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 outLock 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 delayingthe 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.
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 ($1,000,000 note less $238,000 cash used to pay the tax on the gain) rather than the full $1 million, as would be the case if she had applied the installment method.
Any deferred gain remaining at the time of the seller's death is income in respect of a decedent when collected.8 Accordingly, there is no opportunity to avoid income tax by using the installment method to defer gain until after the year of the taxpayer's death.
Avoid the Sec. 453A interest charge on deferred tax
Sec. 453A generally imposes interest on the tax deferred (with the tax amount being calculated at the maximum rate under Sec. 1 for individuals and Sec. 11 for corporations) using the installment method if the sale price of the property sold exceeds $150,000 and the face value of installment notes that arose during the tax year and are outstanding at close of the tax year exceeds $5 million. The interest rate varies based on the IRS's underpayment interest rate (3% for the first quarter of 2021).9 A discussion of the computation of the interest charge is beyond the scope of this article. The election out of the installment method avoids the interest charge, which is generally nondeductible personal interest for an individual taxpayer.10
Facilitate investment in an opportunity zone
The tax reform legislation known as the Tax Cuts and Jobs Act11 added three incentives for taxpayers to reinvest capital gains in an opportunity zone fund during a 180-day replacement period:
- Deferral of the recognition of gain until the earlier of the date on which the opportunity fund investment is sold or exchanged or 2026;12
- Permanent exclusion of up to 15% of the deferred gain;13 and
- Permanent full exclusion of capital gains from the eventual sale or exchange of the ownership interest in the opportunity zone fund held for at least 10 years.14
Final opportunity zone regulations provide two options for a taxpayer to determine when a 180-day period begins with respect to installment gain. The taxpayer can treat the 180-day period as beginning on (1) the last day of the tax year in which the taxpayer would have recognized the gain on the installment method; or (2) the date the installment payment is received.15 If the date the payment is received is chosen, each payment will begin a new 180-day period.
In some cases, it will be preferable for a taxpayer to fund an opportunity zone investment all at once rather than make investments as installment payments are collected (e.g., for administrative ease of making just one investment or to start the clock on the 10-year holding period necessary to achieve permanent exclusion of the gain from the opportunity zone investment). While the opportunity zone regulations do not directly address the issue, it seems reasonable that a taxpayer can elect out of the installment method and invest the entire gain from an installment sale in the year of sale.
Example 3: S sold land held for investment on an installment basis during 2021. S will recognize $100,000 of gain for each of the next five years as payments are collected. To invest the entire gain in an opportunity zone fund, she would generally need to invest $100,000 each year. S identified a suitable opportunity zone investment in 2021 and would like to invest $500,000 in the fund. S could elect out of the installment method in 2021 and use money from other sources to fund the $500,000 investment. The deferred gain will be recognized when she sells or exchanges her investment in the qualified opportunity fund or on Dec. 31, 2026, even if some of the installment payments have not been received by that time.
Accelerate basis recovery in certain contingent installment sales
If an installment sale includes some contingent consideration, the timing of the taxpayer's basis recovery depends on whether there is a cap on the amount of contingent consideration or a fixed period over which contingent payments will be received. If there is a cap on the contingent consideration, the installment gain is computed using the maximum selling price in the installment gain calculations.16 The gross profit percentage generally is adjusted if the resolution of contingencies reduces the maximum selling price. If there is no cap on the amount of contingent consideration but the period over which the contingent payments will be received is fixed, then the taxpayer recovers its basis in equal annual increments over that fixed period.17
Depending on the timing and amount of contingent payments the seller receives, either of the approaches to basis recovery from the regulations can cause a seller to have a gain in early years and a loss in later years. Capital losses of an individual taxpayer cannot be carried back, and their use may be limited if the taxpayer does not have capital gains from other sources.18 If the taxpayer believes it may generate a gain in early years and a loss in later years under the normal basis-recovery rules (e.g., as a result of contingent payments the taxpayer may not collect), the taxpayer may benefit from electing out of the installment method.19
Example 4: In 2021 E sells stock of a company with a basis of $5 million for $5 million cash upfront plus an additional $5 million if the company goes public in the next five years. The likelihood the company will go public is relatively low, and an appraiser determines the fair market value (FMV) of the contingent payment is $1 million.
