Too Good . . .?
What if I told you that you could sell your property today, receive cash in an amount equal to the property’s fair market value, and defer the payment of any tax imposed upon the gain from the sale?[i]
It sounds contrived, doesn’t it? How can one have their cake and eat it too?[ii]
Interestingly, a number of folks of late have asked me about so-called “monetized installment sales,” which are a form of transaction that promises these very results.
Before describing how such sales are often “structured,” and then reviewing their intended tax consequences, it would behoove us to first review the basic rules for the taxation of an ordinary installment sale.
Assume that a taxpayer sells a capital asset or Section 1231 property[iii] to a buyer in exchange for cash that is payable at closing. The buyer may have borrowed the cash for the purchase from a third party; or it may be that the buyer had enough cash of their own available to fund the purchase.
The gain realized by the seller from the conversion of the property into cash is treated as income to the seller. The “amount realized” from the sale is equal to the amount of cash received. The general method of computing the seller’s gain from the sale contemplates that, from the amount realized, there shall be withdrawn an amount equal to the seller’s adjusted basis for the property – i.e., an amount sufficient to restore to the seller their unreturned investment in the property.[iv]
The amount which remains after the adjusted basis has been restored to the seller – i.e., the excess of the amount realized over the adjusted basis – constitutes the realized gain. This gain is generally included in the selling taxpayer’s gross income for the taxable year of the sale, and is subject to federal income tax.[v]
Seller has owned and used Property in their business for several years. Property has a FMV of $100. Seller’s adjusted basis for Property is $40. In Year One, Seller sells Property to Buyer for $100 of cash which is paid at closing. Seller’s gain from the sale is $100 minus $40 = $60. Seller includes the entire $60 in their gross income for Year One.
Years ago, however, Congress recognized that it may not be appropriate to tax the entire gain realized by a seller in the taxable year of the sale when the seller has not received the entire purchase price for the property sold; for example, where the seller is to receive a payment from the buyer in a taxable year subsequent to the year of the sale, whether under the terms of the purchase and sale agreement,[vi] or pursuant to a promissory note given by the buyer to the seller in full or partial payment of the purchase price.[vii]
In cases where the payment of the purchase price is thus delayed, the seller has not completed the conversion of their property to cash; rather than having the economic certainty of cash in their pocket, the seller has, instead, assumed the economic risk that the remaining balance of the sale price may not be received. It is this economic principle that underlies the installment method of reporting.[viii]
A sale of property where at least one payment is to be received after the close of the taxable year in which the sale occurs is known as an “installment sale.”[ix] For tax purposes, the gain from such a sale is reported by the seller using the installment method.[x]
Under the installment method, the amount of any payment which is treated as income to the seller for a taxable year is that portion (or fraction) of the installment payment received in that year which the gross profit realized bears to the total contract price (the “gross profit ratio”). Generally speaking, the term “gross profit” means the selling price for the property less the taxpayer’s adjusted basis for the property – basically, the gain.
Stated differently, each payment received by a seller is treated in part as a return of their adjusted basis for the property sold,[xi] and in part (the gross profit ratio) as gain from the sale of the property.
Same facts as Example A, above, except that Buyer pays Seller $20 at closing, in Year One, and gives Seller a 4-year promissory note with a face amount of $80; the note provides for equal annual principal payments of $20 in each of Years Two through Five. The note also provides for adequate interest that is payable and compounded annually.[xii] Seller’s gross profit is $100 minus $40 = $60. Seller’s contract price is $100. Thus, Seller’s gross profit ratio is $60/$100 = 60%. When Seller receives the $20 payment in Year One, Seller will include in their gross income for Year One an amount equal to 60% of the $20 payment, or $12. The same methodology will be applied over the term of the note. Thus, assuming the timely payment of $20 of principal every year, [xiii]Seller will include $12 in their income in each of Years Two through Five; a total of $60 of gain.[xiv]
The seller’s tax liability that arises from a sale that is reported under the installment method is incurred upon the seller’s receipt of payment; thus, one must be able to identify when such a payment has been received.
