Sunday, February 5, 2012

Installment Sales Section 453

1.  Installment Sales - § 453
a.     § 453(a)- Gain from an installment sale is ordinarily reported on the installed method, which is defined by § 453(c) as “a method under which the income recognized for any taxable year from a disposition is that proportion of the payments received in that year which the gross profit… bears to the total contract price.” Gross profit is the gain realized on the disposition and the contract price is the amount realized.
b.     The goal is to determine the amount of income recognized for a particular taxable year:
                                              i.   Installment Sale Equation § 453(c) = (income recognized)/ payments received in the year = (Gross Profit)/ (Contract Price)
                                            ii.     Income Recognized = Payment Received  * (Gross Profit)/ (Contract Price)
                                          iii.     PRODUCES AMOUNT INCLUDED IN INCOME
                                            iv.     The idea behind the installment method is to treat every principal payment as a microsm of the entire transaction.
c.     Payment is the most disputed, what is consideration. Consideration v. Promise to Pay
                                               i.     Does not include a buyers promise to pay. What about third parties? Include a third party obligation as part of payment. Include it as fair market value.
                                            ii.     EXCEPTIONS:
1.     Readily tradable- If it is liquid and there is an established market, include it as payment received even if it is a debt instrument
2.     Also, if it is secured by cash or a cash equivalent
                                            iii.     These are all rules about principal payments. The tax consequences of interests are different. You must allocate basis among the assets with more complicated payments.
                                              i.     There are also big issues with contingent sales in this area of the law. For example, a percentage of profits the seller is entitled too.
                                             ii.     If we don't know the whole contract price, can’t calculate gross profit. However, congress is clear that in § 453 (j)(2) they wanted them to have installment treatment, regulations about how the installment can work when you don't know the full contract price.
1.     Transaction in which there is a maximum possible price
a.     Treat the maximum as the contract price, if you get less, you re-compute the formula and take a loss deduction for the amount you overpaid.
b.     You can make a deduction if you over paid. TAX BENEFIT RULE
2.     Transaction in which there is no max price, but the period of time over which the payments will come in is known.
a.     Pro-rate the taxpayers basis over the known period of years in the contract.
b.     Then subtract the gain from the basis
3.     Transactions in which we don't know either of the first two things. No max selling price or max time period
a.     IRS might think that it is not a real sale contract. Disguised interest payments, royalties, or rent. Convince the IRS that it is a sale. The IRS will look skeptically upon this.
b.     If they scrutinize all the pertinent facts, they will pretend that the contract is 15 years long and pro-rate the basis over that period of time. You can argue with the IRS over this Then there can be an offset.
e.     INTEREST PAYMENTS received will be included in the gross income of the seller as ordinary income under  § 61(a)(4), and interest paid may be deductible by the buyer under § 163
f.      What about payments that trickle in over time that were not in the original sales contract. Does this apply to involuntary installment sales? There is policy reasons for allowing unintended sales to allow this:
                                               i.     Taxpayers don’t pay realize any gain
                                             ii.     Liquidity problem, might not have enough money to pay the tax on the entire amount.
g.     Amended Agreements: Not clear in § 453 if the buyer agrees to pay in full, and then in amendment is allowed to make some of the payments late. If the amendment is made before the sale closes, then the installment rules should apply.  There was never a contractual right to have the money from the sale, then the installment sale rules can apply.
                                              i.     The installment sale rules don't apply if the parties amend the contract after the seller has fully performed and has an unconditional right to payment. NOT INSTALLMENT SALE
                                            ii.     Doctrine of constructive receipt. Congress does not allow people to avoid tax by turning their back on payments.
h.     There is a lot of fighting over this because Congress has a choice how to tax installment sales, they could have completed them as complete for tax purposes in the first year of the installment sale. However, they thought that was to harsh and allow people to recognize payments gradually.
i.      Limits on Installment Method
                                               i.     You can't do it for stocks on securities market
                                             ii.     Cant do it from dealers on property
                                            iii.     No inventory
                                            iv.     Not for sales of depreciable property to affiliated entities.
j.      Installment Method is elective and can be used in connection with § 1031.  Remember that 1031 like kind exchanges are not elective though and you must conduct the transaction in that manner if you qualify.

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