If E does not elect out of the installment method, he will report a $2.5 million gain in the year of sale (($5 million basis ÷ $10 million maximum selling price = 50% gross profit percentage) × $5 million cash collected). If the company does not go public in the next five years, E will report a capital loss of $2.5 million ($5 million basis in the stock − $2.5 million basis recovered in the year of sale = $2.5 million basis in the installment receivable). If E does not have any capital gain, he is only able to deduct $3,000 of the capital loss per year.
If E elects out of the installment method, he will report a $1 million gain in the year of sale (($5 million cash + $1 million FMV of the contingent receivable) − $5 million basis). Electing out of the installment method reduces the gain recognized in the year of sale. If the company does not go public in the next five years, E will report a $1 million loss.
In lieu of electing out of the installment method, the taxpayer may reduce the risk of having gain in early years and a loss in later years by requesting a ruling from the IRS to use an alternative method of basis recovery.20 The ruling request, filed before the due date (including extension) of the return for the year of the sale, must demonstrate that application of the normal basis-recovery rule would substantially and inappropriately defer recovery of the taxpayer's basis. This requires the taxpayer to show that the alternate method is a reasonable method of ratably recovering basis and that it is reasonable to conclude that over time the taxpayer likely will recover basis at a rate twice as fast as the rate at which basis would have been recovered under the normal basis-recovery rule. This process is seldom used; the last time the IRS granted permission to use an alternative method of basis recovery was in June 2016.21
Absorb expiring carryovers
Net operating loss carryovers generated prior to 2018 expire after 20 years.22 Several other tax attributes are subject to expiration provisions as well, including charitable contribution carryovers, tax credit carryovers, and corporate capital loss carryovers. Accelerating gain recognition may allow certain carryovers to be absorbed prior to their expiration.
Cons of electing out
By electing out of the installment method, the taxpayer recognizes the entire gain in the year of the sale. The seller may need to pay the tax using funds from other sources because the tax on the gain may exceed the amount of cash collected in the year of the sale. Depending on the taxpayer's borrowing capacity and cost of capital, it may be costly or impossible to pay the tax, potentially exceeding the additional tax of deferring the gain to a year when higher rates apply.
Lock in tax rates (assuming rates decrease in the future)
If the taxpayer's tax rate will be lower in future years, the taxpayer may be better off by applying the installment method and paying tax at the lower rates applicable in future years. For example, a 0% net long-term capital gains rate applies to married taxpayers filing a joint return with up to $80,000 in taxable income in 2020 ($80,800 in 2021). For taxpayers with modest incomes, spreading a capital gain over time may allow them to take advantage of the 0% or 15% capital gains rate, assuming those rates are not affected by future tax legislation.
Use of losses from buyer default may be limited
If an installment note becomes worthless, the taxpayer is generally entitled to a capital loss equal to the basis in the installment note.23 If the seller elects out of the installment method, the seller recognizes gain in the year of sale and has a higher basis in the installment note, increasing the potential loss if the buyer defaults on the note. If the seller is unable to benefit from the loss, the election out may increase the seller's tax burden.
Example 5: R started a company in 1985 and has no basis in the stock. He retires in 2021 and sells the stock of the company for installment payments totaling $10 million. R elects out of the installment method and uses funds from other sources to pay $2.38 million in tax on the gain in 2021. The buyer experiences financial difficulty following the sale, and R never collects any of the installment payments. R generates a $10 million capital loss from the worthlessness of the installment note in a subsequent year. R cannot carry the loss back. If R does not generate any capital gains during his retirement, he is able to use only $3,000 per year of the loss.
Use of losses from other sources may be limited
If an individual elects out of the installment method, the individual recognizes the entire gain in the year of sale. Capital losses generated in subsequent years by an individual cannot be carried back to offset the gain. If an individual applies the installment method, capital losses generated in later years may be available to shelter the gain when the gain is eventually recognized. An individual who may generate future capital losses may prefer to apply the installment method to be able to use those losses to offset the gain.
Calculating the gain from electing out of the installment method is straightforward if the amount of the installment note is fixed. The effort to determine the gain from electing out of the installment method increases substantially if contingent consideration is involved. For example, a cash-method taxpayer that elects out of the installment method includes the FMV of any contingent consideration in its amount realized.24 The FMV of the consideration may be ascertained from, but can't be less than, the FMV of the property sold, reduced by the amount of fixed consideration. A taxpayer would need to obtain a valuation to be able to determine the value of the contingent consideration, adding to the administrative burdens of electing out.