For purposes of the installment method, the term “payment” includes the actual or constructive receipt of money by the seller.[xv]
It also includes the seller’s receipt of a promissory note from the buyer which is payable on demand or that is readily tradable.
Receipt of an evidence of indebtedness which is secured directly or indirectly by cash or a cash equivalent[xvi] will be treated as the receipt of payment.
In each of these instances, the seller has wholly converted their interest in the property sold to cash, or they have been given the right to immediately receive cash, or they are assured of receiving cash – they are in actual or constructive receipt of the cash.[xvii]
Because there is no credit risk associated with holding the buyer’s note and awaiting the scheduled payment(s) of principal, the seller is treated, in these instances, as having received payment of the amount specified in the promissory note or other evidence of indebtedness.
However, a payment does not include the receipt of the buyer’s promissory note – an “installment obligation”[xviii] – that is payable at one[xix] or more specified times in the future, whether or not payment of such indebtedness is guaranteed by a third party, and whether or not it is secured by property other than cash or a cash equivalent.[xx]
In the case of such a note, the seller remains at economic risk until the note is satisfied. Thus, that portion of the seller’s gain that is represented by the note will generally be taxed only as principal payments are received.
The “Anti-Pledge” Rule
It goes without saying that sellers will usually welcome the deferral of gain recognition and taxation that the installment sale provides. At the same time, however, sellers have sought to find a way by which they can currently enjoy the as-yet-unpaid cash proceeds from the sale of their property without losing the tax deferral benefit.
One method that was previously utilized to accomplish this goal was for the seller to borrow money from a lender and to pledge the buyer’s installment obligation as security for the loan. In this way, the seller was able to immediately access funds in an amount equal to the proceeds from the sale of their property, while continuing to report the gain from the sale under the installment method as the buyer made payments on the installment obligation; the loan that was secured by the installment obligation would be repaid as the installment obligation itself was satisfied.
Congress eventually became aware of this monetization technique and concluded that it was not consistent with the principles underlying the installment method. In response, Congress amended the installment sale rules[xxi] to provide that if any indebtedness is secured by an installment obligation, the net proceeds of the secured indebtedness will be treated as a payment received on the installment obligation as of the later of the time the indebtedness becomes “secured indebtedness,” or the time the proceeds of such indebtedness are received by the seller.[xxii]
For purposes of this rule, an indebtedness is secured by an installment obligation to the extent that payment of principal (or interest) on such indebtedness is directly secured – under the terms of the indebtedness or any underlying arrangements – by any interest in the installment obligation. A payment owing to the lender will be treated as directly secured by an interest in the buyer’s installment obligation to the extent “an arrangement” allows the seller to satisfy all or a portion of the indebtedness with the installment obligation.[xxiii] It is significant that the Conference Committee report to the Tax Relief Extension Act of 1999 indicates that “[o]ther arrangements that have a similar effect would be treated in the same manner.”[xxiv]
Same facts as Example B, above, except that in Year Two, Seller borrows $80 from Lender, and pledges Buyer’s $80 promissory note as security for the loan. Seller is treated as having received a payment of $80 on the promissory note in Year Two, and is therefore required to report $48 of gain on its tax return for Year Two.[xxv]
Interestingly, the above anti-pledging rule was limited in its reach to obligations which arise from the installment sale of property where the sales price of the property exceeds $150,000; for purposes of applying this threshold, all sales which are part of the same transaction (or a series of related transactions) are treated as one sale.[xxvi]
Monetized Installment Sale
Following the above change in the Code, many advisers and taxpayers set out to find another way to accomplish the desired result – immediate cash and deferred tax – but without running afoul of the anti-pledging rule.
