Introduction
The IRS has for the second time in as many years included monetized installment sales on its annual “Dirty Dozen” tax schemes list. As we discussed in a prior post, the “Dirty Dozen” list alerts taxpayers and practitioners to certain transactions or arrangements that the IRS considers potentially abusive tax arrangements that taxpayers should avoid.[1] Generally, the “Dirty Dozen” list includes transactions that are heavily promoted and that will likely attract IRS enforcement and compliance efforts in the future. The IRS warned taxpayers to beware of, and avoid, advertised schemes, many of which are promoted online, that promise tax savings that are “too good to be true” and that will likely put taxpayers in jeopardy. The purported tax benefits that promoters offer from a monetized installment sale have clearly drawn the IRS’s attention. Generally, these tax arrangements allow taxpayers to sell appreciated property but defer the corresponding tax (typically many years later) when seller receives one or more payments, relying, in part, on the installment sale rules in section 453.
The inclusion of monetized installment sales on the “Dirty Dozen” tax list follows on the heels of CCA 2021180016[2] where the IRS explained six reasons why these transactions are problematic. The CCA also explained why the promoters’ basis for how the transactions purportedly achieve the desired tax consequences, is flawed. Promoters of monetized installment sales often rely on a 2012 IRS Memorandum[3] as support for their position that monetized installment sales have been blessed by the IRS and are legitimate. As discussed below, the 2012 IRS Memorandum was issued in a different factual context and should not be viewed as support for the typical monetized installment sale structure. Taxpayers that are considering, or have engaged in, monetized installment sales, deferred sales trusts, or similar transactions, should consult with an independent tax professional to carefully review the underlying legal requirements and technical analysis on which such arrangements are based.
The Generic Monetized Installment Sale
Promoters market monetized installment sales as a strategy to receive all of the proceeds from the sale of a highly appreciated asset in the year of the sale but defer paying the corresponding tax well into the future. In some cases, promoters are marketing a thirty-year deferral of the tax. If that sounds too good to be true, you are on the right path. If the transaction works as marketed, the promoter is selling an arrangement that takes advantage of the time-value of money. Investing pre-tax dollars received from the sale and allowing that investment to grow over a period of time will yield a larger return than if the same sales proceeds were used to pay the tax at the time of the sale and then the remainder invested post-tax.
The basic steps of a monetized installment agreement are as follows. A seller agrees to sell appreciated property (usually a capital asset) to a buyer for cash but instead of selling it directly to the buyer, the seller sells property to a promoter (or an intermediary affiliated with the promoter) in return for a thirty-year installment note. The promoter then sells the property to the buyer and receives the cash purchase price. Promoter partners with an intermediary to lend the seller 95 percent of the sales proceeds (deducting their fee 5% from the sales proceeds) as an unsecured, nonrecourse loan for the same term as the installment note, thirty years. The promoter tells the seller that because the loan from the intermediary is unsecured, the seller does not have constructive receipt of the original sale proceeds. Moreover, the interest income on the installment note is directed to an escrow account, which is used to make interest payments on the loan to the intermediary. The seller deducts the interest payments to the intermediary, offsetting the interest income that seller received from promoter under the installment note.
In effect, through these series of related steps and intermediaries, the seller received an amount equivalent to the sales price, less transactional fees, in the form of a purported loan that is nonrecourse and unsecured. Because the seller executed an installment note with the promoter, the seller takes the position that the income received under the installment note is only included in income when it is received, in the future, under the installment sale rules of section 453. By paying a promoter and an intermediary a fee for their services, the seller received the full amount of the sales proceeds in the year of the sale, without paying any tax on it, and can use those pre-tax funds as desired, for thirty years until the tax is due.
Contrast with a Generic Installment Sale Under Section 453
The tax benefit of a monetized installment sale is clearer when it is compared against the tax consequences of a traditional installment sale under section 453. Generally, under section 453, if an individual taxpayer (individual taxpayers must report income on the cash basis method, i.e., it is reported when received) sells property to a buyer in exchange for a thirty-year installment note (principal and interest to be paid in equal yearly payments for thirty years), the taxpayer only reports and pays tax on the income that it actually receives, each year, under the note. Thus, under section 453, the taxpayer includes the sales proceeds in income as it receives the proceeds. The same result would occur if the installment note was an interest only note with a balloon payment at the end of the loan term. The taxpayer would include the interest in income yearly as it is received but because it did not receive any principal, the principal would not be included in income until year thirty when the taxpayer received the sales proceeds.
