Congress and the Trump Administration have expressed a strong desire for new legislation to significantly reduce individual and corporate income tax rates, but the timing of the potential reductions is uncertain. Therefore, sellers planning a sale closing in 2017 should review the possibility of an installment sale and its attendant tax benefits and business concerns. For example, by using an installment sale, sellers may be able to defer the recognition of most of the income from the sale into a later year, and pay tax on that income at the new lower tax rates Congress may adopt. Although installment sales have been part of the tax and business landscapes for many years, certain aspects of installment sales are worth revisiting. This Alert identifies 2017 planning opportunities and summarizes many, but not all, of the installment sale rules.
What Qualifies for an Installment Sale?
Generally, a sale of non-publicly traded stock, assets of a business, a sale or redemption of a partnership interest, or a sale of real estate are among the types of transactions that may fit into an installment sale. Installment reporting cannot be used for certain assets, including (among others) sales of inventory and sales of securities traded on an established securities market.
How Many Installments Are Required?
The installment method applies where at least one payment is received after the tax year in which the sale occurs. A 2017 installment sale could be structured with two payments; a down payment at the closing of the sale and at least one more payment deferred into the seller’s following tax year. For example, a sale could close September 30, 2017, with 10 percent of the price paid at closing and the remaining 90 percent payable on January 2, 2018.
How Is an Installment Sale Taxed?
Generally, the ratio of the seller’s gross profit (sales price minus seller’s tax basis) to the total sale price determines a gross profit percentage. For example, if an individual sells closely-held stock for $1 million and the seller’s basis in the stock is $300,000, then the gross profit percentage is 70 percent [($1 million – $300,000) / $1 million]. Therefore, 70 percent of each payment (less interest) will be reported as taxable gain. Historically, as installment payments are received the gains recognized are taxed according to the tax rates in effect for the year of receipt; we are unaware of any planned change in the pending income tax proposals. Thus, if the tax rates are reduced effective January 1, 2018, any installments received in 2018 will be taxed at the new 2018 rates. For example, in the hypothetical stock sale described above, and ignoring interest, if the seller receives a payment of $100,000 at a sale closing in 2017 when his combined tax rate on a capital gain is 23.8 percent (the top 20 percent regular capital gain rate plus the 3.8 percent investment income tax) and another $900,000 payment in 2018 when his capital gain rate is 15 percent (assuming the top regular capital gain rate is lowered to 15 percent and the 3.8 percent investment income tax is repealed), the seller will pay $16,660 tax for 2017 [$100,000 x 70 percent x 23.8 percent = $16,660] and $94,500 tax for 2018 [$900,000 x 70 percent x 15 percent = $94,500]. The seller’s total tax would be $111,160 as compared to a 2017 tax of $166,600 if the entire purchase price was paid in 2017.
Can an Installment Sale Convert Short-Term Capital Gain Into Long-Term Capital Gain?
No. Installment reporting affects the timing of gain recognition, but not the character of the gain. The requisite holding period to qualify for long-term capital gain is determined at the time the sale closes, regardless of when payments are made. Deferred payments received later than one year after the seller’s holding period began will not create a long-term gain if the seller’s holding period was less than one year when the sale closed.
Can a Corporation or Partnership Use Installment Reporting?
Currently, regular (C) corporations do not have a preferential tax rate on their sales of capital assets. However, there is a strong possibility that the regular corporate income tax rates may be reduced. Therefore, a corporate seller may also benefit from installment reporting. At one time, an accrual basis taxpayer could not use installment reporting, but that limitation was removed. If the seller is a Subchapter S corporation or a partnership, the qualification for installment reporting is determined at the entity level and the tax accounting method flows through to the shareholders and partners.
To What Extent Can a Seller Secure Payment of the Installments?
This is an area that can trip up sellers. A deferred payment cannot be secured and still qualify for installment taxation. For example, the seller cannot require the purchaser to provide a letter of credit to secure future payments. Also, a seller could not require the purchaser to place the amount of the deferred payment in cash in an irrevocable escrow account. Such arrangements will, for federal income tax purposes, be treated as though the secured amounts were constructively received by the seller when the letter of credit or escrow account is established. Therefore, use of an installment sale places some degree of credit risk on the seller.
