Adventures in Forgiveness and Forgetfulness, Part 2: Intra-family Sales for Beginners

• Publication year: 2007
• Author: By Philip J. Hayes, Esq.

ADVENTURES IN FORGIVENESS AND FORGETFULNESS, PART 2: INTRA-FAMILY SALES FOR BEGINNERS

By Philip J. Hayes, Esq.^*

I. INTRODUCTION

Part 1 of this article, published in the preceding issue of the California Trusts and Estates Quarterly, discussed intra-family loans, the history of judicial and Congressional treatment of below-market loans, avoiding below-market loan status under Internal Revenue Code section 7872, and quantifying the damage if a loan is deemed below-market. No article about intra-family loans is complete, however, unless it also addresses loans in the context of sales transactions, which adds a sometimes inscrutable layer of complexity to the relatively straightforward loan rules. Thus we present Part 2, the abstract counterpart to intra-family loans: intra-family sales.

As we learned in Part 1, Section 7872¹ is complicated, and, in practice, often ignored. The complexity is exacerbated in sales transactions, which implicate both the income tax and gift tax safe harbor of section 7872 and the overlapping income tax (and gift tax?) safe harbors of Sections 483 and 1274 governing installment sales. Focusing on Section 7872, Part 1 dwelled on structuring loans to avoid imputed income tax and gift tax liabilities. This article will mainly try to sort out which rules will apply to a particular transaction—whether Section 7872, or its income tax counterparts Sections 483 and 1274, or both—and will focus on utilizing the proper interest rate and terms to avoid imputed income. Where the concern with Section 7872 intra-family gift loans is mainly with avoiding imputed income and an imputed gift, additional concerns with sales transactions are the characterization of payments received by the lender, and the timing of recognition.

Note that the discussion makes a threshold assumption that the loan under consideration provides for annual payments of interest. With both sales transactions and straightforward loans, if the loan does not call for "qualified stated interest" (e.g., annual payment of interest at a single fixed rate) the Code² may impute phantom income annually under the OID rules even if the interest rate satisfies the applicable safe harbor. So while the use of the proper AFR may protect the lender from recharacterization of payments or an imputed gift, the lender may have to recognize annual interest income although no payments have been received.³

Note that, although practitioners have increasingly employed the installment sale to a grantor trust as an intra-family sale method in recent years, the strategy implicates a different set of considerations beyond the scope of this article. If there is ever a Part III in this series, it will cover installment sales to grantor trusts.

II. INSTALLMENT SALES

Planners have long used traditional intra-family sales to freeze the estate tax value of the assets sold and to provide liquidity by replacing an illiquid asset with cash. These advantages are balanced against the disadvantages of a sale, among them the recognition of gain, loss of control over the asset and loss of income from the asset. To avoid the immediate recognition of gain, sales to family members are often structured as installment sales. The installment method permits the seller to postpone reporting the gain until the actual receipt of the payments (subject to the exceptions noted below).

Although the installment sale method will generally be available under Section 453(a),⁴ there are significant exceptions. In particular, the installment sale method is not available for a sale of marketable securities or other property regularly traded on an established market.⁵ It is also not available to the extent that the gain in question is depreciation recapture and may not be available at all if the sale consists of depreciable property and is to a controlled entity.⁶ Finally, sales of inventory or dealer property generally will not qualify for installment treatment.⁷

Even if the installment method is available, there may be limits on its use. First, interest may be charged on the deferred tax liability if the aggregate face amount of all of the seller's installment obligations from sales during the year exceeds $5,000,000.⁸ Also, a pledge of the installment note will trigger gain recognition.⁹ Lastly, a gift or other disposition of the installment note, or the sale of the purchased property by a related purchaser within two years of the installment sale, may cause the balance of the deferred gain to be recognized.¹⁰

III. WHICH INTEREST-RATE SAFE HARBOR APPLIES TO INSTALLMENT SALES?

One primary, unresolved issue involving "gift" loans under Section 7872¹¹ involves sales of property that may be regarded as part-sale, part-gift.