Disposing of an installment note to accelerate gain
After evaluating the pros and cons of electing out of the installment method, a taxpayer choosing to report gain on the installment method may be able to accelerate gain if circumstances change. For example, the taxpayer may decide that the risk of increasing tax rates is minimal, only to later find a substantial increase taking effect. The taxpayer can accelerate gain by disposing of the installment note receivable.25 Dispositions of an installment note include sales of the note, pledging the entire installment receivable as collateral,26 cancellation of the note or its otherwise becoming unenforceable, or giving the note to a family member or charity. If the sale was a qualifying installment sale to a family member, the forgiveness of the note will trigger immediate recognition. This approach may not be helpful if a tax rate increase is enacted retroactively.
A taxpayer whose estate will be subject to estate tax may use the same disposition techniques to accelerate gain into the pre-death period. The resulting additional income tax reduces the taxable estate as described above and relieves the heirs from including the deferred gain in taxable income as payments are received.
The gain (or loss) resulting from a disposition of an installment obligation is considered to result from the sale or exchange of the property in respect of which the installment obligation was received.27
Considerations for retiring partners
The installment method does not apply to partnership redemptions. Instead, payments are generally treated as a distribution, allowing a withdrawing partner to recover the partner's basis first.28 A retiring partner who wants to accelerate gain may prefer to sell the partnership interest to another partner (or a third party) rather than sell the interest back to the partnership, to preserve the ability to elect out of the installment method. Alternatively, the retiring partner may be able to elect to recognize gain as payments are received.29
Circumstances and expectations guide the decision
As this article shows, numerous factors can influence a client's decision to elect out of the installment method. The adviser should inform the taxpayer of the option of electing out and the ramifications of the election, but the decision is ultimately the taxpayer's. Given the number of variables and the amount of uncertainty surrounding those variables, many taxpayers will be unsure how best to proceed. It may be helpful for the tax adviser to model the present value of the after-tax cash flow for the seller based on the seller's unique circumstances and expectations of future tax rates. The model can be run using different variables to illustrate the sensitivity of the outcome to changes in the assumptions (e.g., what happens if the tax rates stay the same? What happens if the rates go up? What happens if the buyer defaults on the note?). Taxpayers may initially use the installment method while retaining the flexibility to later accelerate gain by disposing of the note if circumstances change, including impending tax rate increases.
5Rev. Rul. 90-46.
9Sec. 453A(c)(2); Rev. Rul. 2020-28. See also Kinkaid and Federanich, "Tax Clinic: Application of Interest Charge for Installment Sale Obligations," 45 The Tax Adviser 549 (August 2014).
10Sec. 453A(c)(5); Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A).
13For investments held for at least seven years. If held at least five years, 10% of the gain is excluded (Sec. 1400Z-2(b)(2)(B)).
15Regs. Sec. 1.1400Z2(a)-1(b)(11)(viii).
16Regs. Sec. 15a.453-1(c)(2).
17Regs. Sec. 15a.453-1(c)(3).
18Secs. 1211 and 1212(b).
19While use of the open-transaction doctrine to recover basis first could mitigate the issue, the IRS believes the open-transaction doctrine should be available only in rare and extraordinary cases involving sales for a contingent price where the fair market value of the purchaser's obligation cannot be reasonably ascertained, so the approach is presumably of limited use (Regs. Sec. 15a.453-1(d)(2)(iii); Field Service Advice 200004009).
20Regs. Sec. 15a.453-1(c)(7).
21IRS Letter Ruling 201626012.
23Secs. 165(g) and 166(d)(1).
24Regs. Sec. 15a.453-1(d)(2)(iii).
28Sec. 736(b)(1); Regs. Sec. 1.736-1(a)(1).
29Regs. Sec. 1.736-1(b)(6).
|John Werlhof, CPA, is a principal in CliftonLarsonAllen LLP's National Tax Office in Roseville, Calif. The author thanks Christopher W. Hesse for his comments on an earlier draft of this article. Any errors are the responsibility of the author. For more information about this article, contact firstname.lastname@example.org.