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Using the installment method with escrow arrangements.


* Tax practitioners may incorrectly assume that if sales proceeds are to be received in tax years after the year of sale, the sale is reported on the installment method and not currently taxed.

* Generally, use of the installment method is mandatory if the seller realizes a gain and the transaction meets the Sec. 453 requirements.

* "Payment" may include not only amounts actually received, but amounts constructively received as well.

Putting proceeds from a sales transaction into escrow does not guarantee that a cash-basis taxpayer can use installment reporting. The presence of restrictions or limits may require use of the installment method, or the constructive receipt or economic benefit doctrine may apply to preclude installment reporting. This article examines the obstacles to be cleared for a cash-basis taxpayer to be eligible to elect installment sale reporting.

As a result of both years of economic growth and a trend in many industries toward consolidation, owners of closely held businesses are receiving (and accepting) rewarding offers to sell their businesses in record numbers. Many of these transactions are structured as taxable stock or asset purchases. More often than not, the stock or asset sale agreement provides for some portion of the sales proceeds to be placed in escrow, or otherwise held back from the sales proceeds due the seller at closing. Typically, some or all of these proceeds be released to the seller in a future tax year after satisfaction of certain conditions, or when the buyer is assured that he has received the benefit of his bargain.

Tax practitioners may readily assume that if sales proceeds are to be received in tax years after the year of sale, the sale is reported on the installment method, and not currently taxed. However, this conclusion has to be based on the facts and circumstances of the individual case, and cannot automatically be assumed whenever a sales agreement provides for an escrow or holdback of sales proceeds.

This article examines the tax rules involved in determining whether sales proceeds deferred under the terms of a sales agreement are subject to installment sale treatment or must be included in income currently. The focus is on taxable sales; the article does not address the installment method as it relates to qualified escrow accounts or qualified intermediaries in the deferred like-kind exchange context.(1) Additionally, because of the recent repeal of the installment method for accrual-basis taxpayers,(2) this article focuses solely on the installment method rules applicable to cash-basis taxpayers.

What Is an Escrow?

An escrow usually takes the form of a written agreement between a buyer, seller and an escrow agent. Typically, the escrow agent will establish an account in which the buyer deposits a portion of the purchase price. The escrow agreement may place restrictions or limits on the seller's right to receive the escrowed sales proceeds. For example, the seller may forfeit some or all of the escrowed funds in the event he has misrepresented to the buyer the company's true financial position or quality of assets. Further, the seller may forfeit the escrowed funds if the company is subject to claims that were unforeseen when the deal was negotiated.

In other circumstances, an escrow agreement may not be quite as formal. The buyer may simply hold back part of the sales proceeds for an agreed-on period to protect his interests.

Under each of the above examples, the seller's tax practitioner often assumes that the installment method automatically applies, because one or more payments will be received after the tax year in which the sale occurred; however, this is not always the case.

Installment Method

Use of the installment method is generally mandatory if the seller realizes a gain and the transaction meets the Sec. 453 requirements. Moreover, in most cases, the seller desires to treat the realized gain under the installment method, because of the ability to defer the tax thereon.(3) According to Sec. 453(b) (1), all "installment sale" is any disposition of property if at least one payment is received after the close of the tax year in which the disposition occurs. Thus, a transaction may be considered an installment sale whether the seller is to receive a single payment in a subsequent tax year or multiple payments spanning various tax years.

While escrow arrangements often implicate the use of the installment method, under certain circumstances, the method may not be available. Transactions involving escrow arrangements or holdback agreements will require the tax practitioner to consider Regs. Sec. 15A.453-1(b)(3)(i), which states that payments include amounts actually or constructively received.

Constructive Receipt and Economic Benefit Doctrines

As defined previously, a transaction constitutes an installment sale if at least one "payment" is received after the close of the tax year in which the sale occurs. However, determining what constitutes a "payment" is not necessarily easy when dealing with escrow arrangements.

One of the underlying rationales behind the installment method is that it recognizes the possibility that the buyer may default on the deferred payment obligation. Thus, to properly match the tax liability on the gain with the ability to pay the tax, gain recognition is typically deferred until payment is received. However, "payment" may include not only amounts actually received,, but amounts constructively received as well.

