Installment Sales: Allocation of Installment Payments

By Jon R. Klunk, CPA, Oak Brook, IL

Editor: Frank J. O’Connell Jr., CPA, Esq.

In certain circumstances the installment sale method permits a sale of property without the seller being required to report the gain until the actual receipt of payment. The rules governing installment sales are well defined, and the gain deferral achieved through installment sale treatment enables the seller, in certain circumstances, to spread gain over the period of installment payments based on the proportion that the gross profit on the sale bears to the contract price. Agreements between buyer and seller to specifically allocate installment payments can maximize tax deferral.

To be eligible for installment sale treatment, at least one payment must be received after the close of the tax year in which the sale occurs (Sec. 453(b)(1)); however, not all transactions involving deferred payments qualify for installment sale treatment. There are a number of ineligible transactions, including transactions where:

  • The overall sale creates a loss;
  • Inventory is sold;
  • The property sold is stock or securities traded on established securities markets; or
  • Depreciable property is sold to a related party.

In addition, Sec. 453 does not permit deferral of depreciation recapture when Sec. 1245 recapture applies to assets sold on installment (Sec. 453(i)).

When a taxpayer sells or exchanges several items of property for an aggregate price that includes installment payments, an allocation of purchase price as well as a specific allocation of particular installment payments is often advantageous. When a taxpayer sells assets comprising a business at a gain and all payments are not received in the year of sale, unless the taxpayer elects otherwise, the gain is required to be reported based on the installment method of accounting. However, tax deferrals in situations in which a number of assets are sold for an aggregate price can be limited when the assets include a variety of tax characteristics—i.e., inventory, items sold at a loss, and other items ineligible for installment sale treatment. An agreement between the parties specifically allocating installment payments to particular assets can maximize tax deferral.

To maximize the installment sale tax deferral, buyer and seller should negotiate an agreement on the allocation of particular installment payments to particular assets. Rev. Rul. 68-13 states that

the sale of a business must be “comminuted into its fragments” where either the selling price or the down payment, or both of them, is separately stated with respect to different assets or types of assets in the agreement of sale. . . . [S]eparate computations must be made to the extent necessary with respect to each asset. . . .

The allocation of early payments to inventory, assets sold at a loss, and other items for which installment reporting is unavailable will maximize the seller’s gain deferral.

Failure to draft installment sale agreements detailing the allocation of installment payments among assets limits the tax deferral achieved from the installment method of accounting. As illustrated by the exhibits, in the event a sales agreement does not specify the allocation of installment payments among the assets, the installment payments must be allocated among the assets on the basis of their relative fair market values (FMVs), often limiting tax deferral.

A specific allocation of installment payments is also beneficial when sale agreements include a substantial initial-year cash payment followed by installment payments in subsequent years. Similar to the analysis above, agreements to allocate the initial payment to assets ineligible for installment method reporting can maximize tax deferral.

Applicability to Sec. 338(h)(10) Installment Payment Allocations

It is unclear whether agreements to allocate installment payments to specific assets under Rev. Rul. 68-13 may be used to defer gain in Sec. 338(h)(10) transactions. When a valid Sec. 338(h)(10) election is made, a parent company’s sale of a subsidiary, or the sale of an S corporation, is treated as a sale of the acquired corporation’s assets. In a Sec. 338(h)(10) transaction, when a payment to purchase stock is received after the tax year, a seller is eligible to use the installment method to report gain. Regs. Sec. 1.338(h)(10)-1(d)(8) outlines the installment sale treatment for Sec. 338(h)(10) transactions; however, the regulations provide no guidance on the applicability of Rev. Rul. 68-13 to deemed-asset sales.

In 2001, Treasury issued final regulations under Secs. 338 and 1060 (T.D. 8940). In the preamble to the proposed regulations issued with respect to these final regulations (REG-107069-97), Treasury stated that the principal purpose for the new regulations was to make the treatment of deemed-asset sales under Sec. 338 substantially the same as actual asset sales under Sec. 1060. Therefore, it would seemingly be incongruous to allow specific allocation of installment payments in a Sec. 1060 asset sale and to deny such an allocation in a Sec. 338(h)(10) transaction. The application of Rev. Rul. 68-13 to Sec. 338(h)(10) transactions furthers the regulatory scheme to report gain on Sec. 338(h)(10) and Sec. 1060 transactions in substantially the same manner.

Conclusion

As shown above, where installment sale reporting is available for asset sales, allocation of installment payments to specific assets can maximize tax deferral. Based on the statutory and regulatory framework, it is not unreasonable to conclude that the advantageous tax deferral received through the specific allocation of Sec. 453 installment payments in actual asset sales outlined in Rev. Rul. 68-13 is applicable to Sec. 338(h)(10) deemed-asset sales.


EditorNotes:

Frank J. O’Connell Jr. is a partner in Crowe Chizek in Oak Brook, IL.

Unless otherwise noted, contributors are members of or associated with Crowe Chizek.

For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or foconnell@crowechizek.com.

Newsletter Articles

SPONSORED REPORT

Year-End Tax Planning and What’s New for 2016

A look at year-end tax planning strategies for individuals and businesses, as well as recent federal tax law changes affecting this year’s tax returns.

PRACTICE MANAGEMENT

CPAs Contend With Tax ID Theft

Tax-related identity theft fraud remains a widespread problem that is often difficult for victims and their tax preparers to correct.