Interest Income & Expense
As the merger and acquisition business continues to prosper, practitioners should be aware of the tax implications and compliance requirements of the interest charge on deferred tax under Sec. 453A that applies to certain installment sale obligations. Because the Sec. 453A interest charge can be substantial and can add significantly to the cost of a transaction, it should be considered when structuring a business agreement.
Interest Calculation Under Sec. 453A
Sec. 453A(a)(1) imposes an interest charge on nondealer installment obligations where the property's sales price exceeds $150,000 and the total amount of all installment sale obligations that arose during the tax year and were outstanding at the end of the tax year exceed $5 million. The $5 million threshold is applied and calculated at the partner or shareholder level for all passthrough entities. Under Sec. 453A(b)(2), persons treated as a single employer under Sec. 52(a) or 52(b) are treated as one person for purposes of the $5 million threshold. However, in Technical Advice Memorandum 9853002, the IRS ruled that married individuals are not treated as one person in calculating the $5 million threshold.
The interest charge is assessed in exchange for the taxpayer's right to pay the tax on the installment sale income over a period of time. The interest charge is assessed each year the installment note is outstanding as of the end of the year and the outstanding balance exceeds the threshold amount. The interest charge is calculated on the applicable percentage of the deferred tax liability at the end of each year. The applicable percentage is calculated by dividing the aggregate face amount of all installment sale obligations outstanding at the end of the year in excess of $5 million by the aggregate amount of the installment sale obligations outstanding at the end of the tax year.
The deferred tax liability is calculated on the installment note obligation in excess of $5 million outstanding at the end of the tax year. Sec. 453A(c)(3) defines deferred tax liability as the amount of unrecognized gain on the installment note obligation as of the close of the tax year multiplied by the maximum rate of tax in effect for the taxpayer. The maximum rate of tax depends on the type of income subject to tax and is calculated using the long-term capital gains rate when that rate applies.
Sec. 453A(c)(2) provides that the interest charge is based on the Sec. 6621(a)(2) IRS underpayment rate in effect in the last month of the year in which or with which the taxpayer's tax year ends. For taxpayers whose year end was December, the 2013 interest rate was 3%. The interest charge is not prorated based on the month the installment sale occurred. The interest charge is also due on the applicable percentage of the deferred tax liability in future years if any portion of the installment note obligation is outstanding at the end of the tax year.
The Sec. 453A interest charge can be substantial. Take, for example, a taxpayer that entered into an installment sale during its 2013 tax year and received an installment obligation of $50 million. The gross profit percentage for the sale is 100%. As of the end of the tax year, the full balance of the installment note continues to be outstanding. For the 2013 tax year, the taxpayer will have an applicable percentage of 90% ($45 million ÷ $50 million). The applicable percentage as calculated for the year of sale will not change in future years as payments are made on the installment note.
The deferred tax liability on the installment note obligation is $10 million ($50 million × 20%), assuming the transaction is taxed using the long-term capital gain rate. The Sec. 453A interest charge is calculated on $9 million ($10 million × 90%), which is the applicable percentage of the deferred tax liability. Therefore, the Sec. 453A interest charge for the 2013 tax year is $270,000 ($9 million × 3%). The taxpayer is required to continue to calculate Sec. 453A interest in future years if there is a deferred tax liability at the end of the tax year. Note that the interest charge is only assessed on the deferred tax liability calculated under Sec. 1 (individuals, estates, and trusts ordinary income tax rates), Sec. 11 (corporate tax), or Sec. 1201 (capital gains). Therefore, this tax will not be included in the calculation for a taxpayer subject to the Sec. 1411 net investment income tax.
Sec. 453A(c)(1) provides that the taxpayer's income tax is increased by the interest charge. The interest charge is reported on the taxpayer's 2013 Form 1040, U.S. Individual Income Tax Return , line 60. The taxpayer should check box c on line 60 and enter "453A(c)" in the space provided.
Sec. 453A(c)(5) further states that any amount paid under this section is taken into account in computing the amount of the taxpayer's interest deduction for the tax year. The interest is subject to the rules that dictate whether interest incurred on tax underpayments is deductible by the taxpayer. A number of court cases, as well as Sec. 163 and related Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A), take the position that interest on an individual underpayment of federal income tax is nondeductible personal interest regardless of whether the tax liability is from a business or investment activity.
Therefore, for individual taxpayers, the Sec. 453A interest charge is considered nondeductible personal interest. But C corporations are allowed to deduct the interest charge as a business expense in most circumstances in the year paid or accrued because C corporations are not subject to the limitations on deductions for personal interest expense.
