Sale of the Business
Imagine Client has just received an attractive, all cash offer[i] for the sale of their business; there is no financing contingency.[ii] The buyer has proposed a cash-free and debt-free deal.[iii] The only post-closing adjustment to the purchase price will be for net working capital;[iv] for example, there is no earnout based upon the post-closing performance of the business. Subject to further diligence, the buyer expects that a portion of the purchase price will be held in escrow by a bank for a stated period[v] to secure the client’s general indemnity obligations with respect to its representations and warranties in the purchase and sale agreement.[vi] Other than the net working capital adjustment and the escrowed amount, the entire purchase price will be payable at closing.
Before accepting the offer, Client – to its credit (and to your relief) – asks that you explain the tax consequences of the proposed transaction; specifically, how much will Client net from the sale on an after-tax basis?[vii]
You explain that, in an all-cash deal, the gain from the sale of the business will be recognized immediately; it will be reported on Client’s income tax returns for the taxable year in which the sale occurs, at which time the federal and state income taxes incurred on such gain will also have to be remitted.[viii]
Client asks whether there is any way to avoid paying the income tax. Not really, you explain,[ix] though it may be possible to defer recognition of the gain and thereby defer the obligation to pay the tax. You explain further, however, that such deferral may only be achieved if Client was willing to defer receipt of the cash purchase price.
Then Client asks whether such deferral may be accomplished in a way that still allows them to access the proceeds from the sale of the business, or at least the earnings from the investment of such proceeds?
You have known Client for several years, so you’re certain they have not been indulging in the recreational use of cannabis, though such use is now legal in 18 states. However, you suspect they may have been busy on the internet, which can be just as harmful.
Which leads to Client’s follow-on question: what do you know about “monetized installment sales” and “deferred sales trusts”?[x]
Before launching into a brief description of these tax deferral “techniques” – which, according to their sponsors, are unknown to many tax advisers – it may be helpful to review the installment sale rules on which they purport to be based.
Assume a taxpayer sells a capital asset or “Section 1231 property”[xi] to a buyer in exchange for cash that is payable at closing (as in the case of Client).[xii]
In general, the seller’s gain from the disposition of their property in exchange for the cash – i.e., the excess of the amount of cash received over the seller’s adjusted basis for the property – must be included in the seller’s gross income for the taxable year of the sale.[xiii]
In contrast, the Code generally recognizes that it may not be appropriate to tax the entire gain realized by a seller in the year of the sale if the seller has not received the entire purchase price for the property sold; for example, where the seller is to receive one or more payments from the buyer in a taxable year subsequent to the year of the sale, whether under the terms of the purchase and sale agreement,[xiv] or pursuant to a promissory note given by the buyer to the seller in full or partial payment of the purchase price.
In cases where the payment of the purchase price is thus delayed, the seller has not completed the conversion of their property to cash. Instead of the economic certainty of cash in their pocket that can be used today, the seller has assumed the risk that the balance of the sale price may not be received; moreover, the right to such future payment may not be monetized currently. These economic principles underlie the installment method of reporting.[xv]
A sale of property where at least one payment is to be received after the close of the taxable year in which the sale occurs is known as an “installment sale.”[xvi] For tax purposes, the gain from such a sale is reported by the seller using the installment method.[xvii]
Under the installment method, each payment received by a seller is treated in part as a return of their adjusted basis for the property sold, and in part as gain from the sale of the property.[xviii]
The recognition of gain, therefore, is tied to the seller’s receipt of payment. For purposes of the installment method, the term “payment” includes the actual or constructive receipt of money by the seller.[xix] It also includes the seller’s receipt of a promissory note from the buyer which is payable on demand or that is readily tradable. Likewise, the receipt of an evidence of indebtedness which is secured directly or indirectly by cash or a cash equivalent[xx] will be treated as the receipt of payment.
