Even before the Biden Administration proposed an increase to the capital gains rate, it has been increasingly common for a seller (“Seller”) of business assets to be approached by consultants promoting a transaction structure whereby Seller can immediately receive nearly all of the cash proceeds of the sale while also deferring the corresponding tax for as long as 30 years. The allure of receiving cash proceeds tax-free for 30 years is a powerful inducement to enter into what is commonly referred to as a “Monetized Installment Sale” (“MIS”) transaction.
Promoters generally outline the steps of an MIS transaction as follows:
- First, Seller initially sells business assets intended for a third-party buyer (“Buyer”) to an intermediary (the “Intermediary”), typically organized as a non-business trust with an “independent” trustee, in exchange for a 30-year installment note with principal due at maturity. Under Section 453 of the Internal Revenue Code of 1986, as amended (“Code”), gain from an installment sale is generally reported for income tax purposes as principal payments are made, with certain exceptions. Since the installment note would not require principal to be repaid until maturity, Seller is told by the promoter that all of the tax associated with the sale to the Intermediary would be deferred until maturity.
- Next, the Intermediary immediately resells to Buyer the business assets it purchased from Seller. The purchase price to Buyer is the exact amount of purchase price in Intermediary’s transaction with Seller resulting in no gain to the Intermediary and the desired basis step-up for Buyer. (Buyer must understand that Seller’s representations and warranties are of no value unless the Buyer’s agreement with the Intermediary appropriately captures such representations and warranties.)
- Next, the Intermediary “invests” the sale proceeds received from Buyer with a third party (the “Lender”), which in turn loans approximately 97% of the sale proceeds to Seller (“Seller’s Loan”), which is typically secured by Seller’s proceeds either held in escrow or by the Lender. (Lender may also be a separate party, which secures the loan with the sales proceeds held either in escrow or an investment account). The discount reflects the service fee charged by the Lender and the interest rate and terms, e.g., a balloon payment at maturity, on Seller’s Loan are substantially identical to the terms of the installment note issued by the Intermediary to Seller. The annual interest paid by the Intermediary to Seller is in turn used by Seller to pay annual interest on the Seller Loan.
MIS promoters regularly reference an IRS Office of Chief Counsel Memorandum dated July 12, 2012 (the “2012 IRS Memorandum”), as representing IRS approval of the MIS transaction structure. Unfortunately for Seller, the 2012 IRS Memorandum says no such thing, but that does not seem to prevent MIS promoters from continuing to reference it as supporting guidance.
Despite repeated efforts by Dykema tax attorneys and other tax professionals advising extreme caution when considering an MIS transaction, the MIS promoters have been unrelenting in trading on the false promise of substantial tax savings. That is, it appears, until now.
On May 7, 2021, the IRS Office of Chief Counsel released a memorandum directly, albeit succinctly, addressing MIS transactions (the “2021 IRS Memorandum”). In the opening paragraph of the 2021 IRS Memorandum, which is directed to an IRS field agent, the IRS Office of Chief Counsel summarizes the matter as follows:
This is in response to your request for our analysis regarding “Monetized Installment Sale” transactions. Note that because there are multiple promoters/sub-promoters, there could be variations in the way the transactions are structured. Some of the points below might not apply to every transaction. However, there do seem to be common features that make the transactions problematic. And we generally agree that the theory on which promoters base the arrangements is flawed.
The 2021 IRS Memorandum then describes various flaws in the MIS transaction structure, two of which deserve special attention. First, Section 453A(d) of the Code includes a special exception to the general installment sale rule when there is a related pledge. Specifically, since the Seller Loan is secured by the right of Seller to receive payment from the Intermediary, there is a deemed payment under the pledging rule whereby the loan proceeds are treated as payment of the installment note (which unwinds the intended tax deferral).
The Office of Chief Counsel also makes it clear that the 2012 IRS Memorandum is distinguishable from the typical MIS transaction. The 2012 IRS Memorandum was premised on an exception to the pledging rule for sales of farm property. Unless Seller’s business assets qualify as farm property, the 2012 IRS Memorandum is of no support for the typical MIS transaction.
On April 19, 2021, the IRS announced the establishment of a new Office of Promoter Investigations (“OPI”). The creation of OPI illustrates the IRS’s commitment to pursuing promoters and combating abusive tax avoidance transactions. The MIS transaction structure has been on the IRS’s radar for several years and the release of the 2021 IRS Memorandum would appear to suggest that OPI will be closely scrutinizing both past and future MIS transactions. Sellers considering an MIS transaction structure based on advice received from a promoter should tread carefully. The potential for being caught up in an IRS sweep of MIS promoters is now stronger than ever before.