This article will be the final in a series of articles covering the installment method of reporting income. In our first article of the series, we discussed §453 and the basics of the installment method of income tax reporting.[1] As noted in the article, the installment method of reporting income can be a powerful tax deferral tool, and the taxpayer can elect out of installment sale treatment if desired, a choice that may be beneficial under the right set of circumstances. In our follow up article, we discussed §453A and the imposition of interest on large installment obligations, including how to calculate that interest.[2] In this final article of the series, we will discuss the disposition or transfer of an installment obligation and associated tax consequences.
General Rule: Gain of Loss to Be Recognized on Disposition
In general, under §453B(a), the transfer, distribution, sale, or other disposition of an installment obligation is a taxable event, meaning it triggers gain or loss. Just how much gain or loss is triggered depends on the type of disposition that takes place and of course, the basis in the obligation.
Where the obligation is satisfied at anything other than face value or sold or exchanged, the amount of the gain or loss is equal to the amount realized less the basis in the obligation.[3] For example, the holder of an obligation exchanges that obligation for a vehicle valued at $35K, the amount realized would be $35K, and the gain or loss would be $35K less the basis in the obligation.
Where the obligation is distributed or disposed of other than by sale or exchange, the amount of the gain or loss is equal to fair market value of the obligation at the time of its disposition, less the basis in the obligation.[4] To illustrate this, assume you have a promissory note with an outstanding principal balance of $20K, and there is no reason to think that balance will not be paid, thus making the fair market value of the note $20K. Now you gift that promissory note to your child. You’ve just created a taxable event with a gain or loss equal to $20K less the basis in the note.
For purposes of determining this gain or loss, the basis is equal to the excess of the face value of the obligation over an amount equal to the income which would be returnable if the obligation were paid in full[5], which in plain English means you take the face value of the obligation and subtract out the unrecognized income associated with the obligation to arrive at the basis in the obligation.
Exceptions, Exceptions
Of course, we would not be writing this article if §453B were as simple as stated above. Although the exceptions are not overly complicated, there are quite a few and we will discuss some of those below.
Transfers on Death
The general rule of §453B(a) does not apply to a transfer that occurs at death[6], though the rules of §691 do apply, commonly referred to as IRD, Income in Respect of a Decedent. In general, the recipient of an asset subject to IRD will recognize future income related to the asset as IRD in the future. This exception makes sense from a policy standpoint as the recipient of the obligation steps into the shoes of the decedent and will continue to recognize income under the installment method as payments on the obligation are received due to the application of the IRD rules of §691.
Distribution to Parent Corporation on Liquidation
In general, the transfer of assets from a subsidiary corporation to a parent corporation is not a taxable event under §337(a). §453B(d) piggybacks on this rule and allows an exception to the general rules for transfers of obligation that comply with §337(a). Thus, the transfer of an obligation from a subsidiary corporation to a parent corporation does not trigger tax under §453B as long as the transfer is governed by §337(a). Just as with the exception for transfers at death, this exception also makes sense from a policy standpoint. The parent corporation steps into the shoes of the subsidiary corporation and continues to recognize income on the obligation as payments are received.
Transfers Between Spouses or Incident to Divorce
Under §1041(a), a transfer is not a taxable event, that is, gain or loss is not recognized, if the transfer is made to a spouse[7] or to a former spouse incident to a divorce.[8] Just as with the exception for parent-subsidiary liquidations, §453B(g) piggybacks off an already existing exception and provides that a transfer that meets the requirements of either §1041(a)(1) or (a)(2) does not trigger gain or less recognition under §453B, and the transferee, that is the recipient of the obligation, steps into the shoes of the transferor for purposes of future tax treatment on the obligation.[9] Again, this makes sense from a policy standpoint since the spouse or former spouse recipient will continue to recognize income under the installment method as payments are received on the obligation.
Liquidation Distributions by S Corporation
If an S corporation distributes an installment obligation to a shareholder as part of a complete liquidation, and that distribution is not treated as payment for stock[10], then no gain or loss is generally recognized by the distributing corporation.[11] As with the other exceptions discussed, this also makes sense as the shareholder recipient will continue to recognize gain on the obligation as payments are received.
Certain Nonrecognition Transactions
While a full discussion of nonrecognition transactions is beyond the scope of this article, Treas. Prop. Reg. §1.453B-1 provides that for purposes of the §453B, those transactions also do not trigger the recognition of gain or loss. Those nonrecognition transactions where an obligation is part of the transfer and which are excepted from the general rule of triggering gain or loss are transfers to a corporation solely in exchange for stock in a transaction that qualifies for §351 treatment (example is transferring assets to a corporation during its formation though it applies to many other scenarios),[12] distributions from a corporation under a reorganization which are not taxable under §361,[13] contributions to a partnership in exchange for partnership interests that satisfy the nonrecognition requirements of §721,[14] and distributions from a partnership to a partner that satisfy the nonrecognition requirements of §731.[15] However, the regulations do provide that these exceptions do not apply to a disposition that results in the satisfaction of the installment obligations, regardless of form, if such disposition is made in exchange for the receipt of stock in a corporation from the corporation in satisfaction of an installment obligation of the corporation[16] or the receipt of an interest in a partnership from the partnership in satisfaction of an installment obligation of the partnership.[17]
Conclusion
As noted at the onset of the article, the general rule is that the transfer or disposition of an installment obligation is a recognition event that triggers gain or loss. However, there are numerous exceptions to this rule, many of which are discussed herein. Taxpayers and their advisors should be aware of the many different exceptions so as to properly structure their affairs to take advantage of these exceptions, or if desired, avoid the exception and trigger gain.
As we approach the end of 2021, and the potential increase in the capital gains tax rate for those with income above a certain threshold (currently $1M is being discussed/proposed by the Biden administration), it may well make sense to intentionally use § 453B to trigger gain on an installment obligation and pay tax at the current 2021 rates rather than potential increased future rates. Knowing the rules and exceptions of §453B is key to properly structure this triggering of gain if so desired. On the flip side, taxpayers may also be able to use the installment method of income reporting in the opposite manner to avoid income that exceeds any such threshold that triggers an increased tax rate.
[1] Charles J. Allen, “Installment Method of Income Recognition – The Basics,” March 16, 2021, https://esapllc.com/installment-sale-basics-2021/.
[2] Charles J. Allen, ” The Installment Method of Income Tax Reporting: Interest on Large Installment Obligations,” June 29, 2021, https://esapllc.com/453a-interest-on-large-installments-2021/.
[3] §453B(a)(1).
[4] §453B(a)(2).
[5] §453B(b).
[6] §453B(c).
[7] §1041(a)(1).
[8] §1041(a)(2).
[9] §453B(g).
[10] See §453(h)(1), which is also discussed in our first article of the series: Charles J. Allen, “Installment Method of Income Recognition – The Basics,” March 16, 2021, https://esapllc.com/installment-sale-basics-2021/.
[11] §453B(h).
[12] Treas. Prop. Reg. §1.453-1(c)(1)(i)(A).
[13] Id.
[14] Treas. Prop. Reg. §1.453-1(c)(1)(i)(B).
[15] Treas. Prop. Reg. §1.453-1(c)(1)(i)(C).
[16] Treas. Prop. Reg. §1.453-1(c)(1)(ii)(A).
[17] Treas. Prop. Reg. §1.453-1(c)(1)(i)(B).
