Use of the installment method in liquidations.

• Author: Harris, Richard W.
• Position: Part one

The retroactive repeal of Sec. 453(a)(2) (1) (which had barred accrual-method taxpayers from using the installment-sale method) has refocused attention on the installment-method's benefits. In particular, Sec. 453(h) permits shareholders receiving qualified installment notes in otherwise taxable complete liquidations to use the method.

Part I of this two-part article, below, discusses shareholders' use of Sec. 453(h) and its effect on the distributing (accrual-or cash-method) corporation. Part II, in the next issue, examines the use of Sec. 453(h) by S corporation shareholders in actual and deemed asset sales and distributions of installment notes with original issue discount (OID).

The Installment Method

Sec. 453(b)(1) defines an "installment sale" as a disposition of property in which at least one payment is received after the close of the tax year in which the disposition occurs. According to Sec. 453(c) and Temp. Regs. Sec. 15A.453-1(b)(2), a taxpayer recognizes income or gain on a disposition as it receives installment payments, (2) using a gross profit ratio (GPR). Temp. Regs. Sec. 15A.453-1(b)(2)(ii) defines GPR as the ratio of the sale's gross profit to its contract price. "Gross profit" is defined by Temp. Regs. Sec. 15A.453-1(b) (2)(v) as the selling price, (3) less the sum of the property's adjusted basis and selling expenses.

Under Temp. Regs. Sec. 15A.453-1 (b)(2)(iii), "contract price" refers to the selling price, less the sum (not in excess of the seller's adjusted basis in the property, modified in some cases by commissions and selling expenses) of (1) all debt secured by the property and (2) certain other debt incurred or assumed by the purchaser on the property. (4) "Payments" include all cash or other property actually or constructively received during the year, but not the buyer's evidences of debt (i.e., the installment note), even if, according to Temp. Regs. Sec. 15A.453-1(b)(3)(i), a third party guarantees such debt.

Example 1: In 2002, T sells a parcel of land with a $200,000 basis and $500,000 fair market value (FMV), subject to a $150,000 mortgage, for $20,000 and a five-year promissory note paying $66,000 annually beginning in 2003, plus 10% interest. T had held the land for investment. T's gross profit, contract price and GPR are $300,000 ($500,000-$200,000), $350,000 ($500,000-$150,000) and 85.714% ($300,000/$350,000), respectively. T's 2002 recognized gain is $17,143 (85.714% x $20,000); in 2003-2007, it is $56,571 (85.714% x $66,000) per year. T recognizes interest as ordinary income as received. T's total gain recognized is $300,000 ($17,143 + (5 x $56,571)).

According to Temp. Regs. Sec. 15A.453-1(b)(3)(i), if the property transferred is secured by debt (whether assumed or taken subject to by the buyer) exceeding the seller's basis in the property, the excess would be additional payment received in the sale year. The contract price is calculated by subtracting from the selling price the debt not in excess of such basis.

Example 2: The facts are the same as in Example 1, except that the mortgage is $275,000. The debt in excess of T's basis is treated as a payment in the sale year. The installment note is $205,000 ($500,000-($20,000 + $275,000)); the gross profit, contract price and GPR are $300,000, $300,000 ($500,000-$200,000), and 100% ($300,000/$300,000). T recognizes $95,000 ($20,000 + $75,000) gain in 2002, and $41,000 ($205,000 note payable over five years) annually in 2003-2007. His total gain remains at $300,000.

Exceptions and Limits

The following items do not qualify for the installment method:

1. Dispositions of inventory and publicly traded stock (Sec. 453(b)(2) and (k)(2)(A) and Temp. Regs. Sec. 15A.453-1 (b)(4)).

2. Depreciation recapture (Sec. 453(i)).

3. Demand notes, notes secured by cash (or cash equivalents) and readily tradable corporate or governmental obligations (Temp. Regs. Sec. 15A.453-1 (e)(1)).

   As discussed in Part II of this article, if an installment note's stated interest rate is inadequate, it might be deemed to include OID, resulting in imputed interest under Sec. 1274(a) or 483.

   Under Sec. 453A(b)(2), if a taxpayer (together with certain related persons) holds at the end of a tax year more than $5 million in face value of installment notes that arose during the year, he would have to pay interest on the tax deferral. Under Sec. 453A(b)(1), if a taxpayer holds an installment note from a sale in which the sales price exceeded $150,000 and pledges it to secure a borrowing, the net loan proceeds would be deemed payments received on the note.

   Finally, Sec. 453B requires gain recognition on most dispositions of installment notes.

   Nonsubsidiary Complete Liquidation

   Sec. 336(a) provides generally that a liquidating corporation recognizes gain or loss on a property distribution as if such property were sold to the distributee at its FMV. Under Sec. 331(a), amounts a shareholder receives in a complete liquidation are treated as full payment in exchange for stock (normally triggering capital...