As far as I can tell, what has emerged, generally speaking, is the following four-party structure:
- Seller wants to sell a Property to Buyer, immediately receive cash in an amount equal to Property’s fair market value, and defer the recognition of any gain realized from the sale under the installment method;
- Seller sells Property to Intermediary[xxvii] in exchange for Intermediary’s unsecured installment obligation in an amount equal to Property’s fair market value; the loan provides for interest only over a fairly long term, followed by a balloon payment of principal, at which point the Seller’s gain from the sale would recognized;
- Intermediary immediately sells Property to Buyer for cash;[xxviii] Intermediary does not realize any gain on this sale;[xxix]
- Seller obtains a loan from Lender, the terms of which “match” the terms of Intermediary’s installment obligation held by Seller; Seller does not pledge Intermediary’s installment obligation as security for the loan;[xxx] escrow accounts are established to which Intermediary will make interest payments, and from which the interest owed by Seller will be automatically remitted to Lender;
- Seller has the non-taxable loan proceeds which they may use currently; Seller will typically invest the proceeds in another business or investment, at least initially, so as to demonstrate a “business purpose” for the loan;[xxxi]
- Seller will report gain on the sale of Property only as Intermediary makes payments to Seller under its installment obligation; in the case of a balloon payment, the gain will be reported and taxed when the obligation matures;
- Seller will use the payment(s) to repay the loan from Lender.
To date, the IRS has not directly addressed the foregoing arrangement. That being said, there is a single Field Attorney Advice (FAA 20123401F)[xxxii] – which represents non-precedential legal advice issued to IRS personnel from the Office of Chief Counsel (“OCC”) – that considered the application of the “substance over form” and “step transaction” doctrines to a fact pattern that included some of the elements described above. It appears that many in the “monetized installment sale” community point to this FAA as support for their transaction structure.
The taxpayer in the FAA was a business entity that needed to raise a lot of cash for a bona fide business purpose.[xxxiii] In order to do so, it decided to sell a portion of its assets. The buyer gave the taxpayer installment notes that were supported by standby letters of credit (issued by Lender A) that were nonnegotiable and could only be drawn upon in the event of default. The taxpayer then borrowed money (from Lender B) in an amount less than the buyer’s installment notes, and pledged the buyer’s notes as security. This pledge would normally have triggered immediate recognition of the gain from the sale; however, the assets constituted farm assets and, so, were exempt from the anti-pledge rule.[xxxiv]
The OCC acknowledged that, in form, the transaction comprised an installment sale and a loan that monetized the installment obligation. The question presented to the OCC was whether the substance of the transaction was essentially a sale for cash because, shortly after the asset sale, the taxpayer obtained the amount of the sale price in cash, through the loan proceeds, all while deferring the recognition of gain and the payment of the resulting tax.
The OCC concluded that the asset sale was a real transaction carried out to raise cash for the taxpayer. The letter of credit provided security for the taxpayer in the event the buyer defaulted on its installment obligation. The monetization loan was negotiated with a different lender than the one what issued the letter of credit. The economic interests of the parties to both transactions changed as a result of the transactions. The transactions reflected arm’s-length, commercial terms, each transaction had independent economic significance, and the parties treated the transactions as a separate installment sale and a monetization loan. Thus, the substance over form and step transaction doctrines were inapplicable.
Monetization, Here We Come?
Call me jaded, but I wouldn’t move too quickly to engage in such a transaction.[xxxv]
The fact remains that the IRS has not spoken to the form of monetized installment sale transaction described above.
The FAA on which the “intermediaries” of such transactions rely is not precedential and addresses the case of a taxpayer that was not even subject to the anti-pledge rule. What’s more, that taxpayer was compelled by a pressing business reason to engage in the sale in the first place – it had to raise cash for purposes of its continuing business.
By contrast, the taxpayer to whom a monetization structure is typically directed is selling their entire interest in the business or property – they are cashing out, period.
