Internal Revenue Code Section 453: "monetizing" the Tax Deferred Installment Sale of Farmland and Farm Commodities

• Publication year: 2022

52 Creighton L. Rev. 153. INTERNAL REVENUE CODE SECTION 453: "MONETIZING" THE TAX DEFERRED INSTALLMENT SALE OF FARMLAND AND FARM COMMODITIES

INTERNAL REVENUE CODE SECTION 453: "MONETIZING" THE TAX DEFERRED INSTALLMENT SALE OF FARMLAND AND FARM COMMODITIES

Darren R. Carlson, J.D. ^[*]

I. SETTING THE STAGE

The use of deferred payment reporting on sales of farmland and farm commodities has existed in various forms since its inception in 1918. ^[1] For farmers who use the cash method of accounting, deferred payment has been a tax strategy utilized to defer the reporting of income into the following tax year. The deferred payment of farmland sales is commonly referred to as an installment sale. ^[2] The deferred payment on personal property, such as grain and livestock, also qualifies for installment sale reporting. ^[3]

The term "monetize" refers to the "process of turning a non-revenue-generating item into cash." ^[4] Thus, the monetization of the deferred payment is simply converting the installment sale of farm real estate or the deferred sale of farm commodities (such as grains and livestock) into cash. ^[5]

The monetization of installment sales transactions has historically been a tax strategy reserved for multimillion-dollar transactions. ^[6] These transactions were exclusively orchestrated by the formerly Big Eight accounting firms. ^[7] A representative sample of the Monetized Installment Sales is set forth below:

Size	Corporate Entity	Transaction Date	Auditor at Time of Transaction
$ 617 M	Kimberly Clark	9/30/1999	Deloitte & Touche LLP
$ 37.90 M	Glatfelter	2003	Deloitte & Touche LLP
$ 22.90 M	Rayonier	3/1/2004	Deloitte & Touche LLP
$ 1.47 B	Office Max	10/29/2004	KPMG
$ 43.25 M	GREIF, Inc.	5/31/2005	Ernst & Young LLP
$ 4.80 B	International Paper	4/4/2006	Deloitte & Touche LLP
$ 744 M	MeadWestvaco	12/6/2013	PricewaterhouseCoopers
$ 183 M	The St. Joe Company	3/5/2014	KPMG

The complexity and cost of structuring these transactions has historically put them beyond the reach of small to midsized farmers. However, recent standardizations of the monetization documentation have made the monetization of deferred payment transactions for the sales of farms and agricultural commodities accessible to nearly all farmers. ^[8] As a result, the monetization of the deferred sale is no longer reserved for multimillion and billion dollar transactions.

Traditionally, the seller structured the installment sale of farmland so that the seller received a series of equal annual payments over ten, fifteen, twenty, or thirty years. This was designed, in part, so the seller could spread out income taxes on the sale of appreciated farm assets over the life of the contract. So long as the seller received at least one payment from the sale after the close of the taxable year of the sale, the transaction was classified as an installment sale under Internal Revenue Code ("Code") § 453. ^[9] The farm seller only had to report and pay income taxes for the proportion of the payments received in that year relative to the overall gain on the sale. ^[10]

Contrast this traditional installment sale transaction with a monetization of an installment sale transaction that is available when selling farms and farm products. For illustration purposes, this article segregates this monetization of an installment sale transaction into four steps.

A. Step One

When monetizing an installment sale, the transaction remains a sale of farmland or farm commodities with an installment contract. Thus, we have a traditional agricultural seller and purchaser with terms of the sale that appear very similar to the traditional installment sale transaction. However, the contract must provide that the purchaser may assign its obligations to make installment payments to a third-party obligor. The purchaser pays the entire purchase price less proration, fees and costs at the preliminary closing. When the obligations are assigned by the purchaser to the obligor, the obligor holds the seller's closing proceeds, which allows the obligor to complete the payment to the seller in accordance with the terms of the installment sale contract. Note that this preliminary closing results in the purchaser getting immediate title to the purchased asset or assets, but the funds are not delivered to the seller or to an agent of the seller until the end of the contract term. The funds remain under the custody of the obligor, who will make payments to the seller in accordance with the installment contract until the end of the contract term. The contract term typically runs fifteen, twenty, or thirty years.