Contrast this result with the monetized installment sale and it is easy to see why the IRS considers it a potentially abusive tax arrangement. As discussed, in a monetized installment sale because of the use of an intermediary and a second nonrecourse unsecured loan, the taxpayer was able to receive the full amount of the sales proceeds (minus the fee paid to the promoter and the intermediary) in year one but defer the tax on the sale until year thirty. Thus, the use of an intermediary and a second nonrecourse unsecured loan allows the taxpayer to get the benefit of section 453 installment sale treatment without reporting any amount in income when it is received in year one.
The IRS’s View Why Monetized Installment Sales are Potentially Abusive Tax Arrangements
In CCA 202118016, the IRS explained several reasons why it believes that monetized installment sales do not work and are potentially abusive tax arrangements. First, the loan from the intermediary lender allows the seller to receive the cash and maintain a thirty-year tax deferral but it is an unsecured, nonrecourse loan. If the loan is unsecured and nonrecourse, then the seller is not liable for it and has no obligation to repay the intermediary lender. As a result, there is no genuine debt and the purported loan is income to seller when it is received.
Second, if the debt to the intermediary lender is secured by the cash escrow, then the cash escrow is security for the intermediary’s loan to the taxpayer. As a result, the taxpayer should be treated as receiving payment under the economic benefit doctrine for purposes of section 453. Alternatively, if the intermediary’s loan is secured by right to payment from the escrow under the promoter’s installment note, section 453A(d) contains a special exception to the general installment sale treatment when there is a related pledge. In this variety of the transaction, because the intermediary’s loan is secured by the seller’s right to payment from the escrow under the installment note, it violates the pledging rule in section 453A(d) and therefore, the loan proceeds are treated as payment of the installment note (which results in no tax deferral under section 453).
Additionally, CCA 202118016 states that the promoter does not appear to be the true buyer of the property sold by the taxpayer. Under section 453(f), only debt instruments from an acquirer can be excluded from the definition of payment and thus, not constitute payment for purposes of section 453. Debt issued by a party that is not the acquirer, would be considered payment, requiring recognition of gain.
Finally, CCA 202118016 makes clear that the 2012 IRS Memorandum that promoters use to legitimize this transaction is factually distinguishable from the typical monetized installment sale transaction that promoters are marketing to taxpayers. The 2012 IRS Memorandum was premised on a specific exception to the pledging rule for sales of farm property. Thus, unless the seller is selling farm property, the 2012 IRS Memorandum does not support the monetized installment sale. Additionally, the 2012 IRS Memorandum did not involve an intermediary that purchased the property from the seller and then sold it to the ultimate buyer.
Parting Thoughts – If it Sounds Too Good to be True, Get Advice from an Independent Tax Professional
The inclusion of monetized installment sales on the last two IRS “Dirty Dozen” lists and the release of CCA 202118016, are a clear indication that the IRS is closely scrutinizing these potentially abusive tax arrangements. In addition to the issues that the IRS identified in CCA 202118016, and as we noted in a prior article, the IRS has indicated that it may start more broadly asserting other authorities or common law doctrines (such as economic substance) to recast a transaction, or the effects of a transaction, that it views as inappropriate. This transaction, and similar variations might be a candidate for such challenges.
Moreover, the IRS recently formed the Office of Promoter Investigations whose mission is to detect and end the promotion, organization, and sale of abusive tax transactions. Transactions like monetized installment sales that are included on the IRS’s “Dirty Dozen” list are likely to be pursued by the Office of Promoter Investigations. Thus, it appears that the IRS is poised to take enforcement action against both promoters and taxpayers that are engaging in monetized installment sales. If you are considering engaging in (or have already completed) a monetized installment sale or any of its numerous varieties, you should speak with an independent tax professional to review the underlying legal requirements and technical analysis on which such arrangements are based. Taxpayers that have already engaged in a monetized installment sale have an opportunity to take corrective actions to mitigate the consequences and substantial tax penalties that may result from these transactions.
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Freeman Law represents companies, executives, and individuals in regulatory and white-collar government investigations and prosecutions. We employ a proactive approach to defend vigorously and strategically position our clients. White-collar matters often involve parallel regulatory and civil proceedings. Freeman Law can navigate the complexities and collateral consequences of multiple proceedings. And when it comes to the court of public opinion, we employ ethical and strategic tactics to manage publicity. Schedule a consultation or call (214) 984-3000 to discuss your allegations and investigations concerns.
[1] See IR 2022-113 (June 1, 2022).
[2] May 7, 2021.
[3] NSAR 20123401F (Aug. 24, 2012).
