
Introduction
The IRS has for the second time in as many years included
monetized installment sales on its annual “Dirty Dozen” tax schemes
list. As we discussed in a prior post, the “Dirty
Dozen” list alerts taxpayers and practitioners to certain
transactions or arrangements that the IRS considers potentially
abusive tax arrangements that taxpayers should avoid.1
Generally, the “Dirty Dozen” list includes transactions
that are heavily promoted and that will likely attract IRS
enforcement and compliance efforts in the future. The IRS warned
taxpayers to beware of, and avoid, advertised schemes, many of
which are promoted online, that promise tax savings that are
“too good to be true” and that will likely put taxpayers
in jeopardy. The purported tax benefits that promoters offer from a
monetized installment sale have clearly drawn the IRS’s
attention. Generally, these tax arrangements allow taxpayers to
sell appreciated property but defer the corresponding tax
(typically many years later) when seller receives one or more
payments, relying, in part, on the installment sale rules in
section 453.
The inclusion of monetized installment sales on the “Dirty
Dozen” tax list follows on the heels of CCA 20211800162
where the IRS explained six reasons why these transactions are
problematic. The CCA also explained why the promoters’ basis
for how the transactions purportedly achieve the desired tax
consequences, is flawed. Promoters of monetized installment sales
often rely on a 2012 IRS
Memorandum3 as support for their position
that monetized installment sales have been blessed by the IRS and
are legitimate. As discussed below, the 2012 IRS Memorandum was
issued in a different factual context and should not be viewed as
support for the typical monetized installment sale structure.
Taxpayers that are considering, or have engaged in, monetized
installment sales, deferred sales trusts, or similar transactions,
should consult with an independent tax professional to carefully
review the underlying legal requirements and technical analysis on
which such arrangements are based.
The Generic Monetized Installment Sale
Promoters market monetized installment sales as a strategy to
receive all of the proceeds from the sale of a highly appreciated
asset in the year of the sale but defer paying the corresponding
tax well into the future. In some cases, promoters are marketing a
thirty-year deferral of the tax. If that sounds too good to be
true, you are on the right path. If the transaction works as
marketed, the promoter is selling an arrangement that takes
advantage of the time-value of money. Investing pre-tax dollars
received from the sale and allowing that investment to grow over a
period of time will yield a larger return than if the same sales
proceeds were used to pay the tax at the time of the sale and then
the remainder invested post-tax.
The basic steps of a monetized installment agreement are as
follows. A seller agrees to sell appreciated property (usually a
capital asset) to a buyer for cash but instead of selling it
directly to the buyer, the seller sells property to a promoter (or
an intermediary affiliated with the promoter) in return for a
thirty-year installment note. The promoter then sells the property
to the buyer and receives the cash purchase price. Promoter
partners with an intermediary to lend the seller 95 percent of the
sales proceeds (deducting their fee 5% from the sales proceeds) as
an unsecured, nonrecourse loan for the same term as the installment
note, thirty years. The promoter tells the seller that because the
loan from the intermediary is unsecured, the seller does not have
constructive receipt of the original sale proceeds. Moreover, the
interest income on the installment note is directed to an escrow
account, which is used to make interest payments on the loan to the
intermediary. The seller deducts the interest payments to the
intermediary, offsetting the interest income that seller received
from promoter under the installment note.
In effect, through these series of related steps and
intermediaries, the seller received an amount equivalent to the
sales price, less transactional fees, in the form of a purported
loan that is nonrecourse and unsecured. Because the seller executed
an installment note with the promoter, the seller takes the
position that the income received under the installment note is
only included in income when it is received, in the future, under
the installment sale rules of section 453. By paying a promoter and
an intermediary a fee for their services, the seller received the
full amount of the sales proceeds in the year of the sale, without
paying any tax on it, and can use those pre-tax funds as desired,
for thirty years until the tax is due.
Contrast with a Generic Installment Sale Under Section 453
The tax benefit of a monetized installment sale is clearer when
it is compared against the tax consequences of a traditional
installment sale under section 453. Generally, under section 453,
if an individual taxpayer (individual taxpayers must report income
on the cash basis method, i.e., it is reported when received) sells
property to a buyer in exchange for a thirty-year installment note
(principal and interest to be paid in equal yearly payments for
thirty years), the taxpayer only reports and pays tax on the income
that it actually receives, each year, under the note. Thus, under
section 453, the taxpayer includes the sales proceeds in income as
it receives the proceeds. The same result would occur if the
installment note was an interest only note with a balloon payment
at the end of the loan term. The taxpayer would include the
interest in income yearly as it is received but because it did not
receive any principal, the principal would not be included in
income until year thirty when the taxpayer received the sales
proceeds.
