The IRS released proposed regulations designating certain monetized installment sale transactions as listed transactions. The new regulations list common elements of monetized installment sale transactions that identify them for additional scrutiny as listed transactions. This move follows the IRS having identified monetized installment sales as potentially abusive via the IRS’s 'Dirty Dozen’ list. Taxpayers should assume that monetized installment sale transactions will be closely reviewed and therefore should be carefully planned and reported.
IRS issues proposed regs for monetized installment sales
The IRS released new proposed regulations (Reg-109348-22) that identify monetized installment sale transactions (and similar transactions) as listed transactions with special reporting requirements.
Monetized installment sales are transactions that attempt to convert a cash sale of appreciated property into an installment sale that defers gain into later tax years. The IRS specifically points out transactions where a taxpayer inserts an intermediary (usually a promoter) such that the transaction becomes an installment sale from the taxpayer to the intermediary, and a cash sale from the intermediary to the buyer, usually including a loan such that the seller gets cash without yet having reported gain.
The IRS signaled its disapproval of these transactions in March when it added them to its 'Dirty Dozen' list of tax schemes, asserting that monetized installment sales 'improperly' delay gain recognition. With the new listed transaction requirements in the new proposed regulations, the IRS ensures that these transactions will be scrutinized and the IRS makes clear that it intends to challenge them as invalid.
What are installment sales, and what’s wrong with them?
An installment sale occurs when the taxpayer sells property in one tax year and receives at least one payment in a subsequent tax year. Installment sales are very common and uncontroversial in their typical form. Installment sales can achieve tax advantages for a seller because the Code provides a special method of accounting for income. The installment method allows taxpayers to include amounts into income over the course of the payment term, generally recognizing gain on payments received each year in proportion to the gain on the transaction. This method logically reflects the economics of a two-party transaction with payments occurring over time or in a later year when the purchaser makes payment. In contrast, an ordinary cash sale typically requires the seller to include all gain as income in the year of the sale, thus reflecting the true economics of a one-time transfer of property for one payment (or multiple payments confined to a single tax year).
The IRS calls out monetized installment sales as attempts to enable a seller to use the installment method for revenue recognition in a way that does not reflect the economics of the transaction. The IRS points to several legal doctrines it may use to challenge these transactions, but the general idea comes down to economic substance – the IRS concludes that the actual monetary effect of the transaction between the seller and the ultimate buyer of the property is that of a typical cash sale, and the seller cannot change the economics by changing the structure or inserting a third-party intermediary to whom it can sell the property via an installment sale.
Taxpayers often avoid the reality of slow installment payments of purchase price by adding a loan that has interest flowing to the intermediary in parallel with the interest on the installment obligation flowing to the seller, such that the taxpayers recognize revenue in later tax years despite having the cash in hand. The IRS argues that taxpayers cannot 'have their cake and eat it too' (or have their cash and defer it too), asserting that such structures are legally ineffective and cannot achieve the deferral they purport.
How can taxpayers (and the IRS) identify monetized installment sales and substantially similar transactions?
In the new proposed regulations, the IRS describes monetized installment sales by listing seven hallmarks of these transactions:
- A seller of appreciated property, or a person acting on the seller's behalf, identifies a buyer who is willing to purchase the property in exchange for cash or other property.
- The seller enters into an agreement to sell the property to an intermediary in exchange for an installment obligation, which provides for interest payments from the intermediary to the seller.
- The seller then purportedly transfers the property to the intermediary, although the intermediary never actually takes title or takes title to the property only briefly before transferring title to the buyer in exchange for the buyer's cash or other property.
- The intermediary purportedly transfers the property to the buyer in exchange for cash (i.e. not an installment sale).
- The seller obtains a loan with an agreement that provides for interest payments from the seller to the lender that equal the amount of interest that the intermediary pays the seller under the installment obligation. Both the installment agreement and the loan provide for interest due over the same periods, with principal due in a balloon payment at or near the end of the term of the installment agreement and loan.
- The sales proceeds received by the intermediary from the buyer, reduced by certain fees, are provided to the lender to fund the loan to the seller or transferred to an escrow account of which the lender is a beneficiary. The lender agrees to repay these amounts to the intermediary over the course of the term of the installment obligation.
- The seller treats the sale as an installment sale under section 453 on a federal income tax return for the year of the purported sale and defers recognition of gain until the year in which the seller receives the principal balloon payment.
The fact pattern described by the seven elements is only a model, and substantially similar transactions can still be listed transactions without containing all of those elements. Listed transactions are defined in Reg. section 1.6011-4(b)(2) to include any transaction that is substantially similar to identified transactions, so taxpayers must consider the economics of a transaction even if using a different form. The IRS asserts in the new proposed regulations that a transaction will be 'substantially similar to a monetized installment sale’ if a seller taxpayer transfers property to an intermediary for an installment obligation, the seller transfers the property to a previously identified buyer, and the seller taxpayer receives a loan for which the cash or property from the buyer serves indirectly as collateral.
By identifying monetized installment sales as listed transactions, the IRS highlights tax returns that take these types of transactions into account. Taxpayers must include a Form 8886 disclosing the transaction with its tax return and may be asked to supply more information on review. If a taxpayer files a tax return that uses the installment method, the taxpayer will report less income in certain tax years than would be required for a normal cash sale. If the installment sale is determined to be invalid, the taxpayer may be subject to significant penalties.
Taxpayers should take caution when planning transactions that bear any of the seven hallmarks of a monetized installment sale, and RSM urges taxpayers to discuss with their tax advisors whether such transactions might be considered ‘substantially similar’ to a monetized installment sale transaction. RSM suggests extra caution for any taxpayers:
- using installment sales as part of a three-party transaction,
- employing any structure that provides a seller with an installment note where the ultimate buyer is paying cash, and/or
- obtaining a loan in connection with an installment sale that provides cash associated with gain not yet reported in income.
Taxpayers that wish to provide comments and other input on the proposed regulations may do so by October 3.