Becker shareholder Michael Burwick authored the following insights to Bloomberg Tax about why potential complications of proposed IRS regulations on installment sales would require certain advisers to file disclosures.
The IRS’s proposed regulations on monetized installment sale transactions are broad enough to implicate ethical transactions in its aim to capture abusive ones. The final regulations will determine which transactions are permissible and that must be listed. Tax advisers must exercise extreme caution in the meantime until there is clear guidance from the IRS.
The proposed regulations, announced last August, would identify monetized installment sale transactions and substantially similar transactions as listed transactions. Under this proposal, material advisers and participants in these listed transactions would be required to file disclosures with the IRS and would be penalized for failure to disclose.
The announcement set forth a hearing scheduled for October that was canceled, and now those potentially impacted by these proposed regulations remain in the dark on a final outcome.
Installment sales, which are covered by Section 453 of the tax code, are sales of an asset (such as a property or business) in which at least one payment is received after the tax year of sale. Many material advisers have used Section 453 to time the payment of capital gains taxes by redeploying the sales proceeds of disposed assets into other forms of for-profit, business-generating activities without the sellers realizing or recognizing the sale proceeds at the time of disposition.
Many well-intentioned material advisers have used Section 453 as a way to redeploy capital from a sale or disposition whereby such capital remains in the stream of commerce—not as a tax avoidance mechanism. Both ordinary income taxes generated by this redeployment and capital gains taxes on the original disposition are paid in full to the IRS when ordinary income and principal are received periodically by the taxpayer.
There are several problems with this description and with the proposed regulations more generally. The monetized installment sale is a specific transaction that aims to place the sale proceeds almost immediately back in the hands of the seller through a series of complex transactions that are designed to circumvent constructive receipt.
This truly monetized version of the installment sale has been proposed and used by only a handful of promoters and, upon review, it isn’t that difficult to see why the IRS has issues with its use as the sale proceeds wind up in the control of the seller in the year of sale. However, the IRS conflates this transaction with many other less aggressive installment sale strategies that it would likely deem substantially similar.
The key difference is the timing of the payments to the seller over multiple tax years. In a true monetized installment sale, the sale proceeds are in the dominion and control of the seller in the year of sale.
In other forms of structured installment sales, the sale proceeds are reinvested in the stream of commerce without ever coming under the control of the seller. This generates revenue—both for the benefit of the for-profit enterprise and to enable payment on the installment sale pursuant to the terms of a note—while also preserving the principal from the sale to be returned to the seller as both capital gain and return of basis.
The seller receives income in the form of interest payments, capital gain, and return of basis each year over a period of tax years. This isn’t tax avoidance—the IRS nets more in taxes through the use of these installment sale transactions than it would under a straight sale because of the addition of income taxes on top of capital gains taxes, as there is no tax on the return of basis.
Moreover, the proposed regulations would seem to include Section 453A, which deals primarily with agriculture. The provision explicitly allows for monetization; it eliminates the anti-pledge rule for these types of applicable transactions.
This was enacted because of the unique nature of agriculture, the periodic harvesting of crops, and the sale of livestock. To include Section 453A in these regulations would essentially usurp the role of Congress in enacting this provision and would cause tremendous harm to an already struggling agricultural industry.
While the IRS has the right and obligation to curb tax code abuse, these proposed regulations cast a very wide net to capture a small number of abusive transactions. In turn, they implicate ethical transactions that are harmonious with the tax code and where all taxes are paid in full.
During this period of uncertainty, both taxpayers and material advisers alike must be cautious. When it comes to undertaking a non-intermediated installment sale, if executed properly, there should be no issue, even if the proposed regulations are enacted in full. At the other extreme, truly monetized installment sales, except in the Section 453A context, will most certainly be deemed listed transactions.
In between these two extremes, there are the various flavors of structured installment sales. Here, at least until the IRS provides clear guidance, there is a risk-reward scenario. Taxpayers must proceed delicately if they elect to defer their capital gains taxes through the use of one of these strategies, especially as the IRS proposes a six-year retroactive mandate as to deeming these listed transactions.
If taxpayers and their advisers elect to move forward, they do so with the risk that the regulations will be enacted in a broad manner as proposed by the IRS. The only other option is to engage in a non-intermediated installment sale, which has its own challenges, or to pay the capital gains taxes in full at the time of disposition, which essentially removes Section 453 from the tax code.
We need prompt clarity from the IRS on these regulations. Let’s hope for something that only captures clearly abusive transactions and delineates this small subset of truly monetized installment sales from the rest.
To read the article in Bloomberg, click here.
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