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- [00:00]
Sam
Foreign.
- [00:11]
Matt Foreman
Welcome to the 35th episode of How Tax Works. I'm Matt Foreman. In this episode, I'll discuss the installment method under section 453 of the Internal Revenue Code. Obviously not as exciting. I don't know of a topic as AI and tax. I, you know, I. I think it's a pretty interesting one. It's definitely one that's worth, you know, you run into it a lot. Um, obviously the, you know, we're back to the original music, but we farmed out the music. See how AI would rein. Imagine the music, which it was. One was kind of jazzy, funky, you know, just sort of a little bit of a remix. Um, we actually got one and I am. I am not exaggerating this here. Someone did it with rap. Pretty sure it's AI rap. It sounds like a voice, but I. I can't tell. I don't really care enough to like inquire. And it's pretty funny either way. But if you would like to hear it just after this episode, we're just going to put it on the end. It's only like a minute or so and it has lyrics that. Boy howdy. There's something is how I'm going to describe it. I don't know how else to explain it. I do listen, you know, pretty broad array of music. I do. I do like hip hop and rap. But this is something is how I'll describe it. Even if you don't like rap, I highly recommend listening to it, if only for the comedic value. But anyway, anyway, How Tax Works is meant for informational entertainment purposes only. This may be attorney advertising and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business decisions we all make. Before we get started, a few administrative things. New episodes every two weeks. Um, I know I did two, the last one, but that was kind of one episode and two parts, so thought it made more sense just to pop them both out at once. Next episode, which will be 36, talk about the grouping rules under section 469. Also pretty similar to the grouping rules under 199 Cap A and elsewhere in the code. So definitely worth worth discussing and interesting. 465 as well. I'll explain what all that stuff is. Don't worry. If you have any questions, comments, or constructive criticism, you can email me at my FRB email address. I have some upcoming webinars that That I think are interesting. They're free so if you want to do it. The Advanced Tax Strategies series. I didn't name it but you know, good enough. They're all Thursdays 1 o', clock, one post Meridian Eastern time. I live in, I live in New York so. So I'm doing everything eastern. No, there are four Thursdays in November and December hour each free CPE for CPAs, CE for easy, CLE for attorneys and CFP. So if you're a CFP you can get continuing as well Short chart titles here. There's more information on the FRB website on the How Tax Works landing page. But November 6th is 704C allocations which I think is a sleepy area that I think to be candid I think people get wrong and don't understand and don't understand when it doesn't matter. So definitely an interesting one. November 20th succession planning at the margins using profits, interest something I do a Fair amount of December 4th is stock, sales, taxes, asset sales, talking about every orgs through 38h10 etc. Etc. Etc. Or yada yada yada however you want to say it. And December 18th changes to QSBS under OB thrice often called Public Law 11921 O triple B obbba. I like OB thrice. It's good for the reference. Anyway, so let's talk about the installment method under section 453 installment sales. What is an installment sale? An installment sale defers gain to when the seller receives the payment. It requires actual or constructive receipt and the payment can be in cash or other property. You can't use it to defer losses. So if you sell loss property, the losses just get recognized in year one even if you didn't receive the cash. So. So that's good. If you sell five assets and two are losses and two are gains, it won't defer the losses, it will defer the gains. So that's actually kind of a very taxpayer friendly way to do it.
- [04:17]
Listener/Interjector
Right.
