Abusive Arrangements
As part of its enforcement efforts, the IRS annually identifies what it describes as potentially abusive transactions that taxpayers should avoid.[i] According to the agency, some of these transactions are focused on more complex arrangements that promoters market to higher-income individuals. The IRS has stated that such arrangements will likely attract additional agency compliance efforts in the future; in other words, they are on the IRS’s “enforcement radar screen.”
Among these suspect tax-motivated transactions, the IRS has included so-called “monetized installment sales” (“MIS”),[ii] which the agency claims involve the inappropriate use of the installment sale rules[iii] by a seller who, in the year of a sale of property, effectively receives the sales proceeds through purported loans.
In 2023, not long after the inclusion of MIS on the IRS’s list of potentially abusive arrangements, the IRS proposed regulations[iv] that would identify MIS transactions and substantially similar transactions as listed transactions, which are a type of reportable transaction.[v]
Participants in these listed transactions, as well as material advisors[vi] (including promoters),[vii] would be required to file disclosures with the IRS and be subject to penalties for failure to disclose.[viii]
In response to the notice of proposed rulemaking (“NPRM”) that accompanied the proposed regulations, one promoter (“Plaintiff”) brought an action against the IRS in federal district court, challenging the agency’s right to promulgate regulations that would identify MIS transactions as listed transactions subject to the applicable disclosure requirements,[ix] and seeking to have the proposed regulations set aside as unlawful. Plaintiff’s complaint presented several counts for relief, but at its core relied on claims under the Administrative Procedure Act (the “APA”).
The government moved to dismiss Plaintiff’s complaint, arguing that the Court lacked subject matter jurisdiction because the agency action that Plaintiff challenged was neither final nor ripe for judicial review.
Before considering the Court’s decision, let’s quickly review the elements of a typical MIS.[x]
The Monetized Installment Sale
According to the IRS, promoters are marketing transactions – MIS – that purport to convert an all-cash sale of appreciated property by a taxpayer (the seller) to an identified buyer (the buyer) into an installment sale to an intermediary (who may be a promoter), followed by a sale from the intermediary to the buyer.
In a typical transaction, the intermediary issues a note or other evidence of indebtedness to the seller requiring annual interest payments and a balloon payment of principal at the maturity of the note. Immediately thereafter, the intermediary transfers the seller’s property to the buyer in a purported sale of the property for cash, thereby completing the prearranged sale of the property by the seller to the buyer.
In connection with the transaction, the promoter refers the seller to a third party that enters into a purported loan agreement with the seller. The intermediary generally transfers the amount it has received from the buyer, less certain fees, to an account held by or for the benefit of this third party (the account). The third party provides a purported non-recourse loan to the seller in an amount equal to the amount the seller would have received from the buyer for the sale of the property, less these fees.
The “loan” is either funded or collateralized by the amount deposited into the account by the intermediary. The seller’s obligation to make payments on the purported loan is typically limited to the amount to be received by the seller from the intermediary pursuant to the purported installment obligation. Upon maturity of the purported installment obligation, the purported loan, and the funding note, the offsetting instruments each terminate, giving rise to a deemed payment on the purported installment obligation and triggering taxable gain to the seller that purportedly was deferred until that time.
According to the IRS, the promotional materials for these transactions generally assert that engaging in the transaction will allow the seller to defer the gain on the sale of the property under the installment sale rules until the taxpayer receives the balloon principal payment in the year the note matures, even though the seller receives cash from the purported lender in an amount that approximates the amount paid by the buyer to the intermediary.
Plaintiff’s Position
Plaintiff maintained that MIS transactions of the kind described above are “expressly permitted by” the Code, and Congress “clearly” intended for sellers to use “the installment method” to “take advantage” of its tax deferral benefits.[xi]
Next, Plaintiff turned to the NPRM and the proposed regulations, pursuant to which MIS transactions would be designated as “listed transactions,” and identified by the IRS as “tax avoidance” transactions.[xii]
Although taxpayers remain free to participate in listed transactions, they would be required, as “participants” in a listed transaction, to file certain disclosures, as would their “material advisors.”[xiii] The proposed regulations would not only subject MIS transactions to these disclosure requirements, but would also impose monetary penalties for non-compliance with such requirements.
