When does it make sense to elect out of the installment method?

• Author: Werlhof, John

Merger-and-acquisition (M&A) activity essentially ground to a halt in early 2020 in the face of the uncertainty associated with COVID-19. M&As came roaring back in the second half of 2020, however, and the trend is projected to continue through 2021. (1) If part or all of the consideration in a sale transaction is received in a subsequent year from the seller's tax year in which the sale's distribution of property occurs, the seller generally reports gain as proceeds are received under the installment method. (2) Despite receiving installments over time, however, the seller can elect out of the installment method of recognizing gain for tax purposes and choose instead to report the entire gain in the year of the sale. (3)

Historically, many taxpayers have reported gains from M&A transactions using the installment method. However, a proposal by President Joe Biden's administration to raise the top capital gains rates for those making more than $1 million per year from 20% to 39.6% (23.8% to 43.4%, including the 3.8% net investment income tax) has taxpayers and their advisers considering whether to elect out of the installment method for recent sale transactions. (4) This article summarizes some of the pros and cons of electing out of the installment method, which are also listed in the chart below, "Pros and Cons of Electing Out of the Installment Method."

Pros of electing out

Lock in current tax rates (assumes rates increase in the future)

In an installment sale, gain is subject to tax at the rates in effect in the year the gain is recognized. While many tax planning strategies involve delaying the time for paying tax, it may be better to accelerate gain recognition to pay tax at today's known tax rates rather than defer the gain into the future, when the tax rates are unknown and may be higher. Note that the IRS generally does not allow taxpayers to retroactively elect out of the installment method if tax rates increase in the future. (5)

Example 1: On Feb. 1, 2021, K sold stock of J Corp., a C corporation, with zero basis for $25 million, with $5 million down and $20 million payable in $4 million installments over a five-year period beginning in 2022. None of the gain is eligible for the Sec. 1202 gain exclusion. Assume a 23.8% federal combined capital gains and net investment income tax rate applies to the gain in 2021 and a 43.4% rate applies in 2022 and later years. K's total federal income tax on the gain will be $9.87 million if he applies the installment method, and the tax will be $5.95 million if he elects out of the installment method. Even factoring in the time value of money, K may be better off electing out of the installment method.

Pros and cons of electing out of the installment method Pros Cons Lock in current tax rates Accelerate tax (if rates increase) Reduce value of Lock in current tax rates (if rates taxpayer's estate decrease) Avoid the Sec. 453A Use of losses from buyer default may interest charge on deferred tax be limited Facilitate investment Use of losses from other sources may in opportunity zone fund be limited Accelerate basis recovery Administrative burdens in certain contingent sales Absorb expiring carryovers Of course, the proposal to raise capital gains rates may never become law, may be adopted in modified form, or could even be adopted retroactively.

The election out of the installment method is made by the extended due date of the income tax return for the tax year in which the disposition occurs. (6) Taxpayers may want to extend their returns for the year of a sale to obtain additional time to decide whether to elect out of the installment method and see how this and any other rate increase proposals unfold.

Reduce the value of a taxpayer's estate

There is no deduction for estate tax purposes for the deferred income tax liability associated with an installment note. Heirs can claim an income tax deduction for estate tax paid on the deferred income, but the income tax benefit of that deduction is less than the incremental estate tax liability. (7) In contrast, any assets used to pay the income tax liability in the year of the sale will not be part of the decedent's estate.

Example 2: A sells the stock of her company in 2021 for $1 million on an installment basis. She has no basis in the stock, and the first payment is due in 2022. If A defers the entire gain under the installment sale and dies before any payments are received, the full $1 million installment note is included in the value of A's estate with no reduction for the tax her heirs will pay on the installment payments as income in respect of a decedent. If A elects out of the installment method and pays $238,000 in tax with her 2021 tax return before she dies, the cash used to pay the tax is no longer part of her estate. The $1 million installment note is still included in the value of her estate, but the net effect is that the value of her estate includes $762,000 on account of the installment note...