For example,¹² assume a mother decides to sell to her adult child a tract of undeveloped land. The sales price is $500,000, to be paid $100,000 in cash and $400,000 by a 15-year promissory note at 6 percent per annum, compounded semi-annually. Total payments over the term of the note would be $907,905. Assume the AFR is 10 percent (yes, this may happen again). The present value of the payments under the contract, discounted at the AFR, would be $234,243. The difference between this amount and the loan amount, $400,000, is $165,757. Because the present value of the total payments would be less than the amount loaned, this is a below-market loan under Section 7872, at least according to the IRS.

[Page 15]

Under similar circumstances, however, taxpayers have argued, and the Seventh Circuit has agreed, that no gift occurred because the transaction falls under the income tax safe harbor of Section 483(e) of the Code, which provides a 6-percent safe harbor for land sales between relatives.¹³ The IRS, the Tax Court, and the Eighth and Tenth Circuits disagree, however, and would assert that Section 483(e) only provides an income tax safe harbor, not a gift tax safe harbor.

What has happened to the relatively straightforward scheme of safe-harbor interest rates outlined in Part 1 of this paper? We have departed from the relative safety of intra-family loans and stepped into the murk of intra-family sales. This area has not garnered much attention in the past decade or so because of the low interest rate environment. In contrast to June 1981, when the average prime rate was 20.3 percent, today 6 percent is not a valuable safe harbor.¹⁴ However, if and when interest rates (and therefore, the AFR) rise, the sleeping bear may be roused.

A. The Statutes

As noted above, prior to the enactment of Section 7872, Congress first entered the realm of interest-rate safe harbors in the context of installment sales. Congress enacted or amended income tax statutes Sections 483 (1964, amended in 1984) and 1274 (1984) to address a problem not involving the gift tax. Under these statutes, certain debt instruments issued in connection with installment sales must bear interest at the AFR to ensure that the instrument provides "adequate stated interest." The statutes were aimed at installment-sale transactions in which the parties had inflated the sales price and imposed reduced-interest or no-interest payments. Sales structured in this manner allowed the seller to convert ordinary income to capital gain and allowed the buyer to treat all payments as basis. Thus, although Sections 483 and 1274 impute interest with the same methodologies as does Section 7872, Sections 483 and 1274 ostensibly address not valuation issues, but rather characterization of income.

1. Section 7872

Section 7872(f)(8) provides that Section 7872 does not apply to a loan given in consideration for the sale or exchange of property; this area is, at first glance, covered by Sections 483 and 1274. This is so even if Sections 483 and 1274 do not apply by reason of exceptions or safe harbor provisions.¹⁵ This straightforward statement is modified somewhat by the regulations and Proposed Regulations, and transmogrified by caselaw (see below).

2. Section 1274

Section 1274 provides the general rule for income tax treatment of installment sales; it applies to a note issued in a sale or exchange unless the note is excepted from its application. Section 1274(d)(2) provides that, in a sale or exchange, the appropriate AFR is the lowest such rate for the three-month period ending with the month there was a "binding contract in writing for such sale or exchange." For installment sales, the appropriate AFR is based not the term of the note, but on its weighted average maturity.¹⁶ The weighted average maturity of an obligation equals the product obtained by multiplying the number of complete years from the issue date until the payment is made by a fraction. The numerator of the fraction is the amount of each payment under the instrument (other than qualified stated interest), and the denominator is the stated redemption price at maturity.¹⁷

a. Special AFR Rules Apply to Certain Transactions

Section 1274(c)(3) lists exceptions to the application of the section, which exceptions include transactions to which Section 483(e) applies.

b. Qualified Debt Instruments

Section 1274A provides a safe harbor of 9 percent, compounded semiannually, for certain qualified debt instruments. In 2006, a qualified debt instrument included any debt instrument given in exchange for property (other than Section 38 property) that had a stated principal amount of not more than $4,800,800.¹⁸ However, a debt instrument issued in a sale/leaseback transaction cannot be a qualified debt instrument.¹⁹ This rate is severely limited in the realm of intra-family sales in that it applies only to bona fide sales between unrelated parties.

c. Sale/Leaseback Transactions

For sale/leaseback transactions involving the transferor or any related party, the discount rate is 110 percent of the AFR, compounded semiannually, and not limited to 9 percent.²⁰

3. Section 483

Section 483 applies, in limited circumstances, to debt instruments issued in a sale or exchange of property excepted from Section 1274 (see below)...