Plaintiff sought to set aside the NPRM and proposed regulations on the grounds that they (1) are arbitrary and capricious, an abuse of discretion, or otherwise not in accordance with law; (2) are unconstitutionally vague and impose “impossible” reporting obligations; and (3) exceed the IRS’s statutory authority to identify “listed transactions.”
Government’s Response
According to the government, the NPRM represented only the first step in the APA’s notice-and-comment rulemaking process – “a process designed to ensure that agencies finalize rules with fair notice and opportunity for feedback.”
The government asserted that because the Court may review only final rules as they applied in a ”concrete setting,” the Court had no subject matter jurisdiction in the present case, and urged the Court to grant the government’s motion to dismiss Plaintiff’s complaint.
Plaintiff could not circumvent these “bedrock principles,” the government concluded, by challenging the NPRM before the proposed regulations became final.
Plaintiff’s Counter
According to Plaintiff, however, the NPRM did not contain merely “proposed” rules that were subject to change.
Instead, Plaintiff saw the NPRM as “the culmination of the IRS’s years-long campaign” against MIS transactions.[xiv]
Plaintiff characterized the NPRM as the IRS’s “final and cumulative policy position” that such transactions were “scams” that violated the Code.
Court’s Analysis
The Court began its consideration of the parties’ positions by reminding Plaintiff that it had the burden of establishing the Court’s jurisdiction in this matter.
The Court explained that Plaintiff’s challenge of the NPRM was premised on the grounds that the government had waived its sovereign immunity; in the absence of such waiver, no jurisdictional basis existed for Plaintiff’s claims.
Final Agency Action
According to the Court, the APA waived sovereign immunity for challenges to agency action seeking non-monetary relief. The Court added, however, that such a waiver was limited to claims regarding “final agency action for which there is no other adequate remedy in a court,” or agency action “made reviewable by statute.”
An agency action is “final,” the Court stated, if it satisfies both prongs of the following test: first, the action must “mark the consummation of the agency’s decision-making process” – it cannot be “of a merely tentative or interlocutory nature”; and second, the action must be one “by which rights or obligations have been determined, or from which legal consequences will flow.”
The Court determined that the NPRM in question failed the test. The NPRM, the Court stated, marked the beginning of the rulemaking process to designate MIS transactions as “listed transactions.” The APA, the Court continued, established a three-step process for promulgating legislative rules: (1) publication of a general notice of proposed rulemaking in the Federal Register; (2) receipt and consideration of public comments; and (3) promulgation of final rules with a statement of basis and purpose.
The NPRM was just the first step in this process: it set forth the proposed rules, invited public comment, and stated explicitly that an MIS transaction would be identified as a listed transaction “effective the date that these regulations are published as final regulations in the Federal Register.”
Plaintiff nonetheless attempted to recharacterize the NPRM as a final interpretive rule that conclusively determined that MIS transactions constituted tax avoidance. Plaintiff pointed to the NPRM’s statement that “the IRS will take the position in litigation that taxpayers are not entitled to the purported tax benefits” of these transactions and argued that this statement had immediate deterrent effects on taxpayer behavior; i.e., “freezing” their business and “presently forc[ing] them to incur compliance costs.”
The Court rejected Plaintiff’s argument, stating it conflated “practical effects with finality of agency action.” Every proposed rule, the Court explained, signals an agency’s tentative position and may influence behavior in the regulated community. “But courts have never reviewed proposed rules, notwithstanding the costs that parties may routinely incur in preparing for anticipated final rules.” Proposed rules, the Court pointed out, have not been treated by the judiciary as final agency actions. Moreover, the Court observed that Plaintiff did not cite a single case finding that a notice of proposed rulemaking constituted final agency action.
