The Installment Method Under Section 453 of Internal Revenue Code

In episode 35 of How Tax Works, Matt Foreman discusses sales where payment is over a number of years, with additional discussions of interest payments due to large notes and interaction with 1031 exchanges

How Tax Works, hosted by Falcon Rappaport & Berkman LLP Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions.

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Transcript

Matthew Foreman [00:00:03]:
Welcome to the 35th episode of How Tax Works. I'm Matt Foreman. In this episode, I'll discuss the installment method under Section 453 of the Internal Revenue Code. Uh, obviously not as, uh, exciting— I don't know— of a topic as AI and tax. I think it's a pretty interesting one. It's definitely one that's worth— you run into it a lot. Obviously, we're back to the original music, but we farmed out the music, see how AI would reimagine the music, which one was kind of jazzy, funky, just sort of a little bit of a remix. We actually got one, and I am not exaggerating this here.

Matthew Foreman [00:00:45]:
Someone did it with rap. Pretty sure it's AI rap. It sounds like a voice, but I can't tell. I don't really care enough to inquire. And it's pretty funny either way. But if you would like to hear it just after this episode, we're just going to put it on the end. It's only like a minute or so and it has lyrics that boy howdy, there's something is how I'm going to describe it. I don't know how else to explain it.

Matthew Foreman [00:01:11]:
I do listen, you know, pretty broad array of music. I do. I do like hip-hop and rap, but this is something is how I'll describe it. Even if you don't like rap, I highly recommend listening to it. If only for the comedic value. But anyway, anyway, How Tax Works is meant for informational entertainment purposes only. This may be attorney advertising and it is not legal advice. Please hire your own attorney.

Matthew Foreman [00:01:34]:
How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business decisions we all make. Before we get started, a few administrative things. New episodes every 2 weeks. I know I did two the last one, but that was kind of one episode in two parts. So I thought it made more sense just to pop them both out at once. Next episode, which will be 36, talk about the grouping rules under Section 469. Also pretty similar to the grouping rules under 199 Cap A and elsewhere in the code. So definitely worth, worth discussing and interesting.

Matthew Foreman [00:02:08]:
465 as well. I'll explain what all that stuff is. Don't worry. If you have any questions, comments, or constructive criticism, you can email me at my FRB email address. Um, I have some upcoming webinars that, that I think are interesting. They're free. Um, so if you want to do it, the Advanced Tax Strategy Series— I didn't name it, but yeah, good enough. Um, they're all Thursdays, 1 o'clock, 1 PM Eastern time.

Matthew Foreman [00:02:31]:
Uh, I live in, I live in New York, so, so I'm doing everything Eastern. Um, no, there are 4 Thursdays in November and December, hour each. Free CPE for CPAs, CE for EAs, CLE for attorneys and CFP. So if you're a CFP, you can get continuing ed as well. Um, short, short titles here. Um, there's more information on the FRB website on the How Tax Works landing page. Uh, but November 6th is 704(c) allocations, um, which I think is a sleepy area that I think, uh, to be candid, I think people get wrong and don't understand and don't understand when it doesn't matter. So definitely an interesting one.

Matthew Foreman [00:03:09]:
November 20th, succession planning at the margins using profits interest, something I do a fair amount of. Um, December 4th is stock sales taxes, asset sales, uh, talking about FRE orgs through 38H10, etc., etc., etc., or yada yada yada, however you want to say it. And December 18th, changes to QSBS under OB Thrice, often called Public Law 119-21, OBB, OBBBA. I like OB Thrice. It's good for the reference. Anyway, so let's talk about the installment method under Section 453. Installment sales. What is an installment sale? An installment sale defers gain to when the seller receives the payment.

