It is quite common in transactions for the seller to accept a promissory note with payments over time rather than being paid the full purchase price up front. In this situation, if the taxpayer were to be taxed on the full amount of income at the time of the transaction, but not be paid the full purchase price at the time, there could be liquidity problems for the taxpayer in paying the resulting tax on the income from the transaction. Recognizing income on the installment method can be a powerful tax deferral tool whereby the taxpayer recognizes income over a period of time as payment is received rather than on the date of the transaction itself. The installment method is in line with the general (but not always applicable) concept that tax should be due when the taxpayer has the wherewithal to pay, that is, when the taxpayer has the assets to pay the income tax.
In this article, we will cover the basics of the installment method under IRC §453. In future articles we will discuss some more complicated issues and applications of §453 including the application of §453A (Special rules for nondealers) and §453B (Gain or loss on disposition of installment obligations).
What is the Installment Method?
The installment method is a method of recognizing taxable income over time as the payment is received by the taxpayer rather than recognizing the income in the year the transaction took place.[1] Generally, a taxpayer must recognize income from a transaction in the year the transaction took place.[2] However, for certain eligible transactions where the taxpayer is paid over time, §453 allows the taxpayer to recognize the income over time under the installment method.[3] The timing and calculations of when and how much income is recognized under the installment method is discussed later in this article.
What is an Eligible Transaction?
For a transaction to be eligible for the installment method, it must be an “installment sale” as defined by §453(b). An “installment sale” is defined as the disposition of property where at least 1 payment is to be received the close of the taxable year in which the disposition occurs.”[4] However, the term does not include sales by a dealer, termed “dealer dispositions,”[5] or the sale of personal property that is deemed as inventory of the taxpayer.[6] A “dealer disposition” is the sale of personal property by someone who regularly sales personal property of the same type on an installment plan,[7] or a disposition of any real property held by the taxpayer for sale to customers in the ordinary course of the taxpayer’s business.[8] There are certain exceptions to the “dealer disposition” definition, including for the sale of farm property[9] and certain timeshares and residential lots.[10]
No Affirmative Election Required
No election is required for a taxpayer to recognize income under the installment method.[11] The taxpayer need only report the income on their tax return using a Form 6252 – Installment Sale Income for the year of the sale and each subsequent year in which an installment payment is received. If a taxpayer prefers to recognize all of the income in the year of the sale, they may elect out of the installment method pursuant to §453(d). There may be valid reasons for doing so, including but not limited to timing issues with matching income with deductions or recognizing income in a year where a taxpayer does not have much other income thus enjoying a lower marginal tax rate and protection against future tax rate increases, whether known at the time of the election out or simply feared by the taxpayer.
How Does it Work?
Under the installment method, income is recognized in each year in which an installment payment is received, and the amount of the income to be recognized is the “proportion of the payments receive in that year which the gross profit…bears to the total contract price”.[12] Put in simple terms, the gain on the transaction is recognized as income proportionally based on the amount of the payment received. To illustrate, see the following example:
T sells an interest in an LLC to B for $100 and receives a promissory note in exchange. The promissory note requires B to pay to T $10 per year for 10 years, with the first payment being made in year 1. T’s adjusted basis in the LLC interest was $10 at the time of the sale, and his total gain on the sale is $90. Absent the installment method, T would have $90 of income in the year of the sale. However, under the installment method, T recognizes the $90 of income over time as the payment is received.
If B pays T the $10 payment annually, with no early payment and no interest, T will recognize $9 of taxable income each year calculated as follows:
Gross profit of $90, total contract price of $100: Gross profit is 90% of the total contract price. Thus, for each payment received, 90% of such payment is treated as taxable income in the year the payment is received. Since B pays T $10 per year, T has $9 of taxable income per year. The remaining $1 is recovery of cost basis.
Of course, this is an oversimplification, but it shows how the installment method works, and how the amount of income to be recognized with each payment is determined.
Exceptions and Things to Watch Out For
While this article is only meant to cover the most basic applications of the installment method, with more detailed articles to follow in the coming months, we do want to point out a few items that commonly trip taxpayers up related to §453. This list is certainly not all inclusive and does not discuss quite a few more complicated issues related to the installment method.