In each of these instances, the seller has wholly converted their interest in the property sold to cash, or they have been given the right to immediately receive cash, or they are assured of receiving cash – thus, they are in actual or constructive receipt of the cash.[xxi]
Because there is no credit risk associated with holding the buyer’s note and awaiting the scheduled payment(s) of principal, the seller is treated, in these instances, as having received payment of the amount specified in the promissory note.
However, a payment does not include the receipt of the buyer’s promissory note[xxii] – an “installment obligation”[xxiii] – that is payable at one[xxiv] or more specified times in the future, whether or not payment of such indebtedness is guaranteed by a third party, and whether or not it is secured by property (other than cash or a cash equivalent).[xxv]
In the case of such a note, the seller remains at economic risk until the note is satisfied. Thus, that portion of the seller’s gain that is represented by the note will generally be taxed only as principal payments are received.[xxvi]
Assuming the risk associated with the deferred payment of the purchase price is reasonable, a seller may welcome the deferral of gain recognition and the resulting tax liability that the installment sale provides. At the same time, however, sellers have sought to find a way by which they can currently enjoy the as-yet-unpaid cash proceeds from the sale of their property without losing the tax deferral benefit.
Pledging the Note
One method that was previously utilized to accomplish this goal was for the seller to borrow money from a lender and to pledge the buyer’s installment obligation as security for the loan.[xxvii]
Many years ago, Congress concluded that this monetization technique was not consistent with the principles underlying the installment method. Thus the Code provides that if any indebtedness is secured by an installment obligation, the net proceeds of the secured indebtedness will be treated as a payment received on the installment obligation as of the later of the time the indebtedness becomes “secured indebtedness,” or the time the proceeds of such indebtedness are received by the seller.[xxviii]
For purposes of this rule, an indebtedness is secured by an installment obligation[xxix] to the extent that payment of principal (or interest) on such indebtedness is directly secured – under the terms of the indebtedness or any underlying arrangements – by any interest in the installment obligation. A payment owing to the lender will be treated as directly secured by an interest in the buyer’s installment obligation to the extent “an arrangement” allows the seller to satisfy all or a portion of the indebtedness with the installment obligation.[xxx]
Monetized Installment Sale
Let’s turn now to the first of the tax deferral techniques mentioned by Client: the
“monetized installment sale.”
Although there are variations of this strategy, they seem to share the following features, as illustrated in the following four-party structure:
- Seller wants to sell Property to Buyer, immediately receive cash in an amount equal to Property’s fair market value and defer the recognition of any gain realized from the sale under the installment method.
- Seller sells Property to Intermediary – the “promoter” of the transaction[xxxi] – in exchange for Intermediary’s unsecured installment obligation in an amount equal to Property’s fair market value; the installment obligation provides for interest only over a fairly long term, followed by a balloon payment of principal, at which point the Seller’s gain from the sale would be recognized.
- Intermediary immediately sells Property to Buyer for cash;[xxxii] because of its fair market value cost basis for Property, Intermediary does not realize gain on this sale; the cash is held in escrow until Intermediary’s installment obligation to Seller comes due.
- Seller obtains a loan from Lender,[xxxiii] the terms of which “match” the terms of Intermediary’s installment obligation held by Seller; Seller does not pledge Intermediary’s installment obligation as security for the loan; escrow accounts are established to which Intermediary will make interest payments, and from which the interest owed by Seller will be automatically remitted to Lender.
- Seller has the non-taxable loan proceeds which they may use currently; Seller will typically invest the proceeds in another business or investment, at least initially, to demonstrate a “business purpose” for the loan.[xxxiv]
- Seller will report gain on the sale of Property only as Intermediary makes payments to Seller under its installment obligation; in the case of a balloon payment, the gain will be reported and taxed when the obligation matures.
- Seller will use the payment(s) to repay the loan from Lender.