Should the IRS Provide for an Interest Expense Deduction Under Sec. 453A?
Taxpayers are required to pay tax, often at the highest marginal rate, as well as net investment income tax, on the interest income collected on an installment sale note obligation. When Sec. 453A applies, taxpayers are further assessed an interest charge based on the deferred tax liability of the installment note obligation. However, for individuals, the interest charge is nondeductible personal interest.
Essentially, the installment note receivable is an investment the taxpayer holds. The amount of the note representing the deferred tax obligation is earning taxable interest income. Therefore, under the concept of debt incurred or continued to carry an investment, a question arises as to whether the IRS should consider the interest charge on a deferred tax liability to be investment interest expense rather than personal interest.
This tax treatment of the interest income and interest expense is inconsistent and punitive to the noncorporate taxpayer. The interest charged under Sec. 453A is calculated on a deferred tax liability that resulted from the sale of a business or investment asset. Therefore, it seems reasonable to allow the taxpayer a deduction for the interest as either business interest or investment interest expense deductible on Schedule A, Itemized Deductions .
However, the 1987 Conference Committee Report on the Omnibus Budget Reconciliation Act of 1987, P.L.100-203 (H.R. Conf. Rep't No. 100-495, 100th Cong., 1st Sess., p. 930 (Dec. 21, 1987)) clearly states that the Sec. 453A interest is considered interest on an underpayment of tax subject to those rules in Sec. 163. Therefore, if the taxpayer is subject to the 20% long-term capital gain rate on the installment note obligation, the effective tax rate is increased by 20% of the IRS underpayment rate.
The increase in the effective tax rate will vary based on the applicable tax rate and the effective interest rate. For example, if the IRS underpayment rate is 3%, the effective tax rate on the sale of long-term capital gain property is 20.6% (20% + (20% × 3%)). For large installment sale transactions, the additional cost could be significant and negate the benefit of installment sale reporting depending on the underpayment rate (and the deductibility of the interest charge) and the interest rate of the installment note. In these situations, the practitioner should consider advising the taxpayer to elect out of the installment method. If the taxpayer elects out of the installment sale reporting, the deal should be structured so that the taxpayer gets enough cash upfront to pay the additional tax liability.
If a taxpayer dies before receiving payment on the installment note obligation, the taxpayer will never receive the funds, but because of Sec. 453A, the IRS will have collected a nondeductible interest charge on an outstanding deferred tax liability that the taxpayer no longer owes. The installment gain would be income in respect of a decedent (IRD) to the recipient of the note. The Code and the 1987 Committee Report do not contain language that would indicate that the recipient of the IRD should be excluded from the Sec. 453A interest charge. Sec. 453A(b)(1) states that the section applies to any obligation that arises from the disposition of property. Sec. 453A focuses on whether there is an obligation and does not exclude any type of taxpayer from being subject to the interest charge.
Other adverse scenarios might involve an earnout included in the installment sale obligation. If the criteria to be paid the earnout are not met and it is never paid to the taxpayer, the taxpayer pays an interest charge on taxes that will never be owed. Sec. 453A does not contain provisions for recovery of the interest charge in this case. Letter Ruling 200728039 has set the stage for future litigation and held that the amount of a contingent earnout payment should be included in calculating the interest charge under Sec. 453A to the shareholders. A similar result would occur in cases when the maker of the installment note defaults and the note is written off as worthless.
In certain cases, Sec. 453A can provide a harsh result, and a taxpayer can pay a nonrefundable interest charge on a deferred tax liability calculated on funds that the taxpayer will never collect.
Conclusion
Tax practitioners should consider Sec. 453A when analyzing installment sale transactions and advise clients of the interest charge, which is an additional economic cost of entering into the installment obligation. Practitioners should analyze the increased tax liability associated with reporting the Sec. 453A interest and how many years the taxpayer may be subject to the Sec. 453A interest. Consider planning alternatives to avoid the additional interest charge on installment obligations, including electing out of installment sale reporting. Also consider whether intraspousal gifts of the property to be sold can reduce the impact of Sec. 453A. Since each spouse will receive his or her own $5 million threshold in the calculation of the interest charge, a gift of the target property from one spouse to another effectively doubles the threshold amount.
EditorNotes
Anthony Bakale is with Cohen & Co. Ltd., Cleveland.
For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Co. Ltd.
