As income tax rates increase, beware of certain deferral strategies

Monetizing installment sale techniques may draw IRS scrutiny

While still in the proposal phase, the Biden administration has proposed an increase in the long-term capital gains rate to 39.6% from 20% for households making more than $1 million. A summary of the Biden plan can be found in this article: President Biden unveils his American Families Plan. After inclusion of state and local taxes and the net investment income tax, this can leave taxpayers looking at tax rates on capital gains in excess of 50%, which would represent a very significant increase. Beyond holding investments and not selling, taxpayers are likely to look for monetization strategies that attempt to defer taxation, yet provide liquidity. One such example involves monetized installment sale (MIS) transactions, which generally involve monetization of the installment consideration through a third party loan while hoping to avoid gain acceleration rules. 

In a recently issued Chief Counsel Advice (CCA), the IRS raised concerns regarding just the types of MIS transactions that taxpayers may look at more closely if higher rates become a reality. The CCA is a reminder that transactions such as MIS transactions must be scrutinized closely to ensure they comply with both the form and substance of the federal tax rules. 

What are monetized installment sale transactions?

In general, under section 1001, a taxpayer who sells property must recognize gain and pay tax currently on the sale of property. However, if payment of the purchase price is deferred, the installment sale rules of section 453 generally allow taxpayers to defer the tax until the year of payment. 

Example: Seller sells property with a FMV of $100M and an adjusted basis of $20M. Seller’s gain realized is $80M. Instead of paying the purchase price in cash, in Year 1 Buyer issues Seller an installment note for $100M (plus adequate interest), payable after five years. Buyer makes the payment on the note in Year 5. Under the installment sale rules, Seller defers the $80M of capital gain until Year 5.

While deferral is obtained in an installment sale, the taxpayer does not receive access to proceeds, which drives the attempt to monetize without accelerating gain. Congress eliminated the ability to borrow against the installment sale consideration by adding section 453A(d)(4), which generally provides that if debt is secured by an installment obligation, the debt proceeds are treated as a payment. 

Example: In the above example, In Year 1 Seller borrows $100M from a bank for five years and uses as collateral the installment note received from Buyer. Seller must include the entire $100M as the amount realized and recognize $80M of capital gain in Year 1.

The CCA addresses the IRS concerns with elements of MIS transactions that promoters have suggested avoid the acceleration rule. In a common MIS transaction, a seller sells property to an intermediary in exchange for a note. The intermediary then immediately sells the property to a buyer for cash. The intermediary does not realize any gain on this sale, as the intermediary’s basis in the property is now equal to the sales price. The seller then obtains a loan from a bank in the amount of the note. The seller does not pledge the intermediary’s installment obligation as security for the loan. Rather, the intermediary establishes an escrow account into which the intermediary places the cash proceeds and from which the intermediary makes interest payments to the bank. When the intermediary ultimately pays the seller as required under the note’s terms, the seller repays the bank loan. 

Chief Counsel Advice Memorandum 202118016

CCA 202118016 states that although there are variations in the way MIS transactions are structured, there are some common features that make the transactions “problematic.” It states further that “we generally agree that the theory on which promoters base the arrangements is flawed” and that “the general structure raises a number of issues.”

The CCA notes several specific problems with various forms of MIS transactions, including:

• The ‘economic benefit’ doctrine, which dictates that a tax is imposed on a taxpayer for any benefit conferred so long as the benefit has an ascertainable fair market value. Here, in effect, the cash escrow is security for the loan to the taxpayer. If so, the taxpayer economically benefits from the cash escrow and should be treated as receiving payment under the economic benefit doctrine for purposes of section 453.
• Whether the intermediary was the true buyer. Under case law, in a back-to-back sale situation intermediaries are sometimes ignored. Here, the intermediary does not appear to be the true buyer of the property sold, which is immediately thereafter sold to the true economic buyer. Under section 453(f), only debt instruments from an ‘acquirer’ can be excluded from the definition of payment and not constitute payment for purposes of section 453. Debt instruments issued by a party that is not the ‘acquirer’ – such as the intermediary in this case – might be considered payment, requiring immediate recognition of gain.
• The cash escrow. The regulations state: “Receipt of an evidence of indebtedness which is secured directly or indirectly by cash or a cash equivalent . . . will be treated as the receipt of payment.” Reg. section 15a.453-1(b)(3). Here, the installment note from the intermediary to the seller is secured by a cash escrow. The taxpayer might therefore be treated as receiving payment irrespective of the pledging rule. 

Conclusion

CCA 202118016 is a reminder that taxpayers should carefully analyze tax deferral techniques that appear too good to be true and seek appropriate tax advice.