Not Applicable to Demand Notes or Readily Tradable Notes
The installment method is not available where the payment is received in the form of an indebtedness obligation that is payable on demand or that is readily tradable.[13] When a taxpayer receives a note that is payable on demand or that is considered readily tradable, the taxpayer is treated as having received the payment itself rather than an installment obligation.[14] For purposes of §453, the term “readily tradable” is defined as a bond or other evidence of indebtedness that has interest coupons or is in registered form[15], or is otherwise in a form that is readily tradable on an established securities market.[16]
Sales to Related Parties and Future Dispositions
While the installment method may still be used to report income generated by a sale to a related person[17], the original taxpayer may have to recognize the income immediately upon a subsequent disposition from the related party to a third party.[18] For purposes of applying this rule, there is a two year cutoff for sales of items other than marketable securities[19] and thus the application of §453(e) may generally be avoided by having the related party hold the asset for more than two years. Additionally, among a few other exceptions to this rule, §453(e)(7) provides for an exception to recognition requirement on the subsequent sale by a related party where the principal purpose of neither the first nor second sale was tax avoidance.
Use of the Installment Method by Shareholder Who Receives an Installment Obligation in Liquidation
Under §453(h)(1), where a shareholder of a corporation receives an installment obligation as a party to a liquidation to which §331 applies[20], and the liquidation is a complete liquidation accomplished within twelve months of the corporation’s plan of liquidation being adopted, then the taxpayer may treat the payments received under the installment obligation as payments received in exchange for stock in the liquidating corporation. The result is that the taxpayer is viewed as having sold the stock directly in exchange for the installment obligation and can then report the income from such sale under the installment method, assuming no other factors would prevent it. There are certain restrictions on this treatment including where the obligation was received by the corporation in exchange for inventory in a non-bulk sale[21], the shareholder who receives the obligation and the payer under the obligation are related[22], and the potential application of the second disposition by a related party rule under §453(e) discussed above.[23]
Recognition of Depreciation Recapture Income in the Year of the Sale
Under §§1245 and 1250, assets that have been previously depreciated are generally subject to income recapture, which serves to treat any gain on the sale of such assets as ordinary income up to the amount of depreciation previously deducted. Pursuant to §453(i), the installment method does not apply to such recapture amount and it must be recognized as ordinary income in the year of the transaction. Gain in excess of the recapture amount may still be recognized as income under the installment method.[24]
Summary
In closing, the installment method is a great way for taxpayers to defer the recognition of income and payment of resulting taxes until the payment is received where assets are disposed of in exchange for an installment obligation. Payment in the form of an installment obligation is fairly common in transactions, particularly where the seller is seller financing some or all of the transaction. While the installment method automatically applies when eligible, assuming no election out, taxpayers should be careful to structure their transactions to make sure to avail themselves of the benefits of the installment method and avoid having to pay the tax up front when they may not have the liquidity to do so. While this article only covers the basics, saving some more in-depth applications and issues for a later article, hopefully this will provide the reader with a basic understanding of the installment method and a few items taxpayers should be aware of when structuring their affairs to have §453 be applicable. Taxpayers should seek advice from a professional advisor to ensure the intended results and avoid one of the may tax traps of Section 453 that await the unwary.
[1] §453(c).
[2] §451(a).
[3] §453(a).
[4] §453(b).
[5] §453(b)(2)(A).
[6] §453(b)(2)(B).
[7] §453(l)(1)(A).
[8] §453(l)(1)(B).
[9] §453(l)(2)(A).
[10] §453(l)(2)(B).
[11] §453(a).
[12] §453(c).
[13] §453(f)(4).
[14] §453(f)(4).
[15] §453(f)(5)(A).
[16] §453(f)(5)(B).
[17] §453(f)(1) defines a related person for purposes of §453 as someone whose stock would be attributed to the taxpayer under §318(a) or someone who bears a relationship to the taxpayer described in §267(b).
[18] §453(e)(1).
[19] §453(e)(2).
[20] In general, §331 applies to taxable liquidations.
[21] §453(h)(1(B).
[22] §453(h)(1)(C).
[23] §453(h)(1)(D).
[24] §453(i)(1)(B).