The Court then found that the NPRM failed to satisfy second prong of the test – it determined no rights or obligations and created no legal consequences. Plaintiff, in fact, acknowledged that the NPRM “by its plain terms does not currently oblige Plaintiff” to file any disclosure statements. The proposed regulations were not yet legally enforceable; thus, no penalties could be assessed for non-compliance, and no legal obligations flowed from them. Rather, the Court went on, “[a]ny such legal obligations or prohibitions will be established, and any legal consequences for violating those obligations or prohibitions will be imposed,” only after the rule is finalized. Any representations the IRS may have made to the NPRM’s effect did nothing to change this analysis.[xv]
Therefore, the Court declined to find that the NPRM’s alleged “chilling effect” transformed the proposed rule into final agency action.
The Court also rejected Plaintiff’s alternative argument that, even if the NPRM did not constitute final agency action, it still qualified as agency action “made reviewable by statute” under the APA. The Court observed that Plaintiff cited no supporting case law and failed to acknowledge that cases finding agency actions “made reviewable by statute” involved statutes containing explicit review provisions.
The law is clear, the Court stated: “When a statute does not specifically make agency action reviewable, the [APA] limits the right of judicial review to ‘final’ agency action.” Because the APA did not specifically make agency action reviewable, and the NPRM did not constitute final agency action, the Court determined that it lacked subject matter jurisdiction over Plaintiff’s claims, “grounded in the APA,” that sought to set aside the NPRM.
Thus, the Court granted the government’s motion to dismiss all the claims in Plaintiff’s complaint, albeit without prejudice, for lack of subject matter jurisdiction.[xvi]
What to Expect
As mentioned above, the IRS has indicated that it intends to use multiple arguments to challenge the reported treatment of an MIS transaction as an installment sale to which installment method reporting purportedly applies.
In brief, these arguments include the following:
- the intermediary is not a bona fide purchaser of the property that is the subject of the purported installment sale; the intermediary is interposed between the seller and the buyer (usually after the seller has decided to sell the property to such buyer at a negotiated purchase price) for no purpose other than Federal income tax avoidance;[xvii] the purported resale by the intermediary to the buyer generally takes place almost simultaneously with the purported sale to the intermediary for approximately the same price; the intermediary neither enjoys the benefits nor bears the burdens of ownership of the property, so it is inappropriate to treat the intermediary in the MIS transaction as the acquirer of the property that is the subject of the purported installment sale;
- the seller is appropriately treated as having already received the full payment at the time of the sale to the buyer because (1) the purported installment obligation received by the seller is treated as the receipt of a payment by the seller because it is indirectly secured by the sales proceeds, or (2) the proceeds of the purported loan are appropriately treated as a payment to the seller because the purported loan is not a bona fide loan for Federal income tax purposes, or (3) the pledging rule[xviii] deems the seller to receive full payment on the purported installment obligation in the year the seller receives the loan proceeds;
- the transaction may be recharacterized under the economic substance rules or the substance over form doctrine;[xix] the transaction with the intermediary lacks an independent business (non-tax) purpose, should not respected for Federal income tax purposes, and should instead be treated as a sale of the property by the seller directly to the buyer in the taxable year in which the property was transferred by the seller.
Let’s assume, not unreasonably, that the proposed regulations issued with the NPRM will be finalized without significant changes and, consequently, that MIS transactions will be identified as listed transactions.
The prospect of being required to report such transactions to the IRS, coupled with the prospect of being charged penalties for having failed to file such reports, is bound to have a chilling effect upon promoters of MIS transactions and upon those taxpayers who are willing to participate in such transactions.
In the end, that’s not a bad thing.
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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 IRS’s so-called “Dirty Dozen” campaign is undertaken, in part, to warn taxpayers regarding promoters selling bogus tax strategies.
[ii] The transaction described in Prop. Reg. Sec. 1.6011-13(b) includes the following elements:
- (1) A taxpayer (seller), or a person acting on the seller’s behalf, identifies a potential buyer for appreciated property (gain property), who is willing to purchase the property for cash or other property (buyer cash).
- (2) The seller enters into an agreement to sell the property to a person other than the buyer (intermediary) in exchange for an installment obligation.