Matthew Foreman [00:03:53]:
It requires actual or constructive receipt, and the payment can be in cash or other property. You can't use it to defer losses. So if you sell loss property, the losses just get recognized in year 1, even if you didn't receive the cash. So that's good. If you sell 5 assets and 2 are losses and 2 are gains, it won't defer the losses, it will defer the gains. So that's actually kind of a very taxpayer-friendly way to do it, right? You can elect out under Section 453(d)(1). I'm not going to really go through how to do that because I don't really think it's all that interesting, not worth the time. To qualify as an installment sale, you must receive at least 1 payment in the year after the year of sale.

Matthew Foreman [00:04:33]:
Sometimes you'll see installment sales they close in February, there's a payment in April, there's a payment in September, there's a payment in December, not installment sale, all in one taxable year. So, you know, that's it, you can receive $0 in the year of sale. Oftentimes, you'll have a deal close in, you know, this early December, there's sort of a wait to see how certain factors of business go, set the price, etc. The next year you get it, you'll have it. But I think it's important to note that even if you receive $0 in the year of the sale, you may have to recognize some income there are rules as to certain assets that do not qualify for the installment sale. So it's really important to understand how this works because you can accelerate payments pretty significantly, especially for certain businesses. So I think that that's a really, really important point. All right.

Matthew Foreman [00:05:22]:
So it is not an installment sale if it is an annuity payment such as, you know, an annuity payments defined for this context as the payment is over the life expectancy of the seller, 453(b)(1). The factors for this are in GCM, General Counsel Memoranda, I believe. 3— hmm, that's some good writing there. It's either 39503 or 34503. It's from 1986. My handwriting's a little messy. Yes, I take notes and I have an outline for this and I handwrite it and it's messy. And then that's just how it goes.

Matthew Foreman [00:05:54]:
That's the way the cookie crumbles. So rolling for it. So there are 3 main components. For installment sales. Um, the first one is a non-taxable recovery basis. The second one is the taxable portion of the sale, which is capital gains or ordinary income. And the third is interest. Interest, interest, interest doesn't mean you're bored by my podcast.

Matthew Foreman [00:06:14]:
It means there is interest, which is always ordinary income. If there's no interest or insufficient interest charged, you must impute interest, um, and lower the taxable portion. The imputed interest is at the AFR, applicable federal rate, which you can find by Googling. Just Google AFR IRS and you'll get it. It's based on a number of factors, which month you use, etc., etc. Um, you can use an installment sale even if you don't transfer title or possession immediately. So sometimes you'll get it where the money's transferred but you're not going to actually get the asset for some period of time. That's great.

Matthew Foreman [00:06:47]:
Treasury Regulations 1.453-4A doesn't care. Um, again, you know, how do you elect out? I already said under 453 D-1, you can, and you file it for the year including extensions, including extensions that the installment sale started, right? So 2 years later, you can't elect out. Um, you can— I've seen it, you know, people like, well, why would you elect out of installment sales? And the answer is very simple. If you have a large loss and you want to offset the loss and you do an installment sale, you may want to accelerate that income to just use the loss. You don't have to run into the NOL rules. Um, federally only 80%, a lot of states decrease the amount of NOL that you can use, so on and so forth. So it actually can be helpful to elect out of it, um, and you don't actually need a promissory note. A lot of them are evidence, especially in the sale of business, by a promissory note, but a handshake is more than sufficient.

Matthew Foreman [00:07:37]:
An email is wonderful. As I always point out, contracts don't have to be written. They don't have to meet a lot of the real requirements. So there's a lot of situations where you're not eligible for the installment sale treatment. they're all under, generally speaking, 453(b)(2), but not all. There's 7 that I have written here and they're all pretty interesting. Sale of inventory. So if you sell assets and part of the assets of a business, for example, are inventory, the portion that's inventory is just not eligible for the installment sale.

Matthew Foreman [00:08:07]:
So that amount is pushed into year 1. Any gain on that situation, 453(b)(2)(cap)(b). Most dispositions by dealers, I'll get into that a little bit later, 453(b)(2)(cap)(a). Sale of publicly traded property for 453(k)(2), that's generally, you know, equities, debt, things like that. You know, a lot of companies will hold debt, they'll hold equities as part of their overall asset mix. So that can't be subject to it. The basic premise of why it can't be, you know, it's not subject, it's not eligible, I should say, for installment sale treatment for publicly traded properties, 'cause you can just sell it for cash and get it 'cause it's publicly traded. The sale of depreciable property that is related to persons, That is, excuse me, the sale of depreciable property to related persons, but the related per— and that's under 453g.

