Using an installment sale to defer shareholder gain on a liquidation.

Facts: Smith Partnership owns 100% of Sheepcorp. The partnership's basis in the corporation is $100,000. George Smith owns a 60% general partnership interest in Smith Partnership; his nephew, Stanley Smith, owns a 40% limited partnership interest. Sheepcorp has been winding down its operations for several years; its only remaining assets are the small building in which its offices are located and the land that surrounds it. Sheepcorp purchased the land and building several years ago for $520,000. The corporation's basis in the property is $495,750; its current fair market value (FMV) is $500,750. Depreciation on the building was computed using the straight-line method; therefore, no portion of any gain on the disposition of the property would be treated as ordinary income. There is no mortgage on the building. George and Stanley disagree over what the corporation should do with the remaining property. Stanley feels it will begin to increase in value soon. However, George feels the value of the property will either remain constant or decline slightly. Because of their disagreement and because Sheepcorp is no longer actively engaged in a business, George and Stanley have decided to liquidate the corporation. Stanley would like to purchase the property, but does not have sufficient cash at this time. He has offered to purchase the property for $500,750 ($150,750 in cash plus a note for $350,000). George is willing to allow the corporation to sell the property to Stanley only if the tax consequences of such a sale would not be any more severe than a sale to an outside party. Issue: How can the transaction be structured to allow Stanley to purchase the land without any adverse tax consequences?

Analysis

The tax adviser could recommend that the corporation be liquidated. As part of the plan of liquidation, the land could be sold to Stanley in an installment sale. A corporation must recognize in the year of liquidation all gain on installment obligations, including obligations arising from sales during the liquidation period. However, in this instance, the amount of gain the corporation will have to recognize is only $5,000 ($500,750 - $495,750), with a resulting tax liability of $750 (15% rate). Therefore, the corporation's net proceeds from the sale will be $500,000 ($150,750 cash-$750 tax + $350,000 installment note).

Shareholders who acquire a corporation's preliquidation installment obligations (those acquired by the corporation prior to the date of adoption of the liquidation plan) as part of a liquidating distribution must be taxed on their gain at the time the installment obligations are received. However, shareholders who receive post-liquidation installment obligations (those arising from sales entered into on or after the date of adoption of the liquidation plan) from sales of noninventory assets can defer gain until the time of collection. This deferral treatment is available only if the installment obligation arises from a sale during the 12-month period beginning with the date of adoption of the liquidation plan, and the liquidation is completed during that period.

The shareholder (Smith Partnership) will realize total gain of $400,000 ($500,000 liquidating distribution- $100,000 basis).

Special rules apply if the installment obligations result from the sales of property to certain related parties.

Shareholders are not permitted to defer gain if the installment obligation was received by the corporation as the result of an installment sale of depreciable property to a party related to the shareholder. Related parties include:

1. the shareholder's spouse; and

2. all controlled entities, including:

a. any corporation or partnership in which the shareholder owns an interest (either directly or indirectly) of more than 50% (indirect ownership includes stock owned by the shareholder's family (brothers, sisters, spouse, ancestors and lineal descendants)), and

b. any other entity considered a related person (e.g., corporations that are members of a controlled group, or a corporation and a partnership if the same persons own more than 50% of the partnership and the corporation).

If the installment obligation is the result of a sale of other corporate property to a related party and that party resells the property within two years, the shareholder is taxed to the extent of the amount realized on the resale of the property. Related parties for this purpose are those considered related by application of Secs. 318 and 267(b) (e.g., spouse, child, grandchild, parent, controlled corporation or partnership, etc.). Exceptions exist for certain transactions (e.g., an involuntary conversion is not treated as a second disposition).

Before recommending an installment sale, the tax adviser must determine whether these related-party rules apply to a sale of the property to Stanley.

The partnership, not Stanley, is the shareholder in the corporation. Because Stanley owns 50% or less of the partnership, it will not be considered a controlled entity. Therefore, for Stanley and the partnership to be considered related parties, his uncle's ownership would have to be attributed to him. If it is, the partnership will be a controlled entity in relation to Stanley, and the partnership will not be able to defer the gain until payments are received on the installment obligation.

Under the constructive ownership rules, ownership is not attributed to nephews. Therefore, his uncle's ownership will not be attributed to him, and the partnership (the shareholder) will not be considered a controlled entity.

Conclusion

The tax adviser could recommend that the corporation liquidate and that, as part of the plan of liquidation, the property be sold to Stanley in an installment sale. The installment obligation could then be distributed to the partnership as a liquidating distribution. The partnership could defer gain on the installment sale until collections were received on the note.

The tax consequences of the transaction would be the same as if the property had been sold to an outsider:

Sheepcorp would have to recognize gain on the sale of the property.

Smith Partnership would be able to defer reporting gain on the property until collections were received on the note.

Therefore, George should not object to the proposed transaction.