In recognition of this fact, and in order to “soften” its impact, some intermediaries recommend (others “require”) that the selling taxpayer immediately invest the loan proceeds in another property or business.[xxxvi]
As for the bona fide nature of the transaction-elements that comprise the installment sale monetization structure, consider the following: the taxpayer will sell the property to the intermediary in exchange for a long-term (thirty years is often mentioned), interest-only, unsecured loan. How is this a commercially reasonable transaction?
The intermediary, in turn, will immediately resell the property acquired from the taxpayer to the buyer, usually for cash – indeed, the property is often direct-deeded from the taxpayer to the buyer, so that the intermediary never comes into title. Thus, the intermediary never really “owns” the property – they merely act as a conduit.[xxxvii]
What’s more, the intermediary’s interest payments and, ultimately, the balloon payment, match the payments owing from the seller to the lender. The accounts that are created for the purposes of receiving the intermediary’s interest payments to the taxpayer, and of then remitting the taxpayer’s interest payments to the lender, ensure that the taxpayer never has control over these funds, and afford the lender a degree of security.
Query: why didn’t the taxpayer just sell the property to the buyer for cash, and pay the intermediary a broker’s fee for putting the parties together? Why turn down an all-cash buyer and accept a long-term promissory note instead, while at the same time borrowing an equal amount from a third party?
In the meantime, the intermediary has cash available for its long-term use – i.e., until the maturity date of the intermediary’s installment obligation to the taxpayer, which happens to coincide with the maturity date of the lender’s loan to the taxpayer – in the amount of the balloon payment which it received from the buyer as payment of the sale price for the property.
Although it is not clear to me where these funds are kept, or how they are invested by the intermediary, based upon the arrangements made for the interest payments, and given what must be described as the lender’s and the intermediary’s risk aversion, it is probably safe to say that the balloon payment – which ultimately belongs to the selling taxpayer and then the lender – is itself protected.
No, this arrangement is not undertaken as a formal pledge by the seller-taxpayer of the intermediary’s installment obligation; and, no, the intermediary’s obligation to the seller is not formally “secured” by cash or cash equivalents.
Nevertheless, the monetized installment sale arrangement described above is substantively the same as one or both of these gain-recognition-triggering events. As noted, above, “[o]ther arrangements that have a similar effect” should be treated in the same manner.[xxxviii]
The IRS should clarify its position accordingly.
[i] No, the recreational use of marijuana is not yet legal in New York.
[ii] Have I ever mentioned my knack for mangling idioms? I think I got this one right. That being said, I was once speaking to a group of accountants and, after belaboring a particular point, I said something like “Well, we’ve beaten this horse to death.” After a collective gasp from the audience, someone corrected me, stating that the phrase I should have used was “beating a dead horse.” Either way, it’s not a pretty visual.
[iv] IRC Sec. 1001; Reg. Sec. 1.1001-1. The unreturned investment – the adjusted basis – is the taxpayer’s original cost basis for the property, plus the cost of any capital expenditures (for example, improvements to tangible property, or additional paid-in capital in the case of an equity interest in a business entity); depending on the property, this amount may be reduced by any depreciation allowed or allowable; in the case of stock in a corporation, certain distributions will reduce a shareholder’s basis; in the case of pass-through business entities, the allocation of losses to the interest holder will reduce basis. You get the picture.
[v] IRC Sec. 1 and Sec. 11. In the case of an “individual,” the gain may also be subject to the 3.8% surtax under IRC Sec. 1411.
[vi] For example, where an amount otherwise payable by the buyer is held in escrow for the survival period of the seller’s reps and warranties (to secure the buyer against the seller’s breach of such), or where there are earn-out payments to be made over a number of years (say, two or three) based on the performance of the property (almost always a business).
[vii] There are many reasons why a buyer will give a note to the seller rather than borrowing the funds from a financial institution; for one thing, the buyer may have greater leverage in structuring the terms of the note vis-à-vis the seller. In addition, the buyer will often seek to offset the note amount by losses incurred as a result of the seller’s breach of a rep or covenant.