Matthew Foreman [00:08:54]:
Um, but related persons has an unexpected exclusion. I'll get into that a little later. The portion of sales that are depreciable recapture, 453i, um, looks a lot like Romanette 1, but it's just i. And sales of personal property under a revolving credit plan. Revolving credit plans are not eligible for installment sale treatment, 453(k)(1). There are a number of things that decrease installment agreement tax benefits. Interest charged over a certain amount under 453(k)(a), I'll get into that later. Pledge of a note, that's a deemed payment.

Matthew Foreman [00:09:25]:
So if you pledge the note, that is considered constructive receipt, 453(k)(a)(d)(1). A note is payable on, and if the note is paid, excuse me, the benefit for an installment agreement, installment sale, is decreased if the note is payable on demand or readily tradable. You can just say, hey, pay, pay it to me, uh, now. Or if you can get someone else to buy it from you, then you don't get installment sale treatment, right? 453(f)(4). Um, there are related party resale rules under 453(e), and there are sales of installment notes. If you sell the installment note, it is taxable immediately to the seller, right? Uh, 453(c)(b), not going to talk about that a lot. I've always felt that rule was a little bit too obvious. Never really understood why it's not, but here we are, right? Here we are.

Matthew Foreman [00:10:12]:
Before we delve into, you know, things that are not eligible for installment sale treatments, that's the sale of inventory. Let's, let's get some music going. I think that'll really lighten things up. All right, welcome back. So a little more on things that are not eligible for installment sale treatment. So sale of inventory is not eligible. Um, there's an exception to that, as, as is tradition, right? Um, that if the sale of inventory is not in the usual course of business, um, the most comment— the most common one for that is if you're selling inventory to satisfy a tax lien, that, that is— that can be done on the installment sale method. Um, pretty broad-based, pretty much everything is in there.

Matthew Foreman [00:11:12]:
Um, watch out for hot assets, right? So generally hot assets, that includes inventory for a partnership, right? Um, no, no installment sale treatment. So what happens a lot of times You need to make sure that in year 1, and I'll, I'll get into this I'm sure later, but as I talk about different items and different assets, right, that can be sold, is you want to make sure in year 1 you have at least enough cash to pay the tax on all the assets that are not eligible for installment sale treatment, right? And that's really important. That's why you need to know how much inventory there is, not just, uh, to fill out the form under Section 1060, but, you know, to know how much is there, right? So number 2, dealer disposition, you know, the disposition of personal property, so not real property, by a person who sells the same type or person who sells it in the ordinary course of their trade or business, right? There are exceptions to the exceptions. So types of dealer dispositions that are eligible for installment sale treatment, sales of farm property, farmers, you know, real estate is one of the most tax favored. Farms, very tax favored as well, even though they always seem to get the short end of the stick these days. Number 2, certain sales of timeshares, either the right to use residential property for 6 weeks per year or fewer, or a residential lot where the seller or someone related to the seller cannot make improvements. So parking lot, you sell a parking lot, you are eligible, even if you're a dealer of parking lots, you're eligible for that treatment. Thought that was interesting.

Matthew Foreman [00:12:42]:
Yeah, that's just kind of how it is. You know, and if an installment sale for either, right, either, either type of timeshares or the seller can't make improvements, right, there's also an interest charge on them because you're allowed to take the installment sale. That is a deferral, right, mechanism under 453(c)(a), which I promise I will get to a little later. Sales of publicly traded property. Don't be cute. Taxpayers lose on these a lot, a lot, a lot. 453(k). They're, you know, Congress gave the Treasury and the IRS the ability to promulgate regulations.

