In a previous article, I wrote about the basics of the installment method of income tax reporting under IRC §453.[1] As noted in my prior article, the installment method of income tax reporting can be a powerful way of deferring income tax where the seller receives payments over time. However, there are numerous exceptions and special rules to reporting income under the installment method, some of which were briefly mentioned in my prior article and others of which were discussed in more detail. One such special rule is the addition of interest on certain deferred tax liabilities on installment obligation balances in excess of $5 Million at the end of any taxable year under §453A.
When Does §453A Apply?
In general, §453A applies to any sale of property for a sales price in excess of $150,000 that is reported under the installment method.[2] However, there are a few exceptions to this. §453A does not apply to the sale of personal use property as defined by §1275(b)(3)[3] or any property used or produced in the trade or business of farming as defined by §2032A(e)(4), (5).[4] §1275(b)(3) defines personal use property as any property substantially all of the use of which by the taxpayer is not in connection with a trade or business of the taxpayer or an activity described in §212 (income producing activity). §2032A(e)(4) and (5) cover most of the typically activities that one might consider to be farming related, including the raising of livestock, crops, fruits, furbearing animals, and any agricultural or horticultural commodity.
In addition to the exception for personal use and farm property, §453A does not apply to the sale of residential lots or timeshares sold by a dealer (a taxpayer who holds such property) for sale to customers in the ordinary course of the taxpayer’s trade or business.[5] Instead, the reporting of a sale of such property by a dealer is subject to interest under §453(l)(3).[6]
For purposes of applying §453A, all sales or exchanges that are part of the same transaction or any series of transactions shall be treated as a single sale or exchange.[7]
Interest on Large Installment Obligations
Under §453A(c)(1), any installment obligation that is subject to §453A carries with it an obligation to pay interest on the deferred tax liability if any portion of the installment obligation remains outstanding at the close of the taxable year. However, under §453A(b)(2), for purposes of this additional interest payment, at least some portion of the installment obligation must be outstanding at the close of the taxable year[8] and the face amount of all installment obligations held by the taxpayer and which arose during the taxable year must exceed $5 Million.[9] So in short, if the taxpayer’s total amount of installment obligations to which §453A applies does not exceed $5 Million, the interest component of §453A is not applicable, though the other rules of §453A remain applicable.
How is the Interest Calculated?
The formula for calculating the amount of interest owed is fairly straightforward and is a matter of walking through the statute mechanically. Let’s use the following example to help us walk through it: Taxpayer sells property in 2021 for a sales price of $10M, with a $1M basis. Taxpayer receives a secured promissory note in return. Buyer pays $1M on the note the end of 2021, leaving the balance on the promissory note as $9M. Let’s assume this property is long-term capital gain property and thus the applicable tax rate is 20%.
Here’s the formula, with each component explained below:
| §453A(c)(2) | §453A(c)(3) | §453A(c)(4) | § 453A(c)(2)(B) | |||
| Interest on Deferred Tax Liability | = | Deferred Tax Liability | x | Applicable Percentage | x | Underpayment Rate |
Deferred Tax Liability
First, we need to determine how to calculate the Deferred Tax Liability. This is determined by taking the amount of gain which has not been recognized at the close of the taxable year, multiplied by the maximum tax rate applicable to the taxpayer under §1 (taxpayers other than corporations) or §11 (corporations), provided however, that where the gain is long-term capital gain, the rate used is the net capital gain rate under §1(h).[10] It is important to note that the Deferred Tax Liability calculation applies to “any taxable year” and thus will need to be recalculated each year.[11]
In our example, we have a $9M gain ($10M-$9M), less the $900,000 recognized on the first $1M payment (gross profit percentage of 90%), leaving outstanding gain of $8.1M, multiplied by the long-term capital rate of 20% for a Deferred Tax Liability of $1,620,000.
Applicable Percentage
The Applicable Percentage is calculated by taking the amount of the installment obligation outstanding at the end of the taxable year in which the obligation arose in excess of $5M, and dividing it by the amount of the installment obligation outstanding at the end of the taxable.[12] It’s important to note here the Applicable Percentage is set in the first year of the application of §453A and remains constant in future years for purposes of calculating the interest in future years.[13]
In our example, we have $9M outstanding at the end of 2021, less $5M, equals $4M, which is then divided by the outstanding balance of $9M, for an Applicable Percentage of 44%.
