Defer tax with IRC 453, without crossing the line
The advantage of owning is that you pay no taxes until you sell. The downside is that the longer you own, the worse the sale hurts. Fortunately, there are ways to transfer your capital into a new investment, tax-free. The first is to use the old investment as collateral for a loan. Another is a 1031 exchange or any other unrecognized transaction. This article discusses a third method, the seller-financed installment sale under Section IRC 453.
Installment sales work like 1031 swaps: interest payments are taxed like the rent on the replacement property. Principal payments are taxed as partial dispositions of that property. They are more flexible than 1031s, in that the asset being relinquished does not have to be real estate. Even better, the buyer gets a cost basis, before they have paid anything. Ideally, the income from the ticket is more reliable than the income from the seller’s former business. If the buyer’s creditworthiness is in doubt, the parties can pay an escrow company to secure the note.
The installment method is rightly the first suggestion on any tax planner’s tongue. But sometimes it doesn’t work. This article summarizes these situations.
Prohibitions related to the nature of the property sold
Sometimes installment processing is denied due to certain characteristics of the property being sold. In the table below, the left column identifies the ineligible assets. The right column describes how to treat the sale of an interest in a partnership that owns these assets, i.e. if we “review” the partnership and test its underlying assets.
Congress directed the Treasury to prescribe regulations providing that, in an installment sale, the sale of an interest in a partnership “shall be treated as a sale of the proportionate share of the assets of the partnership.” See IRC Section 453A(e). The Treasury has yet to do so, and it is unclear what force the law has in their absence. See Philippe Gall, “Shadow tax regulation: the curse of rejected delegations(analyze when delegations to create regulations have independent legal force); Field Service Advice, 1995 FSA Lexis 124 (11 September 1995) (citing IRC Section 453A(e)(2) and Rev. Rule. 89-108 such as the power to treat the sale of the interest in the partnership as the sale of proportionate shares of the assets of the partnership).
Prohibitions unrelated to the nature of the asset sold
In other cases, tranche processing is denied for reasons that are not closely related to the nature of the asset being sold. These include:
Sales by resellers—see IRC Sections 453(b)(2)(A), 453(l); Payment obligations secured by cash or cash equivalents – see Treasures. Reg. § 15a.453-1(b)(3)(i)). See Bittker & Lokken, “Federal Taxation of Income, Estates and Gifts” ¶108.3, “cash equivalent” probably does not include widely traded stocks; however, “prudence advises against securing a payment obligation with a pledge of any debt obligation for which a market exists”; installment bonds offered as security for another loan – see IRC Section 453A(d); holds laddered obligations of more than $5 million in this year. The staggered salary is not denied, but the taxpayer owes interest on the excess. See IRC Section 453A(c); Sales to a related party, who resells the asset without having borne the risk of loss in value for at least two years—see IRC Section 453(e) and Election out—see IRC Section 453(d).
Substance (equity) rather than form (debt)
Continuing the 1031 analogy, an installment seller can only “exchange” the buyer’s note. That is, the seller’s new business must consist solely of collecting interest on an amount in principal equal to the pre-tax selling price of his old business. Indeed, the seller must move from a capital position to a debt position. But what if the seller is not interested in becoming a lender? Using a remittance note, can the seller trade for a non-loan, equity-like position?
In my opinion, this is what intermediate installment sales seek to offer. These are market transactions that involve a formally independent intermediary but who, in practice, is a paid agent of the seller. The intermediary purports to purchase the asset from the seller for an installment payment, receiving a cost basis. Then it immediately sells the asset, tax-free, to a pre-agreed buyer for the same cash price, which is used to service the remittance note. The most aggressive arrangements include these features:
The intermediary selects a NewCo to invest in, reflecting the seller’s appetite for risk and reward. The intermediary’s “note” has an above-market interest rate, matching NewCo’s yields, effectively transferring equity value from the intermediary to the seller. This increases the likelihood that the intermediary will default on the loan. Nevertheless, the loan is insufficiently secured; it is secured by the invested assets but is not guaranteed. These operations are popular. However, looking at substance rather than form, debt seems to me to cross the line into a retained interest, that is, a high-risk, high-return interest, similar to a stake in NewCo.
This is not an installment sale; it is a service relationship, in which the “seller” pays for the services of the intermediary who acts as the commercial agent of the seller and prepares documents which conceal this fact. To see See Knetsch v. US, 364 US 361— the difference of $91,570 retained by the company corresponded to its fees for providing the facade of “loans” by which the applicants sought to reduce their taxes for 1953 and 1954 for a total amount of $233,297.68. To see Treasures. Reg. Section 15a.453-1(c)(1): Refuse installment processing when the seller has a “retained interest” in the property sold, i.e. when “the payment obligation represents, according to the applicable principles of tax law, a retained interest in the property which is the subject of the transaction, an interest in a joint venture or a partnership, an interest in a company or similar transactions”.
In CCA 202118016, the chief IRS attorney announced that he was studying a particular arrangement, the “monetized installment sale”. In my opinion, his logic applies to all intermediate installment sales. Proceed with caution.
This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Andrew Gradman is the director of the law firm of Andrew L. Gradman.
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