1976, June, Pg. i. Installment Reporting for Income Tax Purposes.

• Author: by Randall W. Roth

5 Colo.Law. 1

Colorado Lawyer

1976.

1976, June, Pg. i.

Installment Reporting for Income Tax Purposes

iVol. 5, No. 6, Pg. iInstallment Reporting for Income Tax Purposesby Randall W. Roth and John T. KearnsRandall W. Roth, Denver, is in the private practice of law as a shareholder-employee of Randall W. Roth, P.C. He is also an Assistant Professor of Accounting at Metropolitan State College. John T. Kearns, Denver, is in the private practice of law as a shareholder-employee of John T. Kearns, P.C. 759Section 453 of the Internal Revenue Code grants taxpayers the election to report the gain from the sale or other disposition of certain property on the installment method for income tax purposes regardless of their regular method of accounting.(fn1) By making this election, a taxpayer can spread the amount of gain over the number of tax years in which payments are received, thereby deferring the payment of taxes and avoiding an unusually high marginal tax bracket for the year of sale. Appreciation of the potential advantage of this method of reporting gain requires an understanding of the alternatives.

DEFERRED PAYMENT SALE UNDER TAXPAYER'S REGULAR METHOD OF ACCOUNTING

If § 453 is not available or if it is available but is not elected, the gain from a sale or exchange of property will generally be recognized for tax purposes in the year of sale.(fn2) This results even though the seller may receive little or no cash in that year. The amount of the gain in the year of sale will depend upon the taxpayer's regular method of accounting.

Cash basis taxpayerUpon the sale or exchange of property, a cash basis taxpayer must include in the amount realized from the sale or exchange the cash received as well as the fair market value (hereinafter referred to as "FMV") of any other property received.(fn3) The taxpayer's recognized gain for the year of sale is the difference between the amount realized and his basis in the property sold or exchanged.(fn4) The character of this gain (capital or ordinary) will depend upon the nature of the property sold or exchanged, as well as the taxpayer's holding period for that property.(fn5) If the payments to be received by the taxpayer have a face value in excess of the FMV which was included in the amount realized, this excess will be treated as ordinary income and a portion of such excess must be reported in each year in which a deferred payment is received.

To illustrate the income tax results of a deferred payment sale by a cash basis taxpayer, assume the following facts.

S sells a tract of land in 1976 to B for a total sales price of $100,000. B makes a $20,000 down payment and gives S an $80,000, 6 percent promissory note, payable $10,000 of principal per year over the next 8 years. Because of the low rate of interest and the term of the

760note, the note has a FMV of only $60,000. S had paid $10,000 for the land in 1970 and has held it strictly for investment purposes.

Being a cash basis taxpayer, S would include the amount of cash, $20,000, and the FMV of other property received, $60,000, in his amount realized; less his $10,000 basis, S will report a recognized gain of $70,000 in 1976. Since the property sold was a capital asset and S had a holding period in excess of six months, this $70,000 will be reported as a long-term capital gain. In 1977 when S receives his first $10,000 deferred payment, he will have to report $2,500 as ordinary income while the remaining $7,500 will constitute a return of capital and be tax-free.

To understand why $2,500 of this payment has to be reported and why it is reported as ordinary income, keep in mind that S expects to receive $80,000 of principal payments from B over the eight-year period following the year of sale. Irrespective of that fact, he was required to include only $60,000, the note's FMV, in his amount realized for purposes of computing the gain on the sale. The excess of the note's face value over its FMV, which was not included in S's amount realized, will presumably be received by S over the eight-year period. Since gross income includes all "gains from dealings in property" this $20,000 must be taken into income by S as it is received.(fn6) This income generally does not qualify for capital gains treatment as it results from collection of a note rather than a sale or exchange.(fn7) Even though there are no assurances that the full face value of B's note will be collected, S cannot delay recognition of the ordinary income amounts until he has realized a complete return of capital. Instead, only a percentage of each payment can be considered as a return of capital.(fn8) That percentage is determined by dividing the face value of the note into its FMV at the date of sale. In the above example, $60,000/$80,000 or 3/4 of each payment represents a return of capital; the remaining 1/4 has to be reported as ordinary income. In addition, any interest received by S will be reported as ordinary income for the year of receipt.(fn9)

In the above example, it was assumed that B's note had an ascertainable FMV. In rare situations, it may be impossible to value B's obligation with any reasonable degree of certainty. This may be particularly true if the amount of B's obligation is based upon factors unknown at the time of sale, such as future profits. When such a situation exists, the seller is allowed to exclude the obligations from his amount realized. The payments received by the seller are treated as a return of capital up to the amount of his basis in the property sold. Once his basis has been completely recovered, all additional payments are taxed when received.(fn10) The character of this income is determined by the circumstances of the original sale. In the above example, S would, under this cost recovery approach, spread his taxable gain over the nine-year period (the $10,000 basis having been recovered in the year of sale) and, except for interest, all income would be reported as long-term capital gain.

Of course, the cost recovery method does not apply to S in the above example since B's note was subject to valuation. Furthermore, it is only in rare and extraordinary cases that the buyer's obligation will be considered to have no FMV.(fn11) The fact that the buyer's obligation may have a FMV considerably below its face amount does not qualify the seller to utilize the cost recovery approach.(fn12) Non-negotiability of the buyer's obligation may affect the amount of its FMV, but it generally does not permit the use of the cost recovery method.(fn13)

761Accrual basis taxpayerAn accrual basis taxpayer must include income when "all events have occurred to establish the right to the income and the amount thereof can be determined with reasonable accuracy."(fn14) Furthermore, there must be at least a reasonable expectation that the amount will eventually be received.(fn15) Since it is the right to receive, rather than actual receipt, that determines inclusion into income, an accrual basis taxpayer must take the entire selling price into the amount realized, even if the FMV of the buyer's obligation is substantially below its face value. To illustrate, in the above example S would have an amount realized of $100,000, cash received of $20,000 plus the $80,000 face value of B's obligation; less his $10,000 basis, S's gain would be $90,000. It would all be reported as long term capital gain in 1976, the year of sale. Interest would be reported as ordinary income when it was earned.

Although its applicability is uncertain, the regulations under § 453 seem to give an option to the accrual basis taxpayer who sells real property on a deferred payment basis.(fn16) It purports to allow such a seller to include only the FMV of the buyer's obligation, rather than face amount, in the amount realized from the sale. Basically, this enables the accrual basis taxpayer in that narrow situation to report his gain in the same way as it would have to be reported by a cash basis taxpayer.

Problems without installment reportingAs discussed above, whether the seller is normally on the cash basis or the accrual basis, a deferred payment sale will almost always create two substantial problems. Both problems stem from the fact that the greatest portion of the gain will have to be recognized in the year of the sale. First, by lumping all or most of the gain into one taxable year, the seller may find himself in an unusually high marginal tax bracket. Second, the resulting tax on the recognized gain will be due relatively soon after the actual sale even though the down payment received by the seller might be substantially less than the taxes which are due.

The seller may be able to negotiate or otherwise transfer the buyer's obligation in order to raise more cash. Even if the obligation is transferable, however, it may not be desirable for the seller to do this for any one of a number of reasons. For example, if the obligation is secured by the property itself, he may wish to retain the obligation to preserve his right to regain the property in the event of a subsequent default. Also, the obligation may be transferable only at a substantial discount even though the accrual basis

762taxpayer had to include its full face value in computing his gain on the sale.APPLICATION OF SECTION 453

Assuming that § 453 is available to S in the example above, a much different treatment results. S still has a realized gain of $90,000 ($100,000 selling price minus $10,000...