The Risks of Using Escrows as Security for Installment Sales
| Publication year | 1978 |
| Pages | 960 |
1978, June, Pg. 960. The Risks of Using Escrows as Security for Installment Sales
Section 453 of the Internal Revenue Code permits installment reporting of gain on the casual sale of personal property for a price in excess of $1,000 and on any sale of real property.(fn1) Even if a purchaser is willing to pay cash, a seller may insist on an installment sale to take advantage of lower bracket tax rates and to avoid or reduce the minimum tax on tax preference items.(fn2) In order to qualify under Section 453, the seller may receive no more than 30% of the sales price in the year of sale. The remainder of the purchase price is usually evidenced by a promissory note which is normally secured by a deed of trust or other security interest in the property sold.
A deed of trust securing the purchase money note may be unsuitable in the sale of real property. For instance, a developer may be unable to obtain construction or permanent financing without a subordination of the seller's security in the property. A subdivider-purchaser would need to obtain partial releases to convey unencumbered title to the property. Also, the subdivider may anticipate a complete sellout of the lots in a time period shorter than the seller wishes to report his gain. Similar problems may arise in connection with the sale of personal property. The seller of stock in a closely-held corporation may doubt the purchaser's ability to maintain its value. In all of these situations, the buyer may be willing to pay the entire amount in cash.
To preserve the installment sale and accomplish their other economic goals, the parties may agree that the purchaser will transfer cash, certificates of deposit or other property to an escrow agent or trustee. Alternatively, the purchaser may provide a letter of credit to the seller assuring future payment of the note representing the unpaid portion of the purchase price. These arrangements could arise at the time of sale or, because of subsequent events, as a substitute security device in a later year. These agreements may have disastrous tax consequences to the seller. If the escrow arrangement is established at the time of sale (or during the seller's taxable year of sale), the seller may not qualify to report the gain on the installment method. If established after the year of sale, the arrangement may accelerate the tax on all previously unrecognized ordinary income or capital gain from the sale.
Escrows can be used in connection with installment sales for purposes other than providing security for the purchaser's deferred payment obligation. For example, the purchaser may insist on an escrow agreement to secure the seller's covenant not to compete(fn3) or the seller's warranties of title or representations as to the nonexistence of undisclosed liabilities.(fn4) If the seller's right to receive payment from such escrows is subject to a substantial restriction, the purchaser's payment to the escrow agent will not be considered a payment to the seller.(fn5)
When escrow arrangements are used solely for the purpose of providing security for payment to the seller, taxpayers have been for less successful in obtaining installment reporting under Section 453. At the outset, it should be noted that once a seller (1) has an enforceable right to demand a cash payment or (2) receives a cash payment, the opportunity to use installment reporting is lost.(fn6) Among other decisions(fn7) involving escrow agreements as security for installment payments, two Tax Court decisions and two revenue rulings on the subject best represent the recent evolution of the law in this area.
In Revenue Ruling 68-246,(fn8) the taxpayer sold real property receiving 30% in cash at closing. The balance was paid by installment notes secured by a deed of trust on the property. In a later year, the purchaser wanted to...
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