- [04:17]
Matt Foreman
You can elect out under section 453D1. I'm not going to really go through how to do that because I don't really think it's all that interesting. Not worth the time. To qualify as an installment sale, you must receive at least one payment in the year after the year of sale. Sometimes you'll see installment sales, they close in February, there's a payment in April, there's a payment in September, there's a payment in December, non installment sale all in one taxable year. So you know that's it you can receive zero dollars in the year of sale. Oftentimes you'll have a deal close in, you know, this early December. There's sort of a wait, see how certain factors of business go set the price, et cetera. The next year you get it, you'll have it. But I think it's important to note that even if you receive $0 in the year of the sale, you may have to recognize some income. There are rules as to certain assets that do not qualify for the installment sale. So it's really important to understand how this works because you can accelerate payments pretty significantly, especially for certain businesses. So I think that that's a really, really important point. All right, so it is not an installment sale if it is an annuity payment, such as, you know, annuity payments defined for this context as the payment is over the life expectancy of the seller. 453B 1. The factors for this are in GCM General Counsel memoranda, I believe. 3. That's some good writing there. It's either 39503 or 34503. It's from 1986. My handwriting is a little messy. Yes. I take notes and I have an outline for this and I hand write it and it's messy. And then that's just, that's just how it goes. That's the way the cookie crumbles to rolling for it. So there are three main components from for installment sales. The first one is a non taxable recovery basis. The second one is the taxable portion of the sale which is capital gains or ordinary income. And the third is interest. Interest, Interest. Interest doesn't mean you're bored by my podcast. It means there is interest, which is always ordinary income. If there's no interest or insufficient interest charged, you must impute interest and lower the taxable portion. The imputed interest is at the AFR applicable federal rate, which you can find by googling. Just Google AFR IRS and you'll get it. It's based on a number of factors, which month you use, et cetera, et cetera. You can use an installment sale even if you don't transfer title or possession immediately. So sometimes you'll get it where the money's transferred, but you're not going to actually get the asset for some period of time. That's Great. Treasury Regulations 1.4534 a doesn't care. Again, how do you elect out? I already said under 453.3D1 you can and you file it for the year, including extensions, including Extensions that the installment sale started.
- [07:03]
Listener/Interjector
Right?
- [07:04]
Matt Foreman
So two years later you can't elect out. You can. I've seen it. You know, people are like well why would you elect out of installment sales? And the answer is very simple. If you have a large loss and you want to offset the loss and you do an installment sale, you may want to accelerate that income. So just use the loss. You don't have to run into the NOL rules. Federally only 80%. A lot of states decrease the amount of NOL that you can use, so on and so forth. So it actually can be helpful to elect out of it. And you don't actually need a promissory note. A lot of them are evidence, especially in the sale of business by a promissory note. But a handshake is more than sufficient. And email is wonderful. As I always point out, contracts don't have to be written. They don't have to meet a lot of the real requirements. So there's a lot of situations where you're not eligible for the installment sale treatment. They're all under, generally speaking 453 B2 but not all. There's seven that I have written here and they're all pretty interesting. Sale of inventory so if you sell assets and part of the assets of a business for example are inventory, the portion that's inventory is just not eligible for the installment sale. So that amount is pushed into year one. Any gain on that situation. 453B2CAPB Most dispositions by dealers. I'll get into that a little bit later. 453B2CAP A sale of publicly traded property 453K2 that's generally, you know, equities, debt, things like that. You know, a lot of companies will hold debt, they'll hold equities as part of their overall asset mix. So that that can't be subject to it. The basic premise of why it can't be, you know, it's not subject. It's not eligible, I should say for installment sale treatment for public trade properties because you can just sell it for cash and get it because it's publicly traded. The sale of depreciable property that is related to persons that is, excuse me, the sale of depreciable property to related persons. But the related and that's under 453G but related persons has an unexpected exclusion. I'll get into that a little later. The portion of sales that are depreciable recapture453 I looks a lot like Romanet1 but it's just I and sales of personal property under a revolving credit plan. Revolving credit plans are not eligible for for installment sale treatment. 453 K1 There are a number of things that decrease installment agreement tax benefits, interest charge over a certain amount under 453cap a I'll get into that later. Pledge of a note that's a deemed payment. So if you pledge the note that is considered constructive receipt. 453Cap A D1A note is payable on and if the note is, excuse me, the benefit for an installment agreement has decreased. If the note is payable on demand or readily tradable, you can just say hey, pay. Pay it to me now. Or if you can get someone else to buy it from you then you don't get installment sale treatment.
- [09:50]
Listener/Interjector
Right?
- [09:50]
Matt Foreman
453F4 there are related party resale rules under 453E and there are sales of installment notes. If you sell the installment note it is taxable immediately to the seller.
- [10:01]
Listener/Interjector
Right?