This transaction looks somewhat similar to a like-kind exchange under Code § 1031. ^[11] Similar to how a qualified intermediary steps in to complete the purchase of like-kind property in a § 1031 exchange, the obligor must step into the purchaser's shoes. The documentation makes clear that the obligor is taking receipt of the funds to fulfill the installment payment contract and is stepping into the shoes of the purchaser through an assignment of the purchaser's obligation to complete the transaction pursuant to the installment contract. Immediately following the preliminary closing, the purchaser is out of the transaction and the obligor steps into the purchaser's shoes to fulfill the purchaser's obligation to complete the payments.

B. Step Two

Unlike traditional installment sales contracts, in the monetization of an installment contract the contract typically provides for a one-time payment of the principal balance to the seller in ten, twenty, or thirty years. In addition, the contracts provide for monthly or quarterly interest payments to the seller. To memorialize these regular interest payments and interest terms, a nonnegotiable promissory note is provided to the seller. The obligor will deposit the funds in a segregated investment account that is comprised of United States Treasury bonds. Since the obligor is required to have the purchaser's funds available to complete the transaction at the end of the contract term, it is essential that as much of the investment risk as possible be removed from the transaction. The obligor will pay the interest on the invested funds to the seller in accordance with the terms of the non-negotiable promissory note. These funds, which are held in United States Treasury instruments, are used to secure an irrevocable standby letter of credit that is provided to the seller to guarantee performance under the installment sales contract by completing all the nonnegotiable promissory note payments.

C. Step Three

Once the nonnegotiable promissory note and the corresponding standby letter of credit are in the seller's hands, the asset (i.e., the promissory note) and the collateral (i.e., the standby letter of credit) are in place for the seller to obtain a loan for nearly the entire installment sale contract price. Since this loan is 100 percent collateralized, the seller can borrow at very favorable interest rates that are slightly above the amount that the seller would receive on the nonnegotiable promissory note. The loan, which is obtained by the seller for nearly the entire sales amount, less transaction fees and costs, is not considered sales proceeds that will trigger income taxes. Rather, the monetization (i.e., getting cash from a loan) for the entire value of the net sales price in the installment sales will receive favorable installment sale income tax reporting under Code § 453. ^[12]

D. Step Four

Upon the ultimate closing at the end of the installment sales contract, the transaction is closed out. The purchase proceeds held by the obligor are then delivered to the seller in exchange for return and cancellation of the nonnegotiable promissory note. In turn, the seller uses the proceeds to retire the loan with the lender. Once the transactionis closed, the seller will have to report gain on the sale proceeds in excess of seller's basis. ^[13]

The economic impact to a seller of monetizing the installment sale is substantial. The installment sale permits the sale of property used or produced in the business of farming (i.e., farmland or farm commodities) while enabling the seller to immediately receive the entire sales proceeds, less transaction costs and fees. In addition, the seller defers the income taxes over the duration of the installment sale term. On a monthly or quarterly basis, the seller has payment obligations on the loan, which are offset by the interest received from the obligor. The net interest payments paid by the seller on the loan is, in effect, the spread between the net earnings on the interest received from the obligor and the interest paid on seller's loan from the lending institution.

A monetized deferred sale of farmland or farm commodities with a deferred tax payment, unavoided, for years, even decades, gives the seller tremendous leverage and the opportunity to earn a significant return on the taxes deferred and on the sale proceeds. Since the seller does not have to pay the income taxes for the duration of the contract, the seller has the opportunity to invest the entire loan proceeds, approximately equal to the sales proceeds, instead of just investing the net after-tax proceeds over the contract term.

Another advantage to the...