebtedness becomes a “secured indebtedness” and (ii) the proceeds of such indebtedness are received by the taxpayer. IRC § 453A(d). However, the amount of the net loan proceeds treated as a deemed payment may not exceed the excess of the total contract price of the installment obligation over any portion of the total contract price received before the time the deemed payment arises. IRC § 453A(d)(2). After a deemed payment is received under the installment obligation pursuant to the pledge rule, any actual payments received with respect to the installment obligation will result in gain recognition only to the extent those payments exceed the deemed payment. IRC § 453A(d)(3). The $5,000,000 threshold applicable to the interest change does not apply to the pledge rules.
The Tax Relief Act of 1999 extended the pledge rules to indirect pledges by providing that any arrangement into which the taxpayer enters which gives him the right to satisfy an obligation with an installment note, will be treated in the same manner as the direct pledge of the installment note. IRC § 453A(d)(4). The Committee Report provides that “were the taxpayer to pledge the installment note as security for a loan, it would be required to treat the proceeds of such loan as a payment on the installment note . . . Under the provision, the taxpayer would also be required to treat the proceeds of a loan as payment on the installment note to the extent the taxpayer had the right to “put” or repay the loan by transferring the installment note to the taxpayer’s creditor.” Conference Agreement, H.R. 1180.
Despite the new rule relating to indirect pledges, it is not clear whether the pledge of an installment obligation as security for an obligation rather than for a loan, or for a loan guarantee, will constitute a “secured indebtedness” under IRC § 453A. It is possible that pledging an installment obligation as security for an obligation to pay rent under a lease does not result in “indebtedness” under the statute, and the payments due under the lease are not “net proceeds under the loan.” If this is the case, it may be advantageous for taxpayers holding installment obligations to lease, rather than purchase, property, and secure the lease obligation with the installment obligation.