Tax Season Lesson #2: Do You Owe the IRS for Your Use of the Installment Method?
For Lesson #1 on how to compute themaximum mortgage interest deduction when total mortgage debt exceeds the statutory limits, click here.
Installment sale reporting is generally a pretty cool thing. I.R.C. § 453 permits a taxpayer who sellsan asset in exchange for payments to be made over a period of years to recognize the corresponding gain as the payments are received, rather than all at once in the year of sale. But it comes with a cost; one that’s often misunderstood or just flat-out missed by tax practitioners, creating needless risk of IRS scrutiny.
But before we get into that, first, a primer on installment sales:
Assume I sell a share of stock for $10,000,000 when my basis in the stock is $2,000,000, for a total long-term capital gain of $8,000,000. The proceeds are to be paid to me in five annual installments of $2,000,000 each, with the first payment made upon closing.
Absent the installment sale rules — or if I were to “elect out” of the installment sale rules — I would recognize the full $8,000,000 of gain in the year of sale. Under I.R.C. § 453, however, I am permitted to defer much of the gain, and recognize it as each payment is received based on the portion of each payment that represents my gross profit from the sale, which in the case of my stock sale is 80%:
| Amount realized on stock sale | $10,000,000 | a |
| Basis in stock sold | ($2,000,000) | b |
| Gross Profit | $8,000,000 | c |
| Gross Profit % | 80% | c/a |
As each $2,000,000 payment is received, 80% of the payment is treated as capital gain, with 20% treated as tax-free return of capital.
|
|
Capital Gain (80%) |
Basis Recovery (20%) |
| Year 1: $2,000,000 |
$1,600,000 |
$400,000 |
| Year 2: $2,000,000 |
$1,600,000 |
$400,000 |
| Year 3: $2,000,000 |
$1,600,000 |
$400,000 |
| Year 4: $2,000,000 |
$1,600,000 |
$400,000 |
| Year 5: $2,000,000 |
$1,600,000 |
$400,000 |
| TOTALS |
$8,000,000 |
$2,000,000 |
Unfortunately, many taxpayers are so blinded by the opportunity for deferral that they fail to recognizethe cost of the installment method.This cost is in the form of an interest charge required to be paid to the IRS when the gain deferred on an installment sale exceeds certain thresholds as defined in I.R.C. § 453A.
It’s helpful to look at I.R.C. § 453A this way: Throughout the Code,whenthe statute throws taxpayers a bone, it often asks for a little something in return. [i]In this instance, in exchange for the ability to defer a large amount of gain under the installmentsale provisions,I.R.C. § 453A requires taxpayerstopay interest on the deferred gain .For those of you under the age of 30, just thinkof it asthe steep cover charge that gains you access to a kick-ass club.
It works like this. The interest charge is required only when:
- The sales price of a particular installment sale exceeds $150,000; and
- The combined installment receivables at the end of the year of all the installment sales made during the year exceed $5,000,000.
If both requirements are met for an installment sale for a given year, the interest due to the IRS is computed as follows:
- The taxpayer must determine the “applicable percentage” of the deferred gain outstanding at the end of the year. This percentage is equal to a) the excess of the installment receivables as of the end of the year over $5,000,000 b) divided by the amount of installment receivables at the end of the year. [ii]
- The taxpayer then must determine the total “deferred gain” at the end of the year; defined as the unrecognized gain under the installment method multiplied by the applicable tax rate for the year.
- Multiply the applicable percentage in #1 by the deferred gain in #2.
- Multiply the interest rate in effect under I.R.C. § 6621 [iii] by the amount determined in #3.
Applying I.R.C. § 453A to my installment sale facts, we first determine whether I’m required to pay interest on my sale:
- Does my sales price of $10,000,000 exceed $150,000? Sure does.
- Do the installment notes receivable as of the end of the year of sale from all installment sales made during the year exceed $5,000,000? At the end of the year of sale, Istill have $8,000,000 of receivable outstanding. So yes again.
I meet both tests, and am thus required to pay the IRS interest on a percentage of my deferred gain. Now I go about applying my formulas:
- Applicable Percentage = ($8,000,000-$5,000,000) / $8,000,000 = 37.5%
- Deferred Gain = $6,400,000 ($8,000,000 total gain less $1,600,000 recognized in the year of sale) * 15% (long-term capital gain tax rate) = $960,000 (think of this as the tax the IRS is not collecting in Year 1 thanks to my use of the installment sale provisions)
- 37.5% * $960,000 = $360,000
- Assuming the interest rate for the last month of my year of sale was 5%, the interest due is $360,000 * 5% = $18,000.
So in summary, for my right to defer $6,400,000 of gain beyond the year of sale, I’m required to pay the IRS $18,000 in Year 1, with subsequent computations to take place in every year that an installment receivable related to my sale is outstanding at the end of the year. [iv]
Still a small price to pay for a significant tax deferral, but the real downside is not in the cost, but in the failure to recognize the issue and report it appropriately, thus invitingunwanted attention from theIRS.
[i]Consider the exclusion for cancellation of indebtednessincome under I.R.C. § 108. Several of these exclusions require the taxpayer to reduce certain tax attributes like NOLs for the amount of the excluded COD. In essence, the IRS is saying, “Don’t pay us now, pay us later.”
[ii] This computation is done only for the year of sale and only on those installment sales made during the year that meet both requirements. For example, if a particular installment sale has a sales price less than $150,000, or if it was made in the prior year when it failed to meet both requirements, it is not included in the computation of those sales made during the current year on which interest is required. Once this percentage is determined in the year of sale, it stays constant throughout the life of the all the installment obligations that were created during that year.
[iii] As of the last month of the tax year.
[iv] In my facts, I would do additional computations at the end of years 2, 3, and 4.
Also note, for partnerships and S corporations, the $5 million threshold is applied, and the interest charge is computed, at the partner or shareholder level rather than at the entity level.