- [10:02]
Matt Foreman
453Cap B not going to talk about that a lot. I've always felt that rule is a little bit too obvious. Never really understood why it's not. But here we are.
- [10:11]
Listener/Interjector
Right?
- [10:11]
Matt Foreman
Here we are. Before we delve into, you know, things that are not eligible for installment sale treatments as a sale of inventory, let's. Let's get some music going. I think that'll really lighten things up.
- [10:33]
Sam
Foreign.
- [10:38]
Matt Foreman
Welcome back. So a little more on things that are not eligible for installment sale treatment. So sale of inventory is not eligible. There's an exception to that. As. As is tradition, right? That if the sale of inventory is not in the usual course of business, the most common comment, the most common one for that is if you're sat. You're selling inventory to satisfy a tax lien. That. That is, that can be done on the installment sale method. Pretty broad based. Pretty much everything is in there. Watch out for hot assets, right? So generally hot assets, that includes inventory for a partnership, right? No. No Installment sale treatment. So what happens a lot of times you need to make sure that in year one and I'll get into this, I'm sure later, but as I talk about different items and different assets, right. That can be sold is you want to make sure in year one you have at least enough cash to pay the tax on all the assets that are not eligible for installment sale treatment.
- [11:41]
Listener/Interjector
Right?
- [11:42]
Matt Foreman
And that's really important. That's why you need to know how much inventory there is not just to fill out the form under section 1060 but you know, to know how much is there.
- [11:50]
Listener/Interjector
Right.
- [11:51]
Matt Foreman
So number two, dealer disposition. You know, the disposition of personal property. So not real property by a person who sells the same type or person who sells it in the ordinary course of their trade or business.
- [12:03]
Listener/Interjector
Right.
- [12:03]
Matt Foreman
There are exceptions to the exceptions. So, so, so types of dealer dispositions that are eligible for installment sale treatment. Sales of farm property. Farmers. You know, real estate is one of the most tax favored farms. Very tax favored as well. You know, they always seem to get the short end of the stick these days. Number two, certain sales of timeshares. Either the right to use residential property for six weeks per year or fewer or res a residential lot where the seller or someone related to the seller cannot make improvements. So parking lot. You sell a parking lot, you are eligible. Even if you're a dealer of parking lots, you're eligible for that treatment. Thought that was interesting. Yeah, that's just kind of how it is, you know. And if an installment sale for either.
- [12:47]
Listener/Interjector
Right.
- [12:47]
Matt Foreman
Either. Either type of timeshares or the seller can't make improvements.
- [12:52]
Listener/Interjector
Right.
- [12:53]
Matt Foreman
There's also an interest charge on them because you're allowed to take the installment sale. That is a deferral right mechanism under 453 cap, which I promise I will get to a little later. Sales of publicly traded property. Don't be cute. Taxpayers lose on these. A lot. A lot, a lot for 3K there. You know, Congress gave the treasury and the IRS the ability to promulgate regulations. Has not happened yet. But you know, treasury can. They haven't. And they probably haven't because they've won the vast majority of the cases that they litigated. Probably because courts are very willing to look at this pretty broadly. Because what people will do is they'll drop it into a C Corp. And sell the C Corp.
- [13:37]
Listener/Interjector
Right.
- [13:38]
Matt Foreman
No, not how that works. Right. So not. Not a big deal. Sales of depreciable property to related persons. The related persons. This is where I said it was an unexpected exception. The related persons are all business relations, not familial relative. I always find this. I had this conversation with the client. I always find it fascinating that related under the Internal Revenue Code doesn't often mean what people in normal discussions say is related. And that kind of fascinates me. And sales of mutual properties, related persons. You know, there's also an exception. If there's no tax avoidance motive. You. You can do it. 453 is fine. So you can sell stuff to your kids. That's great. Have at it.
- [14:18]
Listener/Interjector
Right.
- [14:19]
Matt Foreman
Determining the gain Recognized each year.
- [14:21]
Listener/Interjector
Right.
- [14:21]
Matt Foreman
4C and treasury regulation. I'm going to read this to you 15A. It's a lowercase A dot 453 1B. Don't know why it's in 15A. Probably because it's a. It's a timing mechanism rather than an actual inclusion amount. But some such as life.