Regs. Sec. 1.451-2(a) provides that income is constructively received by a taxpayer when, without substantial limits or restrictions on his control of its receipt, the income is either (1) credited to his account, (2) set apart for him or (3) made available so he may draw on it at any time. Conversely, there will not be constructive receipt when (1) the taxpayer enters into an agreement to defer income before it is earned,(4) (2) the taxpayer's right to the income has not yet matured or vested and (3) the taxpayer's right to the income is contingent on the occurrence (or nonoccurrence) of an event or condition (and is therefore subject to a restriction). Some courts have interpreted the constructive receipt doctrine to mean simply that taxpayers may not deliberately turn their backs on income.(5)

The economic benefit doctrine, on the other hand, dictates that a tax be imposed on any benefit received, as long as some ascertainable value can be attributed to it. The economic benefit doctrine is generally applied when the taxpayer has received a cash equivalent.

The constructive receipt and economic benefit doctrines significantly overlap; thus, a distinction would be artificial. Ultimately, however, the application of either doctrine would have the same net effect; the future payment(s) would be treated as received in the year of sale, thus eliminating the use of the installment method. Therefore, determining whether a seller has constructively received a payment in the year of sale requires scrutiny of the parties' escrow or holdback arrangement.

Reviewing the Escrow Arrangement

The seller must review the escrow arrangement or holdback agreement for the presence of a "substantial restriction" on his right to receive the withheld funds. If a substantial restriction is present, use of the installment method may be required. When there is no substantial restriction on the seller's right to the withheld funds, the installment method will not be available, because the escrow or holdback amount will be considered a "payment" in the year of sale.

Identifying a substantial restriction, however, is not always clear. In Murray,(6) more than 75% of the purchase price of stock was placed in escrow as security for the sellers' agreement to refrain from entering a competing business for five years. One-fifth of the escrowed funds were to be delivered to the sellers annually; if at any time during the escrow period, they engaged in a competing business, they would forfeit all. rights to the remaining amount held in escrow. The IRS contended' that the sale was completed in the year of sale and that the funds placed in escrow were constructively received by the sellers. The Board of Tax Appeals rejected this argument, stating that this was exactly the type of transaction Congress had in mind when it established the installment method rules. The court further stated that the covenant not to compete was a vital part of the contract; it was definite, real and not dependent in any way on the sellers' whim or caprice. Thus, the court held that the sellers did not constructively receive the funds placed in escrow in the year of sale.

Rev. Rul. 77-294(7) later cited Murray for the proposition that, if an escrow arrangement imposes a substantial restriction on a seller's right to receive sales proceeds, the seller can use the installment method of reporting (assuming the sales transaction otherwise qualifies under Sec. 453). In Rev. Rul. 79-91,(8) the IRS later restated its position on substantial restrictions contained in escrow agreements. It cited Murray and clarified its position on escrow agreements and the installment method, stating that, for an escrow arrangement to impose a substantial restriction, it must serve a bona fide purpose of the purchaser (i.e., a real and definite restriction placed on the seller or a specific economic benefit conferred on the purchaser).

While most escrow arrangements or holdback agreements will provide some restriction or limit on a seller's right to escrowed funds, it cannot be assumed that every restriction will be sufficiently substantial to avoid application of the constructive receipt doctrine.


A seller's restriction on escrowed funds based solely on the passage of time is not a substantial restriction. For example, according to Rev. Rul. 79-91, an escrow agreement in which a seller has no right to or interest in the escrowed funds unless and until the buyer defaults on the installment obligation does not impose a substantial restriction. In this situation, it is not a question of whether the seller will be paid; rather, the issue is when the seller will be paid, because he is absolutely guaranteed to receive the balance of the installment obligation. If the buyer defaults on the obligation, the seller need only look to the escrow fund for payment of the installment obligation balance. In a similar example, a buyer who simply deposits the unpaid balance of the purchase price in an escrow to be paid over several years does not create a substantial restriction.(9) Again, the buyer has met his obligation in full when the escrow deposit is made; the seller need only look to the bank after expiration of the stated period for payment.

Moreover, Regs. Sec. 15A.4531(b)(3)(i) states that receipt of an installment obligation secured "directly or indirectly by cash or a cash equivalent" will be treated as a "payment" in the year of sale. The regulation defines "cash" and "cash equivalents" as bank certificates of deposit and Treasury notes.(10) Presumably, "cash" and "cash equivalents" would also include certain bonds or securities readily traded on an established securities exchange, because they can usually be converted to cash easily.

