The U.S. Treasury recently issued its “Green Book” which includes, among other items, a proposed increase in the capital gains rate up to 43.4% for taxpayers with incomes over $1 million as well as an elimination of like-kind exchanges where gain deferral will exceed $500,000. This means that taxpayers will be subject to significantly higher tax exposure in liquidity events, whether the sale is of real estate not qualifying for like-kind exchange treatment, a business, or otherwise. The result is that taxpayers will become incentivized to engage in planning to keep taxable income below $1 million, to defer gain into later years hoping for a return to current rates, or simply to defer gain due to time value of money considerations.
One strategy that has been promoted to defer gain has been referred to under various names, taking slightly different forms, is the “monetized installment sale” or “deferred sales trust.” Each of these strategies includes a sale of assets to an intermediary buyer in exchange for an installment note that defers recognition of tax with the intermediary buyer ultimately selling the asset to a third party with the sales proceeds being held in trust or escrow. This purportedly results in the seller deferring gain while gaining control over cash which can be invested free of any capital gains. IRS Chief Counsel has recently issued guidance to advise field agents raising arguments which would disallow these benefits.
Structure of Transaction
Since the recent IRS guidance relates to the “monetized installment sale” transaction, I will summarize that transaction. However, while being different in certain respects, the “deferred sales trust” transaction is similar in concept. The transaction involves the seller, an intermediary, and a buyer.
- Seller sells the asset to the intermediary for an unsecured, long-term, interest only installment note, ballooning many years later (often 30 years). Gain from this sale is reported by the seller under the installment method such that there is no tax paid until principal is paid many years later.
- The intermediary sells the asset to the buyer in exchange for a purchase price typically equal to the purchase price for which the intermediary purchased the asset from seller. The intermediary recognizes no tax on the sale due to having a cost basis equal to the original purchase price. Also, the intermediary is not a related party to avoid required recognition of gain on the second sale under a 2-year rule requiring acceleration of gain under an installment note from a related party upon subsequent sale within 2 years.
- The intermediary then invests the proceeds with a lender, holding the funds in escrow, which uses these funds as collateral for a loan to the seller (typically up to 97% of the sales proceeds). The loan typically mirrors images the installment note between the seller and the intermediary such that seller’s interest payments to the intermediary are used to pay interest on the commercial loan. This purportedly allows the seller to have current cash, pay the commercial lender only upon receipt of cash from the intermediary, and avoid current income tax.
As previously mentioned, there are variations on this transaction, including the identity of the intermediary as a promoter-facilitator or trust (which often avoids using commercial lenders, rather allowing the seller/creditor to have specified investment authority over their collateral, i.e. proceeds from the second sale). However, the basic structure of allowing the seller to report under the installment method utilizing a long-term balloon note while receiving tax-free cash available for current investment remains the same.
An important development occurred with respect to these transactions when the IRS determined favorably with respect to a similar transaction in 2012. In that guidance, the IRS considered whether the “substance-over-form” or “step-transaction” doctrines would apply to deny the taxpayer with the intended tax benefits specific to the fact patterns presented. Those facts were that the seller used an installment note (secured through standby letters of credit) from the sale of assets as collateral for a loan. The IRS noted that the transaction allowed the seller to monetize their installment note but did not find substance-over-form or step-transaction should deem the set of transactions as equivalent to a sale for cash.
Different than a “monetized installment sale” or a “deferred sales trust,” this transaction did not use an intermediary. Also, the transaction used different lenders to issue the standby letters of credit than to issue the loan to the seller. The economic consequences of the parties changes as a result of the arrangement, whereas a monetized installment sale transaction appears to neutralize the economic consequences of the arrangement to cause the effect of an asset sale without actually engaging in an asset sale. Notwithstanding these differences, this guidance may be seen by some as authority supporting the monetized installment sale transaction.
Between the 2012 guidance and the recent issuance of new guidance by the IRS, these transactions have continued to proliferate. In response, the IRS outlined in its new guidance a non-exclusive list of arguments that may be raised to deny taxpayers the benefits intended by the monetized installment note transaction. Quoted from the IRS guidance, those arguments include:
- 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.
- 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 the 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).
- Debt secured by dealer note. Alternatively, the Monetization Loan to the 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).
- 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).
- 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.”)
- 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.
As can be seen from this list of potential arguments, the IRS has a number of tools at its disposal to challenge these transactions. The California Franchise Tax Board already put into place penalties for like-kind exchange qualified intermediaries who facilitate monetized installment note transactions. Depending on the structure of any such planning strategy, some, none, or all of these arguments may apply.
Of course, Chief Counsel advice is not binding precedent. Likewise, it is not proof that a transaction does not work. Rather, it merely is the statement of the Office of Chief Counsel about legal positions it feels may support denial of taxpayer benefits. Time will tell whether the IRS is successful in court with any of these positions. However, what taxpayers can see from this guidance is that the transactions are not as bulletproof as many promoters portray.
Given the expected increase in capital gains rates, taxpayers will be motivated to engage in planning to reduce or defer their exposure. Taxpayers desperate to save taxes may be easily lured into believing anyone who tells them they hold the keys to tax-free (or tax-significantly-deferred) sales. Buying into a promoter’s sales pitch, who may be able to “talk the talk” but who is not a tax professional (or the “hired gun” tax professionals they engage) may seem appealing. However, this recent guidance should warn taxpayers to seek the advice of their respected tax advisor rather than believing those interested in selling a marketed “product.” Depending on the circumstances, there may be valid planning opportunities which can accomplish similar outcomes based on individualized planning and designed to mitigate against IRS arguments rather than likely feeding into a transaction subject to IRS attack.
 See General Explanations of the Administration’s Fiscal Year 2022 Review Proposals, https://home.treasury.gov/system/files/131/General-Explanations-FY2022.pdf
 This includes a proposed increase in ordinary income rates to the prior top bracket of 39.6% and application of the 3.8% net investment income tax.
 IRC § 453
 IRC § 453(e)
 Note that using the escrow funds as collateral for the loan rather than the original installment note avoids the anti-pledge rules of IRC § 453A applicable to sales over $150,000 which would deem the loaned funds to constitute payments on the installment note.
 For a critique specific to deferred sales trusts, see Breitstone, Stephen M., Vivek A. Chandrasekhar, Robert F. Mann, and E. John Wagner, III, “A Critical Look at ‘Deferred Sales Trusts’,” American Bar Association – Section of Taxation, 2015 May Meeting, May 9, 2015.
 The IRC § 453A anti-pledge rules discussed at supra note 6 would currently deem the loan as a payment on the installment note changing the outcome of FAA 20123401F but not on substance-over-form or step-transaction grounds but rather the subsequently enacted statutory provisions.
 See California Franchise Tax Board Notice 2019-05, https://www.ftb.ca.gov/tax-pros/law/ftb-notices/2019-05.pdf
 For an example of another planning structure that may provide similar results through the sale of partnership interests to a non-grantor trust, see Easton, Reed W., “Individual Income Tax Planning with a FLP/LLC,” 8 No. 2 Bus. Entities 24, March/April 2006.