Underpayment Rate
The interest rate is set at the Underpayment Rate in effect at the end of the taxable year as determined by §6621(a)(2).[14] The Underpayment Rate is set on a quarterly basis by the IRS, and generally announced by a Revenue Ruling. For the second quarter of 2021, the rate is 3% so we will use 3% in our example.
The Calculation
| §453A(c)(2) | §453A(c)(3) | §453A(c)(4) | § 453A(c)(2)(B) | |||
| Interest on Deferred Tax Liability
$21,384 |
= | Deferred Tax Liability
$1,620,000 |
x | Applicable Percentage
44% |
x | Underpayment Rate
3% |
Multiplying our Deferred Tax Liability of $1,620,000 by our Applicable Percentage of 44% is $712,800. Applying the 3% Underpayment Rate brings the interest amount under §453A to $21,384 for 2021.
Application to Future Years
As noted in the discussion of Deferred Tax Liability, the Deferred Tax Liability will change over time as the balance of the installment obligation is reduced and more tax is recognized by the taxpayer. However, the Applicable Percentage is calculated in the first year and remains constant. This makes the calculation of interest in future years a little less complex as the taxpayer need only determine the Deferred Tax Liability for each future taxable year and then use the Applicable Percentage previously calculated and the then applicable Underpayment Rate.
Let’s take our example a step forward and assume, that in 2022, the buyer pays $2M more on the promissory note, leaving a balance of $7M at the end of 2022. We take our outstanding balance of $7M multiplied by our gross profit percentage of 90% for an unrecognized gain of $6.3M. We then multiply $6.3M by the applicable tax rate, 20% in our example, for a Deferred Tax Liability of $1,260,000. Now we plug that into our formula using our previously calculated Applicable Percentage and our underpayment rate that is in effect at the end of 2022, which will assume to be 3%.
| §453A(c)(2) | §453A(c)(3) | §453A(c)(4) | § 453A(c)(2)(B) | |||
| Interest on Deferred Tax Liability
$16,632 |
= | Deferred Tax Liability
$1,260,000 |
x | Applicable Percentage
44% |
x | Underpayment Rate
3% |
What happens if, in 2023, the buyer pays another $2M on the promissory note? In that case, the outstanding balance of the promissory note would be $5M, and thus the interest component of §453A would not apply, assuming the taxpayer does not hold any other installment obligations to which §453A applies.
Interest Generally Deductible
The payment of interest under §453A is counted as interest paid for purposes of determining the deduction allowed to the taxpayer for interest paid or accrued during the taxable year.[15] The deduction for interest is regulated by §163 which provides that generally, interest other than personal interest[16], is deductible, although there are numerous other exceptions and rules applicable to the deduction.
Conclusion
As noted at the beginning of this article and in my prior article, the installment method of income tax reporting under §453 is a powerful tax deferral tool that can be used in any number of planning structures where the taxpayer sells assets in exchange for an installment obligation. However, under §453A, the IRS does want some interest for this deferral where the installment obligations exceed $5M. However, as discussed in the calculation section of this article, the interest is only on the Deferred Tax Liability, and then is only the Applicable Percentage of the Deferred Tax Liability, which effectively excludes the first $5M from the calculation. Further, this interest may be deductible. Thus, the taxpayer may not view the interest as overly burdensome, and it may well be more than offset by the interest paid to the taxpayer on the installment obligation. Nevertheless, taxpayers should be aware of this interest component on large installment obligations and the interest payment should factor into a taxpayer’s overall analysis of the financial consequences of the transaction.
[1] https://esapllc.com/installment-sale-basics-2021/
[2] §453A(b)(1).
[3] §453A(b)(3)(A).
[4] §453A(b)(3)(B).
[5] §453A(b)(4).
[6] Id.
[7] §453A(b)(5).
[8] §453A(b)(2)(A).
[9] §453A(b)(2)(B).
[10] §453A(c)(3).
[11] Id. (“with respect to any taxable year”).
[12] §453A(c)(4).
[13] Id. (“with respect to obligations arising in any taxable year”).
[14] §453A(c)(2)(B).
[15] §453A(c)(5).
[16] §163(h).