The IRS Responds
Last year, the IRS Office of Chief Counsel released a Chief Counsel Advice memorandum (“CCA”)[xxxv] in response to a request from within the IRS for an analysis regarding monetized installment sale transactions.
The CCA addressed certain features that often appear in monetized installment sales “that make the transactions problematic.”
No genuine indebtedness. According to the CCA, at least one promoter of such transactions contends that, under their plan, the seller (the taxpayer seeking to defer the recognition of gain) receives the proceeds of an “unsecured nonrecourse loan” from a lender.
“How can a nonrecourse loan be unsecured?” the CCA asked. A “borrower” who is not personally liable for the purported loan, and who has not pledged any collateral to secure the loan, has no reason to repay the loan. Therefore, the “loan proceeds” should be treated as income.
Debt secured by escrow. Another promoter, the CCA continued, states that the lender can look only to the cash escrow established by the promoter for payment (see above). In that case, the cash escrow is security for the loan to the taxpayer.
Because the seller-taxpayer economically benefits from the cash escrow – they are not at economic risk for the loan – they should be treated as receiving payment under the “economic benefit” doctrine for purposes of the installment sale rules.
Debt secured by promoter’s note. Alternatively, the monetization loan to the seller-taxpayer is secured by the right to payment from the escrow under the installment note from the promoter. This would result in deemed payment under the anti-pledging rule (see above), pursuant to which loan proceeds are treated as payment of the promoter’s note.
Section 453(f). The intermediary does not appear to be the true buyer of the asset sold by the taxpayer. Under the installment sale rules, only debt obligations from an “acquirer” (the buyer) can be excluded from the definition of “payment” for purposes of such rules.
Debt instruments issued by a party that is not the acquirer would be considered a payment to the seller that requires the recognition of gain.
Cash Security. To the extent the installment note from the intermediary to the seller is secured by a cash escrow, the taxpayer-seller is treated as receiving payment regardless of the anti-pledging rule.[xxxvi]
Deferred Sales Trusts
It may have been a long time coming, but the IRS’s pronouncement on monetized installment sales should cause many taxpayers and their advisers to think carefully before embarking on such a transaction.
Unfortunately, the IRS has thus far failed to address another “technique” that is being promoted as a tax planning tool for taxpayers who are selling assets: the deferred sales trust, which also purports to rely upon the installment sale rules while producing a result that is inconsistent with such rules.[xxxvii]
As in the case of monetized installment sales, there are variations on the theme, but the basic terms of the deferred sales trust strategy appear to be as follows:
- Taxpayer has agreed to sell their business to Buyer.
- A trust agreement is entered into with an intermediary/sponsor as the trustee and Taxpayer as the “beneficiary” (“Trust”).
- Taxpayer enters into a purchase and sale agreement pursuant to which Trust will acquire the business from Taxpayer in exchange for which Trust will pay the purchase price in installments, according to an agreed-upon schedule.
- Taxpayer may choose to defer receipt of the proceeds, and thereby defer recognition and taxation of the gain, for many years.[xxxviii]
- Trust “purchases” the business from Taxpayer and takes a cost basis therein.
- Taxpayer will recognize and include gain from the sale in its gross income only when payments of the purchase price are made, at which point the gain is reported on the installment method.
- Trust sells the business to Buyer in an all-cash deal.
- Because Trust has a cost basis in the business, Trust does not realize gain on the sale to Buyer.
- Trust invests the sales proceeds.
- Trust pays a rate of interest (perhaps at the higher end of fair market value) to Taxpayer with respect to the deferred purchase price at least annually.
- The amount of interest paid may reflect the performance of Trust’s investments.
- Taxpayer and Trust may agree to modify the schedule of payments, thereby changing the amount of each installment.
- Taxpayer may request that the arrangement with Trust be terminated, and all the remaining proceeds (plus accrued interest) be paid out to Taxpayer, if Trust deems it “appropriate.”[xxxix]
Where to begin?