The direct or indirect control over escrowed funds, even without an absolute right to possess them, may constitute an economic benefit in the year of sale, thus giving rise to the constructive receipt doctrine.(11) Direct or indirect control over escrowed funds includes the seller's ability to withdraw, sell or borrow against such funds.(12) However, the constructive receipt doctrine will not apply merely because the seller can control investment of the escrow fund and subsequently receive the investment income.(13)

Finally, if an escrow agreement is established by a seller after a buyer has made available the full amount of the purchase price, regardless of the terms of the escrow (i.e., a self-imposed limit), the constructive receipt doctrine will apply. This will result in the entire gain being reported in the year of sale.(14)

Additional Considerations

If a seller is required to use the installment method because sales proceeds are locked in an escrow under a substantial restriction, there may be a cost to deferring some or all of the realized gain. If the seller's installment receivable (i.e., the amount of the escrow deposit subject to a substantial restriction) is greater than $5 million, Sec. 453A(a) imposes an annual interest charge on the outstanding tax liability deferred at year-end under the installment method. Additionally, Sec. 453A(d) triggers immediate gain recognition on any installment receivable arising out of a sale in which the sales price exceeds $150,000 and the seller uses the installment obligation as direct security for new or existing debt.


While most escrow arrangements or holdback agreements will afford sellers the opportunity to use the installment method, this is not always the case. Restrictions that (1) are (or appear to be) based solely on the expiration of a period, (2) are self-imposed or (3) give the seller too much control over the escrowed funds, will not be substantial restrictions for purposes of avoiding the constructive receipt doctrine. Thus, escrow arrangements and holdback agreements should be reviewed to determine whether restrictions on the seller's right to the escrow deposit have a valid purpose for the buyer and are not subject to the seller's control.

Additionally, it is important to be actively involved with clients throughout the entire sales process. This will facilitate a better understanding of the client's business and personal objectives and permit the practitioner to implement proper tax planning to achieve them.

Author's note: A special thanks to Robert Greisman, Tax Partner, BDO Seidman, L.L.P., Chicago, IL, for his invaluable assistance in preparing this article.

(1) When a deferred like-kind exchange using a qualified escrow account or qualified intermediary will straddle at least two tax years, the installment method will generally shift gain recognition on the taxpayer's receipt of cash or termination of the escrow or intermediary arrangement to the later tax year.

(2) See Ticket to Work and Work Incentives Improvement Act of 1999, Section 536, adding Sec. 453(a)(2).

(3) In some situations, however, it may be desirable to elect out of the installment method.

(4) See, e.g., John E. Reed, 723 Fd2 138. 143 (1st Cir. 1983)

(5) See, e.g., Hamilton Nat'l Bank of Chattanooga, 29 BTA 63, 67 (1933).

(6) Rebecca J. Murray, 28 BTA 624 (1933). See also Fred M. Stiles, 69 TC 558 (1978), acq., 1978-2 CB 3; IRS Letter Ruling 8629038 (4/18/86).

(7) Rev. Rul. 77-294, 1977-2 CB 173.

(8) Rev. Rul. 79-91, 1979-1 CB 179, amplifying Rev. Rul. 77-294, note 7 supra.

(9) Rev. Rul. 73-451, 1973-2 CB 158.

(10) But see Est. of Mose Silverman, 98 TC 54 (1992) (rejecting the IRS's argument that Regs. Sec. 15A.453-1(b)(3)(i) applied to the taxpayer's receipt of evidences of indebtedness secured by term accounts that were not payable on demand or readily traded on an established securities market).

(11) See W.B. Rushing, 441 F2d 593, 598 (5th Cir. 1971).

(12) Silverman, note 10 supra, at 98 TC 64.

(13) See Stiles, note 6 supra, at 69 TC 564, citing Murray, note 6 supra.

(14) See, e.g., IRS Letter Ruling 9137005 (5/30/91).

William G. Andreozzi, CPA, MST Tax Manager BDO Seidman, L.L.P. Chicago, IL
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Author:Andreozzi, William G.
Publication:The Tax Adviser
Geographic Code:1USA
Date:May 1, 2000
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