Special Rules for a Sale of Depreciable Property Such as Real Estate
Unlike most installment sales where the tax is due on installment payments in the year they are received, and the payments are generally taxed as capital gain if the asset sold was held for at least a year, a sale of depreciable property, such as a commercial building, has two unfavorable aspects. First, any depreciation recapture on the property must be reported as taxable gain in the year of sale, and will be taxed at the rates in effect during the sale year, regardless of the amount of the sale price actually paid in the sale year. Second, the depreciation recapture will be taxed at a higher rate, ranging from 25 percent to ordinary income rates, depending upon the type of property and the method of depreciation. Any recaptured depreciation is added to the tax basis of the property to determine the portion of the gain taxed as capital gain. Only the gain greater than the recapture income is reported on the installment method. These recapture rules do not eliminate the potential tax savings by use of installment reporting, but a seller may want to assure that the portion of the sale price actually paid in 2017 (or early in 2018) is sufficient to pay the accelerated tax caused by the depreciation recapture.
Sale of a Partnership Interest
The sale of a partnership interest is treated as the sale of a single capital asset. However, there is a look through to the underlying assets and the portion of any gain attributable to “unrealized receivables” (that includes depreciation recapture) or inventory items will be taxed as ordinary income and cannot be reported on the installment method. The gain allocated to other assets can be reported on the installment method.
What If the Property Is Sold at a Loss?
If the property sold is business or investment property, then any loss must be claimed in the sale year, regardless of installment payments.
How Is Installment Tax Reporting Elected?
If installment eligible property is sold on an installment basis, then the installment tax reporting method automatically applies unless the seller files an election with his tax return opting to report the entire sale gain in the sale year.
Can the Seller Use an Installment Sale Receivable to Secure Seller's Debt?
Generally, if a seller pledges his installment sale receivable to secure debt of the seller, the net proceeds from the debt will be taxed as if they were a payment on the installment receivable. This applies if the sale price is greater than $150,000. It does not apply to sales of: (i) property used in farming, (ii) personal use property, or (iii) qualifying time-shares and residential lots.
Special Interest Charge on Large Sales
The benefits of installment reporting on certain large sales may be limited by Section 453A, which imposes an interest charge on the deferred tax liability. This section applies if the property had a sales price in excess of $150,000 and the total balance of all nondealer installment obligations arising during, and outstanding at the close of, the tax year is more than $5 million. The effect of this provision should not be material if the total payment period is short.
Must Interest Be Provided on the Deferred Payments?
If the installment sale contract does not provide for adequate stated interest using the “applicable federal rate (AFR)” published monthly by the IRS, then interest will be imputed. Generally, interest income (stated or imputed) will be taxed as ordinary income. If the installments are paid over a short period, interest should not be much of an issue.
Use of a Purchaser Required Escrow
In many sale transactions, the purchaser will require the escrow of a portion of the purchase price to secure the seller’s obligation to indemnify the purchaser if certain representations and warranties are incorrect. Generally, an escrow can be structured such that any payments coming to the seller from the escrow account can qualify for installment reporting. To qualify, there must be a “substantial restriction” on the seller’s right to receive the escrowed funds that serves a bona fide business purpose of the purchaser.
What If Purchaser Assumes Seller's Mortgage?
If the purchaser assumes or otherwise takes the property sold subject to seller’s mortgage on the property, the following applies. If the mortgage amount is not more than seller’s tax basis in the property, it is not considered a payment. Instead, it is treated as a recovery of seller’s basis and the contract price is the selling price minus the mortgage. If the mortgage amount is more than the seller’s tax basis, the seller is treated as recovering all basis and the excess over basis is treated as a payment received in the year of sale.
Any party planning to sell in 2017 a business entity, assets or certain types of investments at a substantial tax gain should strongly consider using an installment sale arrangement to defer part of the taxable gain into a future tax year likely to have an income tax rate lower than the 2017 rates. Although an installment payment arrangement has increased credit risk to the seller if the purchaser defaults in payment, that may be an acceptable risk in cases where the purchaser is creditworthy in order to gain significant income tax savings. Special attention should be given to rules dealing with depreciation recapture and securing the deferred payment which can result in constructive receipt of payment.