- [14:35]
Listener/Interjector
Right.
- [14:35]
Matt Foreman
So the way you compute it.
- [14:37]
Listener/Interjector
Right.
- [14:38]
Matt Foreman
Is the income for the. I'm gonna talk through math. Okay. But in the regulations and in the code, it talks through how to do it. And if you just sit there and read it, you'll actually get through it. It's not too bad. The income for the year is the payment multiplied by the gross profit divided by the total contract price.
- [14:56]
Listener/Interjector
Right.
- [14:56]
Matt Foreman
So that that payment for the year less the income for the year equals recovery of basis. So basically it's the payment and then you multiply it by the amount of profit you have. So if the total payment is $200, but only a hundred dollars of it is profit, $200, $100 profit. You're only get taxed on a hundred dollars. That's the idea. The gross profit is the sales price less basis total contract price is your total sales price. And the gross profit ratio.
- [15:21]
Listener/Interjector
Right.
- [15:22]
Matt Foreman
It's calculated once for each year and it's the ratio that is used for all property acquired. And it does not change. Payment may change. The. The gross profit ratio does not. The gross profit ratio is the gross profit divided by the total contract price. So it's the payment times the gross profit ratio is your income for the year. Pretty straightforward, I think. I hope. All right. So the cash or accrual method 453 has its own rules for that. I could probably talk on that for about 10 minutes. I'm not going to. I don't think it's a good use of time. So I'm going to skip over it. Just know that that can be an issue if you are a cash taxpayer or an accrual basis tax present value versus future value of the obligation. Use the face value of the obligation. So example, a taxpayer sells an office building eligible generally, right. For installment sale. And the fair market value is $4 million. The taxpayer pays you 6 million in five years. 10% interest rate. The sale price is 4 million and $2 million of interest. That's original issue discount. I don't care what the interest rate pretends it to be says it is. That's the face value. The obligations is the fair market value. There's a case that talks about that. What if there Are multiple assets.
- [16:33]
Listener/Interjector
Right.
- [16:33]
Matt Foreman
That's actually discussed in revenue ruling 6813 that title 6813 means that this revenue ruling came out in 1968. This is not new. The example they give is there's land, fair market value of 10 of 10 basis of 15 of building, fair market value of 90, a basis of 5. A little bit of an extreme example, but plausible.
- [16:58]
Listener/Interjector
Right.
- [16:58]
Matt Foreman
Because land, you know, can go up and down. Basis isn't going to move building, obviously, or most likely I should say the basis is going to decrease due to depreciation. Fair market value is another story altogether. The payment is $10 down, $10 per year over nine years, plus interest. I'm just saying plus interest in this and ignore interest for purposes of this example. Year one is all land.
- [17:22]
Listener/Interjector
Right.
- [17:23]
Matt Foreman
10 minus 15 equals a five dollar loss because the loss property does not.
- [17:28]
Listener/Interjector
Get.
- [17:30]
Matt Foreman
Does not get the installment method. Years 2 through 10 or $85 of income total.
- [17:35]
Listener/Interjector
Right.
- [17:35]
Matt Foreman
90 minus 5, which is the total basis remaining.
- [17:38]
Listener/Interjector
Right.
- [17:39]
Matt Foreman
90 times 10 is $9.44 of income per year, 56 cents a basis. Basically it's. It's 8, $85 of total profit remaining S, you know, multiplied by or divided by nine years. So 85 divided by nine is 944. Pretty simple. All right, we're going to go away for a second, but when we come back, we're going to talk about contingent payment sales, which is some really, really exciting stuff. So enjoy the music and we'll come back and bring it on home.
- [18:11]
Sam
Foreign.
- [18:15]
Matt Foreman
Welcome back. So contingent payment sales, we're talking about the installment method under section 453. So contingent payment sales is defined are defined as a sale or other disposition of property in which the aggregate selling price cannot be determined by the close of the taxable year in which the sale or disposition occurs. A contingent payment sale does not include a retained interest in property that's subject to the subject of the transaction. So if there's rollover, no, it does not include an interest in a joint venture or partnership, although most joint ventures are partnerships.