Matthew Foreman [00:13:19]:
Has not happened yet. But, you know, Treasury can. They haven't, and they probably haven't because they've won the vast majority of the cases that they litigated, probably because courts are very willing to look at this pretty broadly. Because what people will do is they'll drop it into a C corp and sell the C corp, right? No, not how that works. So not a big deal. Sales of depreciable property to related persons. The related persons, this is where I said it was an unexpected exception. The related persons are all business relations, not familial relative.

Matthew Foreman [00:13:52]:
I always find this, I had this conversation with the client. I always find it fascinating that related under the Internal Revenue Code doesn't often mean what people in normal discussions say is related. And that kind of fascinates me. And sales of appreciable properties related to persons, you know, there's also an exception. If there's no tax avoidance motive, you can do it. 453 is fine. So you can sell stuff to your kids. That's great.

Matthew Foreman [00:14:17]:
Have at it, right? Determining the gain recognized each year, right? 4(c) and Treasury Regulation, I'm going to read this to you, 15(a), it's a lowercase a,.453-1(b). Don't know why it's in 15(a), probably because it's a timing mechanism rather than an actual inclusion amount. But Such is life, right? So the way you compute it, right, is the income for the— I'm gonna talk through math, okay? But in the regulations and in the code, it talks through how to do it. And if you just sit there and read it, you'll actually get through it. It's not too bad. Um, the income for the year is the payment multiplied by the gross profit divided by the total contract price, right? So that payment for the year less the income for the year equals recovery of basis. So basically it's the payment and then you multiply it by the amount of profit you have. So if the total payment's $200, but only $100 of it is profit, $200, $100 profit, you're going to get taxed on the $100.

Matthew Foreman [00:15:13]:
That's the idea. The gross profit is the sales price less basis. Total contract price is your total sales price. And the gross profit ratio, right? It's calculated once for each year and it's the ratio that is used for all property acquired and it does not change. Payment may change. The gross profit ratio does not. The gross profit ratio is the gross profit divided by the total contract price. So it's the payment times the gross profit ratio is your income for the year.

Matthew Foreman [00:15:39]:
Pretty straightforward, I think. I hope. Um, all right, so the cash or accrual method, uh, 453 has its own rules for that. I could probably talk on that for about 10 minutes. I'm not going to. I don't think it's a good use of time, so I'm going to skip over it. Just know that that can be an issue if you are a cash taxpayer or an accrual basis tax. Uh, present value, uh, versus future value of the obligation, you use the face value of the obligation.

Matthew Foreman [00:16:04]:
So example, a taxpayer sells an office building, eligible generally, right, for installment sale, and the fair market value is $4 million. The taxpayer pays $6 million in 5 years, 10% interest rate. The sale price is $4 million and $2 million of interest. That's original issue discount. I don't care what the interest rate pretends it to be, says it is. That's the face value of the obligation is the fair market value. There's a case that talks about that. Uh, what if there are multiple assets, right? That's actually discussed in Revenue Ruling 68-13.

Matthew Foreman [00:16:38]:
Um, that title, 68-13, means that this revenue ruling came out in 1968. This is not new. Um, the example they give is there's land, fair market value of 10, basis of 15, a building, fair market value of 90, a basis of $5,000. A little bit of an extreme example, but plausible, right? Because land, you know, can go up or down. Basis isn't going to move. Building, obviously, or most likely I should say, the basis is going to decrease due to depreciation. Fair market value is another story altogether. The payment is $10 down, $10 per year over 9 years, plus interest.

Matthew Foreman [00:17:14]:
I'm just saying plus interest in this and ignore interest for purposes of this example, right? Year 1 is all land, right? $10 minus $15 equals a $5 loss because the lost property does not get, um, does not get the installment method. Years 2 through 10 are $85 of income total, right? $90 minus $5, which is the total basis remaining, right? $90 times 10 is $9.44 of income per year, $0.56 of basis. Basically, it's, it's $85 of total profit remaining, S, um, you know, multiplied by or divided by 9 years. So 85 divided by 9 is $944. Pretty simple. All right, we're gonna go away for a second, but when we come back, we're going to talk about contingent payment sales, uh, which is some really, really exciting stuff. So enjoy the music and we'll come back and bring it on home. All right, welcome back.