Let’s start with the back-to-back sales. Is there a bona fide business reason for the sale to Trust? Does Trust really assume the benefits and burdens of ownership? What if a representation as to the business is breached and Buyer suffers a loss? By whom will Buyer be indemnified? To borrow a partnership-related term, who will bear the “economic risk of loss”? I’m willing to bet it’s Taxpayer.
For the same reasons, is there even a sale to Trust? Taxpayer and Buyer most certainly have agreed upon the salient terms of their deal prior to Trust’s “purchase” from Taxpayer.[xl] In addition, Trust certainly cannot decide to forego the subsequent sale to Buyer.[xli]
Because Taxpayer is the beneficiary of Trust, wouldn’t the sale by Trust trigger recognition by Taxpayer under the related party sale rules?[xlii]
Is Trust’s obligation to pay the purchase price secured? By what? The cash received from Buyer? Doesn’t that disqualify the sale from installment reporting notwithstanding Trust’s subsequent investment of the proceeds? It should.
Speaking of disqualification, wouldn’t Taxpayer’s ability to “demand” payment of the purchase price (by unwinding the arrangement with Trust) convert the deferral arrangement into a demand note, thereby accelerating the recognition of gain?
If Trust’s obligation to Taxpayer is not secured, how is Taxpayer protected against Trust’s poor investment performance?
What if Trust’s investments do well? How will Taxpayer benefit? The amount of principal (the purchase price) payable to Taxpayer certainly does not change. The payment of a higher rate of interest? So it seems. At what point does that turn into a participation in the investment and immediate taxation of the purportedly deferred gain under an economic benefit theory analysis?
Where Do We Go From Here?
Reasonable taxpayers and responsible advisers probably share the IRS’s concerns with a monetized installment sale. It’s also likely that they harbor concerns over a deferred sales trust similar to those described above.
Unfortunately, we continue to find ourselves in an environment in which too many representatives in Congress hope to enact significant tax rate increases for the gains realized by businesses and their owners.
Under such circumstances, some taxpayers will remain receptive to questionable strategies that promise to significantly reduce or defer the payment of their tax liability without compromising their economic situation.[xliii]
It is also possible that some variant of these deferral techniques may be developed and promoted to those taxpayers among whom it is likely to gain the most traction: those business owners who are worried about whether they will retain a sufficient amount of after-tax proceeds following the sale of their business at a fair price.[xliv]
Whatever the taxpayer’s reasons, their tax advisers must be careful to alert them to the risk that the IRS may recharacterize their transaction, and to educate them as to the consequences thereof.
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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] The buyer will not issue an equity interest or a promissory note to the seller.
[ii] Meaning that the buyer’s obligation to close will not be subject to the buyer’s obtaining financing for the acquisition.
[iii] Generally meaning that the seller will keep its cash and will pay off its debts at, or prior to, the time of the closing.
[iv] The excess of current assets over current liabilities. This adjustment is often required to be made within 90 days after the closing. It is typically based upon the average for the latest trailing period agreed to by the parties; for example, the latest trailing 6 months.
[v] Say 5 percent for a period of 18 months. Upon expiration of the escrow period, the parties will direct the bank to release the funds.
[vi] If the breach of any representation or warranty made by the seller results in a loss to the buyer, the buyer will have access to the escrow; however, if the loss is substantial enough, the buyer may not be limited to the escrowed amount. Hopefully, the seller will be able to negotiate both a “non-tipping” basket (basically, a deductible) and a cap on the indemnity for the non-fundamental reps. (The indemnity on fundamental reps may be capped at the purchase price.)
[vii] How many times has a client come to you with an executed letter of intent, including of course an agreed-upon price for the sale of the business, before ever considering the tax consequences and their impact upon the economics of the deal? After all, the greater the amount of tax paid by the seller, the lower the return on the seller’s investment in the business.