- [18:46]
Listener/Interjector
Right.
- [18:46]
Matt Foreman
It does not include equity, incorporation or similar transactions. So basically, if there's rollover, that is not a contingent payment.
- [18:55]
Listener/Interjector
All right?
- [18:56]
Matt Foreman
You only bought part of the asset. That's the key. There are three kinds of contingent payment sale that are discussed and analyzed under an Internal Revenue Code and the regulations thereunder.
- [19:10]
Listener/Interjector
Right.
- [19:10]
Matt Foreman
The first one is the maximum selling price is determinable. The second one is the maximum selling price is not determinable, but time for payments is determinable. And the third is neither the maximum selling price nor the time for payments is determinable. Okay, so the maximum selling price is determinable. You treat the price as the sale price.
- [19:29]
Listener/Interjector
Right.
- [19:29]
Matt Foreman
The maximum price is the sale price and you're done, that's it. If you get less than the payment by getting lower payment, you just use the gross profit percentage and that's it, you're done. For number two, the maximum sale price is not determinable, but the time for the payments is you just do equal basis for every year and the actual amount received is used. Right. Pretty straightforward. Then if neither the maximum selling price nor the time for payments is determinable, the question becomes, well, is it really rent or royalty? Is this actually a contingent payment sale? If the sale, it's not really rent or royalty, you just use 15 years. If there is no payment in any year, no loss is allowed unless you meet the worthless debt rules. So. So, you know, it's kind of an interesting one there, right? It's a little more complex. A lot of times it just kicks into 15 years and you really have to analyze it. Is it in fact rent? You know, and people say, well no, we agreed on that. I'm like, well, is it Right. If it's a 900 year transaction and you have no idea how long it's going to take, why, it sounds a lot like rent or royalty, doesn't it? That's the problem. All right, moving on. We're going to talk about interest charges under 453 cap A. That's again cap A 453. Then the capital letter A, no parentheses, right? So a different code section altogether, but very, very important. Basically Congress was concerned, rightfully so probably that what people would do is in order to defer it, defer the sale or defer the recognition of income from the sale, they would just have very, very long of significant amounts for deferral.
- [20:58]
Listener/Interjector
Right.
- [20:59]
Matt Foreman
Especially since families can do this, friends can do this.
- [21:02]
Listener/Interjector
Right?
- [21:03]
Matt Foreman
Is a pretty good opportunity for playing.
- [21:05]
Listener/Interjector
Around a little bit. Right?
- [21:07]
Matt Foreman
So Congress gets ahead, puts 453 cap A and taxpayer must pay the interest, must pay an interest like payment to the IRS on the loan of the tax deferral.
- [21:17]
Listener/Interjector
Okay.
- [21:18]
Matt Foreman
There's a number of steps that determine. In order to determine if 453 Cap A applies and the interest like charge is, is, is imposed and they're under 453 cap a B1 and B2, all right, one sale price must exceed $150,000. The key is the sale price, not the amount of the installment obligation. So the face face value of the amount. So if you have a $30,000, you know, installment sale, that that's fine. That's not an issue at all. That does not trigger for through cap A, it must the the debt. The amount must arise from the disposition of business or investment property and not property for personal use.
- [21:59]
Listener/Interjector
All right.
- [21:59]
Matt Foreman
Must arise in the year of the disposition, must be outstanding at the end of the year, and aggregate face value of all obligations which qualify under the prior four that I discussed must exceed 5 million. So if you wanted to get cute, people have asked me this, well, couldn't I just sell the goodwill as one and sell the trucks as another and sell the patents as a third and you know, they're all under 150 each. If I just broke everything out and the answer is no, you know, the economic substance doctrine would likely group them. So I don't, I don't think that would work. So what happens is you have to keep the total amount under 5 million. So if you have one sale and it's 4 million, it's really not an issue because the aggregate face value is over 5 million. What I tell people to do in this situation is actually really simple. And I'll tell you how to compute it in a moment. What I tell people do is just make sure to impose interest in afr. As long as you're imposing interest at afr, it will more than cover the deduct the amount of the charge and that's a deductible amount. It's at to the payment. So it's not a huge deal. Obviously lowers the amount of effective interest you receive, but you know, that's fine.