Matthew Foreman [00:18:16]:
So contingent payment sales, we're talking about the installment method under Section 453. So contingent payment sales is defined, are defined, as a sale or other disposition of property in which the aggregate selling price cannot be determined by the close of the taxable year in which the sale or disposition occurs. A contingent payment sale does not include a retained interest in property that's subject to the, that is the subject of the transaction. So if there's rollover, no. It does not include an interest in a joint venture or partnership, although most joint ventures are partnerships, right? It does not include equity incorporation or similar transactions. So basically, if there's rollover, that is not a contingent payment. All right. You only bought part of the asset.

Matthew Foreman [00:18:57]:
That's the key. There are 3 kinds of contingent payment sale that are discussed and analyzed under the Internal Revenue Code and the regulations there under. Right? The first one is the maximum selling price is determinable. The second one is the maximum selling price is not determinable, but time for payments is determinable. And the third is neither the maximum selling price nor the time for payments is determinable. Okay, so the maximum selling price is determinable. You treat the price as the sale price, right? The maximum price is the sale price and you're done. That's it.

Matthew Foreman [00:19:32]:
If you get less than the payment, by getting lower payment, you just use the gross profit percentage and that's it. You're done. Um, for number 2, the maximum sale price is not determinable but the time for the payments is, you just do equal basis for every year and the actual amount received is used, right? Pretty straightforward. Then if neither the maximum selling price nor the time for payments is determinable, the question becomes, well, is it really rent or royalty? Is this actually a contingent payment sale? If the sale, it's not really rent or royalty, you just use 15 years. If there is no payment in any year, no loss is allowed unless you meet the worthless debt rules. So, you know, it's kind of an interesting one there, right? It's a little more complex. A lot of times it just kicks into 15 years and you really have to analyze it. Is it in fact rent? You know, and people say, well, no, we agreed on that.

Matthew Foreman [00:20:20]:
I'm like, well, is it, right? If it's a 900-year transaction and you have no idea how long it's going to take, why, it sounds a lot like rent or royalty, doesn't it? That's the problem. All right, moving on. We're going to talk about interest charges under 453 cap A. That's again, Cap A, 453, then the capital letter A, no parentheses, right? So a different code section altogether, but very, very important. Basically, Congress was concerned, rightfully so, probably, that what people would do is in order to defer it, defer the sale, or defer the recognition of income from the sale, they would just have very, very long, of significant amounts for deferral, right? Especially since families can do this. Friends can do this, right? It is a pretty good opportunity for playing around a little bit, right? So Congress gets ahead, puts 453 Cap A, and the taxpayer must pay the interest, must pay an interest-like payment to the IRS on the loan of the tax deferral. Okay, there's a number of steps that determine, in order to determine if 453 Cap A applies and the interest-like charge is is imposed. And they're under 453(c)(a), (b)(1), and (b)(2).

Matthew Foreman [00:21:32]:
All right, one, the sale price must exceed $150,000. Uh, the key is the sale price, not the amount of the installment obligation, so the face value of the amount. So if you have a $30,000, uh, you know, installment sale, that, that's fine. That's not an issue at all. That does not trigger 453(c)(a). It must— the, the debt, the amount must arise from the disposition of business or investment property not property for personal use, all right, must arise in the year of the disposition, must be outstanding at the end of the year, and aggregate face value of all obligations which qualify under the prior 4 that I discussed must exceed $5 million. So if you wanted to get cute, people have asked me this, well, couldn't I just sell the goodwill as one and sell the trucks as another and sell the patents as a third? And you know, they're all under $150 each if I just broke everything out. And the answer is no.

