Installment sales of depreciable property to related parties.

Generally, electing the installment method for reporting gain on a property sale allows a seller to defer the tax on the sale until the proceeds are actually received. This deferral, however, does not prevent a purchaser from reporting, in the year of acquisition, the full purchase price as the property's basis. In essence, a mismatch of income and expenses is allowed; a purchaser is allowed an immediate depreciation deduction for the basis before the seller includes the entire gain from the corresponding sale in income. Congress felt this was acceptable if the parties were unrelated; presumably, the sale would be an "arm's-length transaction." On the other hand, Congress also considered that related parties would be motivated to create sham transactions to take advantage of the installment method election.

Congress incorporated special rules into Sec. 453 to prohibit the use of the installment method for depreciable property sales between related parties. Depreciable property is defined as property that, in the hands of the purchaser, would be depreciable under Sec. 167. In these types of transactions, Sec. 453(g)(1)(B)(i) prohibits a seller from electing the installment method and requires that the seller treat all future payments as received in the disposition year; there are two exceptions to this rule.

First, if the IRS can be convinced that the disposition was not principally for a Federal income tax avoidance purpose, Sec. 453(g)(1) would not apply and the installment method would be permitted. For example, tax avoidance is not present when, at the time of the installment sale, a husband and wife are divorced or legally separated, or if a sale occurs in accordance with a settlement that leads to a divorce or separate maintenance. Another example would be if "no significant tax deferral benefits" would be derived from the sale. The best way to prove this is unclear. In Guenther, TC Memo 1995-280, the Tax Court determined that a significant tax benefit existed when the depreciation available to the related purchaser was more than double that still available to the seller at the time of the installment sale. This case highlights the fact that courts will look to both the seller and purchaser to determine if a significant tax benefit exists.

Second, if the lack of a tax avoidance motive cannot be proven, a seller may still be able to use Sec. 453. When payments to be received are contingent as to amount and the fair market value (FMV) of these payments cannot be reasonably ascertained, a seller can recover his basis ratably.

Example: T sells depreciable property with a $10,000 basis to his related company. "['he sale terms are $2,000 down and a percentage of the company's profits over the next four years. The company is new and engaged in a new type of business; therefore. the FMV of these subsequent payments is not reasonably ascertainable. T would recover his basis ratably over the five-year period; in year one, T would recover the $2,000 down payment and recover the same amount over the next four years. Unfortunately for the purchaser, the company would not acquire any basis in the property other than the $2,000 per year, unless the company's required payment is greater than the $2,000 and this excess is included in T's gross income.

The disallowance of the installment method for depreciable property to related parties is not an all or nothing proposition. If the installment sale includes both depreciable and nondepreciable property, only the depreciable property would be subject to the above limitations. In Letter Ruling 9001013, the Service allowed gain to be calculated separately for depreciable and nondepreciable property, with the installment method allowed for the nondepreciable property.

Perhaps the best way to avoid Sec. 453(g)(1) is to analyze the deferred tax benefit, to ensure that it can be proven to the IRS's satisfaction that the transaction did not have as one of its principal purposes the avoidance of Federal income tax. Familiarity with these rules may prove beneficial to sellers, as businesses are often sold through asset acquisitions between related parties.

FROM FRANK E. BRODNAX, CPA, ELLIN & TUCKER, CHARTERED, BALTIMORE, MD

Philip E. Moore, CPA, MBA Brown, Dakes & Wannall, P.C. DFK International Fairfax, VA