- [23:03]
Listener/Interjector
Right.
- [23:03]
Matt Foreman
And then how to compute right, how to compute the interest charge. So what you do is you have the overall formula is the applicable percentage multiplied by the deferred tax liability multiplied by the underpayment interest rate.
- [23:17]
Listener/Interjector
All right.
- [23:17]
Matt Foreman
And that is about as have about as helpful as a concrete slab someone drowning in the ocean. Not very helpful. But I'll tell you what. Each of the mean right applicable percentage, the first one, the numerator, is the aggregate face value of all obligations outstanding at the end of the year, less 5 million. The denominator is the aggregate face value of all obligations outstanding at the end of the year.
- [23:38]
Listener/Interjector
Right?
- [23:38]
Matt Foreman
So that's it. So if you have 10 million outstanding, the applicable percentage is going to be 5 million less 10 divided by 10 million. Pretty easy. The applicable percentage for each liability remains constant for the entire term. So the applicable percentage can Change, but not for each debt.
- [23:53]
Listener/Interjector
All right.
- [23:54]
Matt Foreman
Number two, the deferred tax liability, right. The gain not recognized at the end of the year multiplied by the maximum tax rate under section 1 or 11. But you know, so that's either capital gains or ordinary income. And the maximum rate is the maximum rate that's applicable to that taxpayer.
- [24:12]
Listener/Interjector
Right.
- [24:12]
Matt Foreman
So if a corporation is the seller, then you would just use the maximum corporate rate, which is also the minimum corporate rate, coincidentally, which is 21%. The underpayment interest rate is effectively provided by the IRS. It is very similar to the AFR. So that's it. So basically you take the amount and that's how you determine the interest payment every year. Believe it or not, there's actually a form the IRS provides. It's pretty easy to calculate, really not that complex. And now we're gonna, we're gonna bring it all home. One of my favorite topics, installment sales and 1031 exchanges. I haven't really discussed 1031 exchanges that might be a multi parter that I get to next year or later this year. We'll see how that goes. We're at the end, you know, so I'm gonna be quick and a little bit general. The general rule is you remove the 1031 portion from 453 calculation. That's it. So you just ignore the amount received. The basis goes to the 10:31 exchange to the extent of the fair market value in real estate.
- [25:10]
Listener/Interjector
Right.
- [25:11]
Matt Foreman
So the proposed regs 1 in 1453 1F are there are pretty good. It can be non pro rata. So the example I always give is, let's say you have a piece of property, you exchange it, right? You get back another piece of property and you get a $50 note, right? The basis that you had in the original property goes, it is allocated, assigned. I don't know what the right word is into the new property, the, the receive property, replacement property, if I can get 1031.
- [25:41]
Listener/Interjector
Right.
- [25:41]
Matt Foreman
And that basis up to the fair record value of the replacement property, that's really important. So you know, it's not total. So there can be some basis in the note. But generally speaking, a lot of times you find that there really. Well, there, there isn't. So I think that's an important one. I think that's a pretty good one under section 453. So that's it. That was the 35th episode of how Tax Works. I hope you learned something back in two weeks with the 36th episode where I'll be discussing the grouping rules under section 469. And now for the best song of all time. But we're going with the rap version, don't forget. I know you Forgot it's been 20 minutes 20 some minutes. Get ready for it because it's. You won't be the same after is all I have to say Not. Not for better, not for worse, just different. Thank you for listening.
- [26:39]
Rap Artist
Yeah, yeah Step into the world where taxes meet the plan Matthew Foreman breaks it down like only he can Falcon rapper Port in Bergman leading the way Showing how taxes shape the moves we make each day Case law, regs, deductions and more how tax works opens up the knowledge college door from finance to business every choice in sight he makes it complicated Feel simple and right so listen up close let your money talk Matthew's here to guide you through the text walk Smart, sharp and always on track Plug in, tune in let's unpack some text.
- [27:19]
Sam
Sam.