Contrast this result with the monetized installment sale and it
is easy to see why the IRS considers it a potentially abusive tax
arrangement. As discussed, in a monetized installment sale because
of the use of an intermediary and a second nonrecourse unsecured
loan, the taxpayer was able to receive the full amount of the sales
proceeds (minus the fee paid to the promoter and the intermediary)
in year one but defer the tax on the sale until year thirty. Thus,
the use of an intermediary and a second nonrecourse unsecured loan
allows the taxpayer to get the benefit of section 453 installment
sale treatment without reporting any amount in income when it is
received in year one.
The IRS’s View Why Monetized Installment Sales are
Potentially Abusive Tax Arrangements
In CCA 202118016, the IRS explained several reasons why it
believes that monetized installment sales do not work and are
potentially abusive tax arrangements. First, the loan from the
intermediary lender allows the seller to receive the cash and
maintain a thirty-year tax deferral but it is an unsecured,
nonrecourse loan. If the loan is unsecured and nonrecourse, then
the seller is not liable for it and has no obligation to repay the
intermediary lender. As a result, there is no genuine debt and the
purported loan is income to seller when it is received.
Second, if the debt to the intermediary lender is secured by the
cash escrow, then the cash escrow is security for the
intermediary’s loan to the taxpayer. As a result, the taxpayer
should be treated as receiving payment under the economic benefit
doctrine for purposes of section 453. Alternatively, if the
intermediary’s loan is secured by right to payment from the
escrow under the promoter’s installment note, section 453A(d)
contains a special exception to the general installment sale
treatment when there is a related pledge. In this variety of the
transaction, because the intermediary’s loan is secured by the
seller’s right to payment from the escrow under the installment
note, it violates the pledging rule in section 453A(d) and
therefore, the loan proceeds are treated as payment of the
installment note (which results in no tax deferral under section
453).
Additionally, CCA 202118016 states that the promoter does not
appear to be the true buyer of the property sold by the taxpayer.
Under section 453(f), only debt instruments from an acquirer can be
excluded from the definition of payment and thus, not constitute
payment for purposes of section 453. Debt issued by a party that is
not the acquirer, would be considered payment, requiring
recognition of gain.
Finally, CCA 202118016 makes clear that the 2012 IRS Memorandum
that promoters use to legitimize this transaction is factually
distinguishable from the typical monetized installment sale
transaction that promoters are marketing to taxpayers. The 2012 IRS
Memorandum was premised on a specific exception to the pledging
rule for sales of farm property. Thus, unless the seller
is selling farm property, the 2012 IRS Memorandum does not support
the monetized installment sale. Additionally, the 2012 IRS
Memorandum did not involve an intermediary that purchased the
property from the seller and then sold it to the ultimate
buyer.
Parting Thoughts – If it Sounds Too Good to be True, Get
Advice from an Independent Tax Professional
The inclusion of monetized installment sales on the last two IRS
“Dirty Dozen” lists and the release of CCA 202118016, are
a clear indication that the IRS is closely scrutinizing these
potentially abusive tax arrangements. In addition to the issues
that the IRS identified in CCA 202118016, and as we noted in a prior article,
the IRS has indicated that it may start more broadly asserting
other authorities or common law doctrines (such as economic
substance) to recast a transaction, or the effects of a
transaction, that it views as inappropriate. This transaction, and
similar variations might be a candidate for such challenges.
Moreover, the IRS recently formed the Office of Promoter
Investigations whose mission is to detect and end the promotion,
organization, and sale or abusive tax transactions. Transactions
like monetized installment sales that are included on the IRS’s
“Dirty Dozen” list are likely to be pursued by the Office
of Promoter Investigations. Thus, it appears that the IRS is poised
to take enforcement action against both promoters and taxpayers
that are engaging in monetized installment sales. If you are
considering engaging in (or have already completed) a monetized
installment sale or any of its numerous varieties, you should speak
with an independent tax professional to review the underlying legal
requirements and technical analysis on which such arrangements are
based. Taxpayers that have already engaged in a monetized
installment sale have an opportunity to take corrective actions to
mitigate the consequences and substantial tax penalties that may
result from these transactions.
Footnotea
1. See IR 2022-113 (June 1, 2022).
2. May 7, 2021.
3. NSAR 20123401F (Aug. 24, 2012).
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.