Applying the Imputed Interest Rules to Seller-financed Debt Instruments

• Jurisdiction: United States,Federal
• Citation: Vol. 15 No. 2 Pg. 202
• Pages: 202
• Publication year: 1986

15 Colo.Law. 202 Colorado Lawyer 1986.

1986, February, Pg. 202. Applying the Imputed Interest Rules to Seller-Financed Debt Instruments

---

202

Vol. 15, No. 2, Pg. 202

Applying the Imputed Interest Rules to Seller-Financed Debt Instruments

by Stuart A. Kwestel

This article explains the Original Issue Discount ("OID") provisions of §§ 1271-1275 of the Internal Revenue Code of 1954, as amended ("Code"), enacted by Congress as part of the Tax Reform Act of 1984 ("TRA 1984"). These provisions were temporarily amended by P.L. 98-612, enacted on October 31, 1984 ("Stop Gap Legislation"), and were more recently simplified by P.L. 99-121, enacted on October 11, 1985 ("New Law").(fn1)

Prior Law

The imputed interest rules that existed under prior law were enacted as part of TRA 1984. The main purpose of the imputed interest rules was to prevent taxpayers from engaging in non-arms-length transactions for purposes of minimizing their tax liabilities.

One of the primary abuses Congress attempted to prevent was the manipulation of principal and interest allocations in a debt instrument arising from seller-financed sales of property. Prior to the enactment of the OID provisions, buyers and sellers of property were able to obtain significant tax benefits by inflating the sales price paid for the property. To compensate the buyer for this, the seller would finance part of the purchase price by accepting the buyer's promissory note bearing a below-market interest rate. This transaction would leave the parties in the same economic position as would have existed had the sale price not been inflated and had the promissory note reflected a market interest rate. However, the parties would have substantially different tax consequences.

If the property being sold was a capital asset in the hands of the seller, the seller would be converting what would otherwise be ordinary income (interest) into capital gain by manipulating the purchase price of the property. The seller's additional sales proceeds would be taxed at capital gain rates, while the ordinary income component, interest received on the note, would be minimized. The buyer would also benefit since the inflated sales price would result in a higher adjusted basis in the property. If the property was depreciable, the buyer would benefit from higher depreciation deductions by electing to use accelerated depreciation.

Definition of OID:

In order to prevent such manipulation, Congress enacted the OID provisions. The purpose of these provisions is to reclassify that portion of the proceeds from sales of property, which in reality represent disguised interest. This disguised interest is also known as OID, which is defined by the Code as the stated redemption price at maturity ("SRPM") of a debt instrument, less the issue price of the instrument.(fn2)

The Code defines SRPM as the amount fixed by the last modification of the purchase agreement, including interest and other amounts payable at that time, but excluding any interest which is both based on a fixed rate and payable unconditionally at fixed periodic intervals of one year or less during the entire term of the debt instrument.(fn3)

In defining issue price, the Code first requires a determination as to whether Code § 1274 applies. If § 1274 is not applicable, then issue price shall be equal to SRPM, in which case OID will be equal to zero.(fn4)

Determining if a Debt Instrument Contains OID:

Code § 1274 applies to any debt instrument given in consideration for the sale or exchange of property if (1) the SRPM for such debt instrument exceeds (a) the stated principal amount where there is adequate stated interest or (b) in any other case, the testing amount, and (2) where some or all of the payments due under such debt instrument are due more than six months after the date of such sale or exchange.(fn5) A debt is deemed to have adequate stated interest if the stated principal amount for such debt instrument exceeds the testing amount.(fn6) The Code defines "testing amount" as the imputed principal amount of a debt instrument, using a discount rate equal to 110 percent of the applicable federal rate ("AFR").(fn7) The imputed principal amount for a debt instrument is the sum of the present values of all payments due under such debt instrument.(fn8)

Thus, once the testing amount is calculated, it is first compared with the stated principal amount of...