Deferring Shareholder Gain by Distributing Installment Notes

When a C corporation sells some or all of its assets during the process of liquidation and takes back one or more installment notes as payment, it must recognize, in the year of liquidation, all unrecognized gains on installment receivables distributed to the shareholders (Secs. 336 and 453B(a)). The gain recognized is the difference between the fair market value (FMV) of the installment receivable on the date of distribution and the corporation’s tax basis in the receivable. This same rule applies to installment obligations arising from sales occurring before the liquidation plan was adopted.

Timing of Shareholder Gain Recognition

Shareholders who receive post-liquidation installment obligations (those arising from sales entered into on or after the date of adoption of the liquidation plan) can defer gain until payment is received on those installment obligations (Sec. 453(h)(1)(A)). In essence, the shareholder treats the installment payments as additional consideration for the stock when they are received. However, this treatment is available only if:

1. The installment obligation is created during the 12-month period beginning with the date of adoption of the liquidation plan; and
2. The liquidation is completed during that 12-month period.

Observation: The timing of the corporate- level installment sale and the completion of the liquidation process are critical. If the timing rules are not met, the shareholder is forced to treat the full FMV of the installment obligation as received in the year of liquidation. The probable result is that gain will be recognized without the accompanying cash needed to pay the tax.

Shareholders who receive these installment obligations report any gain or loss on their stock that is attributable to such obligations on the installment basis, unless they elect out of installment reporting.

If assets sold on the installment method in the post-liquidation period are inventory-type assets (including stock in trade or assets held for sale in the ordinary course of business), they must be sold in a bulk sale or gain will have to be recognized by the shareholder when the installment obligation is distributed (Sec. 453(h)(1)(B)).

Calculating Shareholder Gain

To calculate the gain on a post-liquidation installment obligation received, the shareholder’s basis in the stock surrendered is allocated among all the assets received (i.e., installment note, cash, property) in proportion to those assets’ FMVs. The installment note’s face value less its basis (the allocated amount of the basis in the surrendered stock) equals the gross profit. As the shareholder receives a payment on the installment note, the shareholder recognizes gain from the liquidation equal to the payment amount times the gross profit ratio. The shareholder’s holding period for the installment note begins with the date the note was distributed, not the date the note originated.

Shareholders who receive liquidating distributions in more than one tax year must recompute their gain reported on the complete liquidation by allocating the basis of the stock over all payments received or to be received (Sec. 453(h) (2)). Thus, shareholders who receive installment obligations in a complete liquidation must recompute their gain if payments are received in more than one year. Shareholders receiving installment payments in a future year recognize any additional gain required by the reallocation of basis in the year the additional payments are received. As a result, an amended return for the earlier year is not required, although the shareholders have the option of filing one (Regs. Sec. 1.453-11(d)).

The FMV of a post-liquidation installment obligation that is distributed in a liquidation is its issue price, which is defined as the sum of its adjusted issue price on the date of distribution and its qualified stated interest (within the meaning of Regs. Sec. 1.1273-1(c)) accrued as of the date of the distribution (Regs. Sec. 1.453-11(a)(2)(ii)). Adjusted issue price is the issue price plus accrued original issue discount, if any, at the date of distribution (Regs. Sec. 1.1275-1(b)).

Example: E, Inc. adopted a plan of complete liquidation on June 1, 2009. On June 26, E sold all its assets to an unrelated party at their adjusted basis for $100,000 cash and a $400,000 installment note. On December 15, 2009, the cash and installment receivable are distributed to the sole shareholder, N, in complete liquidation. N‘s basis in the stock is $50,000. N receives one principal payment of $50,000 on the installment note on December 22, 2009. As of December 31, 2009, the remaining balance on the installment note is $350,000.

N can defer recognition of the gain realized on the distribution of the installment note until such time as the payments are received on that note. N‘s total realized gain on the liquidation under Sec. 331 is as in Exhibit 1.

N‘s $50,000 basis in his E stock is allocated between the cash and installment receivable based on each item’s FMV. Therefore, 20% of N‘s stock basis ($100,000 cash/$500,000 total liquidation proceeds), or $10,000, is allocated to the cash. The remaining 80% of the stock basis ($400,000 installment receivable/$500,000 total liquidation proceeds), or $40,000, is allocated to the installment receivable.

Assuming the same facts, N‘s recognized liquidation gain in 2009 is as in Exhibit 2. N recognizes a total gain of $135,000 ($90,000 + $45,000) from the liquidation for the year 2009. The remaining gain is recognized in future years as N receives payments on the installment note. However, under current law, gains recognized after 2010 will be subject to higher long-term capital gain tax rates.

Applying the Related-Party Installment Sale Rules

Special rules apply if the installment obligations arise from sales between certain related parties:

1. Shareholders will not be permitted to defer gain if the corporation received the installment obligation as the result of an installment sale of depreciable property to a specified related party (generally the shareholder’s spouse, a corporation or partnership in which the shareholder has a more than 50% ownership interest, or a trust in which the shareholder is a beneficiary) (Sec. 453(h)(1)(C)). Instead, the shareholder must recognize the full liquidation gain in the year the installment receivable is distributed in liquidation.
2. If an installment obligation is the result of a sale of corporate property to a related party who resells the property within two years, the shareholder is taxed on the amount realized on the resale of the property by the related party (Sec. 453(e)). For this purpose, a related party is defined as any individual who is a related party according to the rules of Secs. 318 and 267(b). The two-year period is suspended while the risk of loss to the related party who purchased the property is substantially reduced by holding a put, by making a short sale, or by “any other transaction” (Sec. 453(e)(2); Shelton, 105 T.C. 114 (1995)). This rule does not apply if tax avoidance is not one of the principal purposes of the transactions.

Distributing Pre-Liquidation Installment Obligations

If the sale took place before the adoption of a plan of liquidation (i.e., the obligation is a pre-liquidation installment obligation), the shareholders must include the full FMV of the distributed installment receivable in the calculation of their gain or loss upon the exchange of their stock for the liquidation proceeds in the year the obligation is distributed to them.

Editor Notes

Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.

This case study has been adapted from PPC’s Tax Planning Guide: Closely Held Corporations, 22d Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, Mary C. Danylak, Timothy Fontenot, James A. Keller, Michael E. Mares, and Brian B. Martin, published by Thomson Tax & Accounting, Ft. Worth, TX, 2009 ((800) 323-8724; ppc.thomson.com).