Matthew Foreman [00:22:25]:
You know, the economic substance doctrine would likely group them. So I don't, I don't think that would work. So what happens is you have to keep the total amount under $5 million. So if you have one sale and it's $4 million, it's really not an issue because the aggregate face value is over $5 million. What I tell people to do in this situation is actually really simple. And I'll tell you how to compute it in a moment. What I tell people to do is just make sure to impose interest at AFR. As long as you're imposing interest at AFR, it will more than cover the amount of the charge.

Matthew Foreman [00:22:54]:
And that's a deductible amount, it's added to the payment. So it's not a huge deal. Obviously lowers the amount of effective interest you receive. But you know, that's fine, right? And then how to compute, right? How to compute the interest charge. So what you do is you have the overall formula is the applicable percentage multiplied by the deferred tax liability multiplied by the underpayment interest rate. All right. And that is about as helpful as a concrete slab to someone drowning in the ocean. Not very helpful.

Matthew Foreman [00:23:23]:
But I'll tell you what each of them mean, right? Applicable percentage. The first one, the numerator is the aggregate face value of all obligations outstanding at the end of the year, less $5 million. The denominator is the aggregate face value of all obligations outstanding at the end of the year. Right. So that's it. So if you have $10 million outstanding, the applicable percentage is going to be $5 million. Less 10 divided by $10 million. Pretty easy.

Matthew Foreman [00:23:45]:
The applicable percentage for each liability remains constant for the entire term. So the applicable percentage can change, but not for each debt. All right. Number 2, the deferred tax liability, right? The gain not recognized at the end of the year multiplied by the maximum tax rate under Section 1 or 11. But, you know, so that's either capital gains or ordinary income. And the maximum rate is the maximum rate that's applicable to that taxpayer. Right. So if a corporation is, is the, the seller, then you would just use the maximum corporate rate, which is also the minimum corporate rate coincidentally, which is 21%.

Matthew Foreman [00:24:22]:
The underpayment interest rate is effectively provided by the IRS. It is very similar to the AFR. So that's it. So basically you take, you know, the amount, um, and that's how you determine, right, the interest payment every year. Believe it or not, there's actually a form the IRS provides. It's pretty easy to calculate, really not that complex. And now we're going to bring it all home. Installment, one of my favorite topics, installment sales and 1031 exchanges.

Matthew Foreman [00:24:46]:
I haven't really discussed 1031 exchanges. That might be a multi-parter that I get to next year or later this year. We'll see how that goes. We're at the end, you know, so I'm going to be quick and a little bit general. The general rule is you remove the 1031 portion from 453 calculation. That's it. So you just ignore the amount received. The basis goes to the 1031 exchange to the extent of the fair market value in real estate, right? So the proposed regs in 1.453-1F are pretty good.

Matthew Foreman [00:25:16]:
It can be non-pro rata. So the example I always give is let's say you have a piece of property, you exchange it, right? You get back another piece of property and you get a $50 note, right? The basis that you had in the original property goes to, it is allocated, assigned, I don't know what the right word is, into the new property, the received property, replacement property, if I can get 1031 right, and that basis up to the fair market value of the replacement property. That's really important. So, you know, it's not total. So there can be some basis in the note, but generally speaking, a lot of times you find that there really, well, there isn't. So I think that's an important one. I think that's a pretty good one under Section 453. So that's it.

Matthew Foreman [00:25:59]:
That was the 35th episode of How Tax Works. I hope you learned something. Back in 2 weeks with the 36th episode where I'll be discussing the grouping rules under Section 469. And now for the best song of all time, but we're going with the rap version. Don't forget. I know you forgot. It's been 20 minutes, 20-some minutes. Get ready for it because it's— you won't be the same after is all I have to say.

Matthew Foreman [00:26:21]:
Not for better, not for worse, just different. Thank you for listening.

Matthew Foreman [00:26:53]:
college door. From finance to business, every choice in sight, he makes the complicated feel simple and right. So listen up close, let your money talk. Matthew's here to guide you through the tax walk. Smart, sharp, and always on track. Plug in, tune in, let's unpack some tax.