On June 1, 2022, the Internal Revenue Service (“IRS”) released the first part of its annual “Dirty Dozen” list (the “List”) alerting taxpayers and practitioners of what the IRS considers potentially abusive” tax arrangements. Although the List is not a legal document or a commentary on the IRS’ enforcement priorities, the List consists of heavily promoted and potentially abusive transactions likely to attract IRS scrutiny and is meant to raise awareness of developments in federal tax administration. The IRS creates the List by identifying problematic transactions through taxpayer audits, promoter investigations and materials marketing ‘too good to be true’ tax schemes.
Among the transactions listed on the first of four installments of the of the List (IR-2022-113), and the focus of this article, is the Monetized Installment Sale (“MIS”). The IRS first identified the MIS in its 2021 Dirty Dozen list (IR-2021-144) and continues to remain on the List for a second year. Specifically, the IRS listed six reasons why it has a problem with monetized installment sales. See Chief Counsel Advice – CCA 202118016 released on May 07, 2021 (the “CCA”).
We reviewed these reasons and the review reassured us that our approach and analysis of the MIS strategy has been in line with how the IRS views the transaction all along.
MIS TRANSACTION IN A “NUTSHELL”
MIS transactions are done with the goal of deferring the capital gains taxes for the seller when a capital asset is sold for up to 30 years. Most MIS transactions consist of three transactions:
- Taxpayer sells his capital asset to an intermediary buyer (“Intermediary”) for an installment note (“1st Sale”) and then immediately thereafter, Intermediary sells the capital asset to a final buyer for the same purchase price (“2nd Sale”).
- A Lender loans funds to taxpayer equal to the sales price, less costs and fees, of the 1st Sale on the terms equal to the installment note payment (“Loan”).
- Taxpayer, Intermediary, and Lender create an escrow account whereby the Intermediary will pay interest and principal (if any) to the escrow as payment for the installment note on the 1st Sale, and then the escrow is instructed to make Loan payments to the Lender.
MIS ISSUES PER THE CCA:
Issue #1: No genuine indebtedness. At least one promoter contends that the seller receives the proceeds of an unsecured nonrecourse loan from a lender, but a genuine nonrecourse loan must be secured by collateral. A “borrower” who is not personally liable and has not pledged collateral would have no reason to repay a purported “loan.” See Estate of Franklin v. CIR, 544 F.2d 1045 (9th Cir. 1976). Therefore, the loan proceeds would be income.
A MIS transaction generally involves a business loan. The underlying premise pushed by promoters is that the seller receives funds from a business loan rather than proceeds from the sale of the seller’s assets. Thus, while the tax event occurs today, the tax liability isn’t due until the installment note from the sale is paid in the distant future. However, in Estate of Franklin the loan involved was structured as an unsecured nonrecourse loan. If an MIS transaction structures this loan in a way that the seller effectively does not have to pay it back, then it is not a genuine loan. As such, the “loan” is income to the taxpayer / borrower.
Think of it this way, if you “borrowed” money from your corporation, and your corporation had no rights to collect, did you really borrow the money or was it a disguised taxable distribution?
Issue #2: Debt secured by escrow. In one arrangement, the promoter states that the lender can look only to the cash escrow for payment. It appears that, in effect, the cash escrow is security for the loan to taxpayer. If so, taxpayer economically benefits from the cash escrow and should be treated as receiving payment under the “economic benefit” doctrine for purposes of section 453. Compare Reed v. CIR, 723 F.2d 138 (1st Cir. 1983).
If there is one rule that must be followed in installment sales, it is the “Pledge Rule” found under IRC 453A(d)(1). The Pledge Rule states that if an installment note is pledged or secured to get a loan, the loan proceeds will be treated as payment received on the installment note, thus taxable. In other words, if you sell an asset via an installment sale and received a promissory note from the buyer, and you then take the note to a lender as security to borrow money, any such money borrowed will be treated as payment from your sale of the assets, and thus, taxable.
If the only remedy for default that a lender has against the borrower is the cash escrow where payments on the installment note are made, that cash escrow should be deemed as a security for the loan, thus violating the Pledge Rule.
Issue #3: Debt secured by dealer note. Alternatively, the Monetization Loan to taxpayer is secured by the right to payment from the escrow under the installment note from the dealer. This would result in deemed payment under the pledging rule, under which loan proceeds are treated as payment of the dealer note. Section 453A(d).
Similar to Issue #2, some MIS structures try to circumvent the Pledge Rule by pledging the right to receive payments from the escrow that receives the installment sale proceeds (presumably from the 2nd Sale) rather than pledging the escrow itself as collateral for the business loan. The arrangement is akin to factoring on the account receivables. The basis of the IRS’s position appears to hinge on whether this arrangement is a secured indebtedness. (See Section 453A(d)(1)(A) & Section 453A(d)(4)).
IRC 453A(d)(4) defines “Secured Indebtedness” for the purposes of an installment sale. A payment is deemed Secured Indebtedness if it is an arrangement that gives the taxpayer the right to satisfy a debt obligation with an installment note. Thus, these secured payments will be treated in the same manner as a direct pledge of the installment note.