[viii] In the case of a corporation, you should consider both entity-level and shareholder-level tax. In addition, don’t forget to account for sales tax and real estate transfer tax, where applicable.
A lot of folks ask about estimated taxes following the sale; no additional estimated taxes are required for the year of the sale so long as the sum of the taxes withheld and any estimated tax payments made during the year of the sale equal at least 110% of the tax shown on the taxpayer’s tax return for the immediately preceding taxable year (assuming it covers 12 months).
[ix] Assume the client does not want to invest the gain in a qualified opportunity zone – the gain would have to be recognized in 2026 in any event – and has no interest in using a like kind exchange to defer the gain from the sale of its real property.
[x] I have heard this question several times since the third quarter of 2021.
[xi] In general, this includes real property used in a trade or business, or other property used in a trade or business that is subject to the allowance for depreciation or amortization; there are certain exceptions. IRC Sec. 1231(b).
[xii] From the seller’s perspective, it generally doesn’t matter whether the buyer borrowed the cash for the purchase from a third party or used its own funds for the purchase.
[xiii] IRC Sec. 1001; Reg. Sec. 1.1001-1. The adjusted basis – the seller’s unreturned investment – is the taxpayer’s original cost basis for the property, plus the cost of any capital expenditures (for example, improvements to tangible property, or additional paid-in capital in the case of an equity interest in a business entity); depending on the property, this amount may be reduced by any depreciation allowed or allowable; in the case of stock in a corporation, certain distributions will reduce a shareholder’s basis; in the case of pass-through business entities, the allocation of losses to the interest holder will reduce basis.
[xiv] For example, where an amount otherwise payable by the buyer is held in escrow for the survival period of the seller’s reps and warranties (to secure the buyer against the seller’s breach of such), or where there are earnout payments to be made over a number of years (say, two or three) based on the performance of the business.
[xv] In general, there is a direct correlation between the economic certainty of a seller’s “return on investment” on the sale of property and the timing of its taxation; where the delayed payment of the sales price creates economic risk for the seller, the taxable event will be delayed until the payment is received.
[xvi] IRC Sec. 453; Reg. Sec. 15a.453-1.
[xvii] Installment reporting does not apply to a sale that results in a loss to the seller. The loss is reported in the year of the sale.
Nor does it apply to the sale of certain assets; for example, accounts receivable, inventory, depreciation recapture, and marketable securities. These are ordinary income items that are recognized in the ordinary course of business, or they are items that represent cash equivalents.
It should also be noted that a seller may elect out of installment reporting, and thereby choose to report its entire gain in the year of the sale.
[xviii] The amount of any payment which is treated as income to the seller for a taxable year is that portion (or fraction) of the installment payment received in that year which the gross profit realized from the sale bears to the total contract price (the “gross profit ratio”). Generally speaking, the term “gross profit” means the selling price for the property less the taxpayer’s adjusted basis for the property – basically, the gain.
[xix] Reg. Sec. 15a.453-1(b)(3).
[xx] For example, a bank certificate of deposit or a treasury note.
[xxi] For example, by demanding payment on the note or by selling the note.
[xxii] It cannot be the note of a third party.
[xxiii] A promise to pay in the future.
[xxiv] A balloon at maturity.
[xxv] A standby letter of credit is treated as a third-party guarantee; it represents a non-negotiable, non-transferable letter of credit that is issued by a financial institution, and that may be drawn upon in case of default – it serves as a guarantee of the installment obligation. In the case of an “ordinary” letter of credit, by contrast, the seller is deemed to be in constructive receipt of the proceeds because they may draw upon the letter at any time.
[xxvi] Of course, the seller will report as income any interest paid (or imputed) in respect of the deferred purchase price.
[xxvii] In this way, the seller was able to immediately access funds in an amount equal to the proceeds from the sale of their property, while continuing to report the gain from the sale under the installment method as the buyer made payments on the installment obligation; the loan that was secured by the installment obligation would be repaid as the installment obligation itself was satisfied.