[viii] In general, there is a direct correlation between the economic certainty of a seller’s “return on investment” on the sale of property and the timing of its taxation; where the delayed payment of the sales price creates economic risk for the seller, the taxable event will be delayed until the payment is received.
[ix] IRC Sec. 453; Reg. Sec. 15a.453-1.
[x] Installment reporting does not apply to a sale that results in a loss to the seller. The loss is reported in the year of the sale.
Nor does it apply to the sale of certain assets; for example, accounts receivable, inventory, depreciation recapture, and marketable securities. These are ordinary income items that are recognized in the ordinary course of business, or they are items that represent cash equivalents.
It should also be noted that a seller may elect out of installment reporting, and thereby choose to report its entire gain in the year of the sale. This was certainly an attractive option before 2018, where the seller may have had expiring NOLs under IRC Sec. 172.
[xi] One minus the gross profit ratio.
[xii] We assume that the interest is determined at the Applicable Federal Rate under IRC Sec. 1274. If a lesser amount of interest were payable, the IRS would effectively treat a portion of each principal payment as interest income, thereby converting what would have been capital gain into ordinary income.
[xiii] Of course, the interest paid by the buyer will also be included in the seller’s gross income.
[xiv] The same amount of gain recognized in the first Example.
[xv] Reg. Sec. 15a.453-1(b)(3).
[xvi] For example, a bank certificate of deposit or a treasury note.
[xvii] By demanding payment on the note or by selling the note or by simply waiting for the scheduled time.
[xviii] A promise to pay in the future.
[xix] A balloon at maturity.
[xx] A standby letter of credit is treated as a third party guarantee; it represents a non-negotiable, non-transferable letter of credit that is issued by a financial institution, and that may be drawn upon in case of default – it serves as a guarantee of the installment obligation. In the case of an “ordinary” letter of credit, by contrast, the seller is deemed to be in constructive receipt of the proceeds because they may draw upon the letter at any time.
[xxi] IRC Sec. 453A(d). P.L. 100-203, Revenue Act of 1987.
[xxii] If any amount is treated as received with respect to an installment obligation as a result of this anti-pledge rule, subsequent payments actually received on such obligation are not taken into account for purposes of the installment sale rules, except to the extent that the gain that would otherwise be recognized on account of such payment exceeds the gain recognized as a result of the pledge.
[xxiii] IRC Sec. 453A(d)(4).
[xxiv] P.L. 106-170; H. Rep. 106-478.
[xxv] $80 multiplied by the gross profit ratio of 60% = $48.
[xxvi] IRC Sec. 453A(b)(1) and (5). Among the installment obligations excluded from the reach of this provision are those which arise from the sale of property used or produced in the trade or business of farming.
[xxvii] A person who facilitates these transactions in exchange for a fee.
[xxviii] In fact, the Intermediary will often, if not usually, have the Property direct-deeded from Seller to Buyer.
[xxix] Do you see where this cash goes? It appears to remain with Intermediary.
[xxx] On its face, therefore, the arrangement does not trigger the anti-pledge rule under IRC Sec. 453A.
[xxxi] It appears that most intermediaries suggest that this be done, at least for an “initial period” so as to demonstrate a business purpose for the loan. The implication is that, after a period of “cleansing,” the investment may be liquidated and the funds used for any purpose at all.
[xxxiii] Which explains the “suggestion” made by many intermediaries that the loan proceeds be applied by the seller toward a business or investment purpose, at least initially.
[xxxiv] IRC Sec. 453A(b)(3).
[xxxv] Stated more colorfully, and perhaps too harshly, as Billy tells Dutch in the 1987 movie Predator, “I wouldn’t waste that on a broke-dick dog.”
[xxxvi] Query how many actually do so.
[xxxvii] This is something that the arrangement borrowed from the deferred like-kind exchange rules.
[xxxviii] P.L. 106-170; H. Rep. 106-478.