In other words, in the event where a seller takes an installment note as payment for the sale of an asset, then pledge the note as security to get a loan. If the seller has the right to use the payment from the installment note to pay off the loan, then the loan proceeds will be treated as payment for the sale of the asset, and thus, taxable. The IRS essentially stretches the reasoning under Issue #2 to say that even if the seller only has the right to use payments from the escrow account (not what’s in the escrow account) to pay off the loan, the loan proceeds would still be taxable.
The reason for treating the loan proceeds as payment on the installment note is that a seller who generates cash by borrowing against the installment notes does not have the liquidity problem that justifies the use of the installment method.
Issue #4: Section 453(f). The intermediary does not appear to be the true buyer of the asset sold by 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 instruments issued by a party that is not the “acquirer” would be considered payment, requiring recognition of gain. See Rev. Rul. 77-414, 1977-2 C.B. 299; Rev. Rul. 73-157, 1973-1 C.B. 213; and Wrenn v. CIR, 67 T.C. 576 (1976) (intermediaries ignored in a back-to-back sale situation).
A MIS transaction generally uses an intermediary buyer to purchase the assets from the seller then sell it again to the final buyer. The intermediary pays the seller with an installment note rather than cash proceeds. This “intermediary” arrangement is the focus of the IRS’s Issue #4. The IRS’s position is that since the intermediary is not an “acquirer” or “purchaser” of the assets, the note should be considered payment and immediately taxable.
However, it needs to be noted that the taxpayer is allowed to get any loan from any lender outside of an installment transaction, so long as the taxpayer does not violate the Pledge Rule or any Pledge-Like Rule. Simply, you are not barred from obtain a loan just because you have an outstanding installment note.
That being said, it appears that the heart of Issue #4 is whether a bona fide installment sale occurred when the assets is sold to the intermediary. While the brief description of Issue #4 released by the IRS seems to suggest that whether the intermediary qualifies as an “acquirer” is determinative, a review of the rulings and case law cited by the IRS shows that the legal analysis focuses on whether the seller has access to the proceeds from the second sale from the intermediary to the final buyer. A bona fide installment sale occurs when the seller does not have direct or indirect access. If such access exists for the seller, the installment sale to the intermediary purchase will be ignored, and the seller will be treated as if he sold the assets directly. Note, most of the cases cited by the IRS are transactions of installment sales to a related party, such as a spouse, controlled company, or children. As such, it is easy to see why the seller would have direct or indirect access to the proceeds of the second sale.
Issue #5: Cash Security. To the extent the installment note from the intermediary to the seller is secured by a cash escrow, taxpayer is treated as receiving payment irrespective of the pledging rule. Treas. Reg. section 15a.453-1(b)(3) (“Receipt of an evidence of indebtedness which is secured directly or indirectly by cash or a cash equivalent . . . will be treated as the receipt of payment.”)
The fact that the IRS has made this an issue tells me that a taxpayer actually tried to do this and claim that their installment sale was bona fide. To be clear, this issue has nothing to do with a loan, but deals with the installment note only. Remember, the Pledge Rule only applies to when the taxpayer pledges the installment note to get a loan.
The Treasury Regulations states that if the installment note is secured directly or indirectly by cash or “cash equivalents,” such as a certificate of deposit or treasury note, it will be treated as payment in the year the secured note is received.
For example, Jack sold his real property, Blackacre, to Jill for $5 million dollars using the installment method. Rather than give Jack a deed of trust to Blackacre as security, Jill gives Jack an installment note and deposits $5 million of cash in escrow as security for the installment note. Unless there are substantial restrictions placed on the escrow, Jack is deemed to have received the full payment under the Treasury Regulations because it is the same as if he received cash.
The rationale behind this rule is that if the installment note is secured by a cash equivalent, then the seller is in constructive receipt of the amounts payable under the note. The general rule on constructive receipt is that a taxpayer constructively receives a payment if it is credited to his account, or otherwise made available to him so that he can draw upon it without notice and without substantial limitations or restrictions. See Treas. Reg. 1.451-2(a).
Simply, as stated above in #4, if the seller has direct or indirect access to the proceeds of the second sale, they will be treated as if they sold the assets directly.
Issue #6: NSAR 20123401F is distinguishable. The case addressed in the memorandum did not involve an intermediary. Further, loans to a disregarded entity wholly owned by seller were secured by the buyer’s installment notes, but the pledging rule of section 453A(d) was not applicable. There is an exception to the pledging rule for sales of farm property, which applied in the case.
NSAR 20123401F is a memorandum issued by the Office of the Chief Counsel of the IRS where a MIS transaction was examined, and in issue was found. Some MIS promoters have used this memorandum to misrepresent that the IRS has approved the MIS strategy when selling a capital asset. The facts of NSAR 20123401F should be used narrowly with either installment sale of farm property or personal use property. However, the NSAR should be read to show that in certain circumstances, the IRS will respect an installment note and a loan as separate instruments. In fact, the IRS ruled in the Chief Counsel Memorandum AM 2007-0014, that the mere fact that two parties enter into offsetting rights and obligations should not result in disregarding the substance of each instrument separately.
As you can see, MIS transactions are very complicated and tax planning solutions are never easy. Legitimate tax strategies are not promoted. Rather, they take time and expertise to develop and implement for each and every client based on varying circumstances.
Have you engaged with a promoter and done a MIS transaction with any of the above-mentioned flaws? If so, we would highly recommend that you talk to a competent tax attorney or tax advisor to take remedial actions immediately.