[xxviii] IRC Sec. 453A(d). If any amount is treated as received with respect to an installment obligation as a result of this anti-pledge rule, subsequent payments actually received on such obligation are not taken into account for purposes of the installment sale rules, except to the extent that the gain that would otherwise be recognized on account of such payment exceeds the gain recognized as a result of the pledge.
[xxix] Interestingly, the above anti-pledging rule was limited in its reach to obligations which arise from the installment sale of property where the sales price of the property exceeds $150,000; for purposes of applying this threshold, all sales which are part of the same transaction (or a series of related transactions) are treated as one sale. IRC Sec. 453A(b)(1) and (5).
[xxx] IRC Sec. 453A(d)(4).
It is significant that the Conference Committee report to the Tax Relief Extension Act of 1999 indicates that “[o]ther arrangements that have a similar effect would be treated in the same manner.” P.L. 106-170; H. Rep. 106-478.
[xxxi] A person who facilitates these transactions in exchange for a fee.
[xxxii] In fact, the Intermediary may have the Property direct deeded from Seller to Buyer.
[xxxiii] Arranged by Intermediary.
[xxxiv] Intermediaries suggest that this be done, at least for an “initial period,” to demonstrate a business purpose for the loan. The implication is that, after a period of “cleansing,” the investment may be liquidated, and the funds used for any purpose at all.
[xxxv] CCA 202118016. This is written advice prepared by the Office of Chief Counsel and issued to field or service center employees of the IRS or Office of Chief Counsel.
[xxxvi] Treas. Reg. Sec. 15a.453-1(b)(3). “Receipt of an evidence of indebtedness which is secured directly or indirectly by cash or a cash equivalent . . . will be treated as the receipt of payment.”
[xxxvii] Another attempt at “having one’s cake and eating it too.”
[xxxviii] The websites of some sponsors use the word “indefinitely” to describe the deferral period.
[xxxix] I imagine a trust would not be popular with future sellers if it developed a reputation for not acceding to a taxpayer’s request.
[xl] See Rev. Rul. 73-157. The true nature of the transaction was that a sale was negotiated between the taxpayer and a third party; in order to avail itself of the installment provisions of the Code, the taxpayer arranged an intermediary installment sale whereby a third party would consummate the prearranged transaction, receive the full payment from the purchaser, and dispense the proceeds from the sale to the taxpayer in installments. Thus, the third party was merely acting on behalf of the seller-taxpayer to receive and hold the proceeds of the sale.
Accordingly, under the circumstances of these situations, it is held that the gain realized by the taxpayer does not qualify for the installment method of reporting under section 453(b) of the Code. Thus, the entire amount of such gain must be included in the taxpayer’s gross income for the taxable year of the sale to the third party.
[xli] Talk about having a field-day with arguments based on step transaction, sham transaction, and/or assignment of income doctrines. Query whether the grantor trust rules may also yield the same outcome. IRC Sec. 671 et seq.
In contrast, a transaction may be considered true installment sale where the trustee, having independent fiduciary duties to the trust, is not subject to the de facto control of the taxpayer. In such a case, the taxpayer is unable to require the trustee’s sale of the property. Moreover, there is no possibility that the taxpayer could immediately realize the full benefit from the sale if the proceeds are placed in an irrevocable trust. See, e,g, Pityo v. Comm’r, 70 T.C. 225 (1978).
[xlii] IRC Sec. 453(e). If one sells property to a related party in an installment sale, and the related party sells the property to another person within two years after the first sale, the original seller will be treated as receiving an amount equal to the purchase price for the second sale. For purposes of this rule, “related” parties include the fiduciary of a trust and a beneficiary of the trust. IRC Sec. 267(b).
[xliii] The ability to use the sale proceeds currently.
[xliv] I know plenty of folks who decided against a sale of their business for that very reason.