- (3) The seller purportedly transfers the property to the intermediary, although the intermediary either never takes title to the property or takes title only briefly before transferring it to the buyer.
- (4) The intermediary purportedly transfers the property to the buyer in a sale of the property in exchange for the buyer cash.
- (5) The seller obtains a loan, the terms of which are such that the amount of the intermediary’s purported interest payments on the installment obligation correspond to the amount of the seller’s purported interest payments on the loan during the period. On each of the installment obligation and loan, only interest is due over identical periods, with balloon payments of all or a substantial portion of principal due at or near the end of the instruments’ terms.
- (6) The sales proceeds from the buyer received by the intermediary, reduced by certain fees (including an amount set aside to fund purported interest payments on the purported installment obligation), are provided to the purported lender to fund the purported loan to the seller or transferred to an escrow or investment account of which the purported lender is a beneficiary. The lender agrees to repay these amounts to the intermediary over the course of the term of the installment obligation.
- (7) On the seller’s Federal income tax return for the taxable year of the purported installment sale, the seller treats the purported installment sale as an installment sale under section 453.
[iii] IRC Sec. 453.
A primer on the installment sale rules: A taxpayer’s gross income includes gains from dealings in property. Under IRC Sec. 1001(a), a taxpayer’s gain on a sale of property is equal to the excess of the amount realized on the sale over the taxpayer’s adjusted basis in the property and, generally, a taxpayer must recognize the gain in the taxable year of the sale. The taxpayer’s amount realized generally includes cash actually or constructively received, plus the fair market value of any property received or, in the case of a debt instrument issued in exchange for property, the issue price of the debt instrument.
IRC Sec. 453 provides an exception to the general rule that gain from the sale of property must be recognized in the year of sale. It provides, in general, that income from an installment sale is accounted for under the installment method. An installment sale is one in which a taxpayer disposes of property and at least one payment is to be received after the close of the taxable year of the disposition. The installment method requires a taxpayer to recognize income from a disposition as payments are actually or constructively received, in an amount equal to the proportion of the payment received that the gross profit (realized or to be realized when payment is completed) bears to the total contract price.
A taxpayer generally does not receive a “payment” to the extent the taxpayer receives evidence of indebtedness “of the person acquiring the property” (installment obligation). As a result, the taxpayer is not treated as having received full payment in the year in which the taxpayer received the installment obligation. Instead, the taxpayer is treated as receiving payments when the taxpayer receives (or constructively receives) payments under the installment obligation.
However, to the extent that the taxpayer receives a note or other evidence of indebtedness in the year of sale from a person other than “the person acquiring the property,” such note or other evidence of indebtedness is the receipt of a payment for purposes of IRC Sec. 453. Likewise, the taxpayer’s receipt of a note or other evidence of indebtedness that is secured directly or indirectly by cash or a cash equivalent is treated as the receipt of payment for purposes of IRC Sec. 453.
Under IRC Sec. 453A(d), if any indebtedness is secured by an installment obligation to which IRC Sec. 453A applies, the net proceeds of the secured indebtedness are treated as a payment received on the installment obligation as of the later of the time the indebtedness becomes secured by the installment obligation or the time the taxpayer receives the proceeds of the indebtedness (the “pledge rule”).
[iv] REG-109348-22; RIN 1545-BQ69. (88 FR 51756, (Aug. 4, 2023).
[v] Prop. Reg. Sec. 1.6011-13(a) would provide that a transaction that is the same as, or substantially similar to, a monetized installment sale transaction described in Prop. Reg. Sec. 1.6011-13(b) is a listed transaction for purposes of Reg. Sec. 1.6011-4(b)(2) and IRC Sec. 6111 and 6112. “Substantially similar” is defined in Reg. Sec. 1.6011-4(c)(4) to include any transaction that is expected to obtain the same or similar types of tax consequences and that is either factually similar or based on the same or a similar tax strategy.
[vi] Material advisors who make a tax statement with respect to monetized installment sale transactions described in Prop. Reg. Sec. 1.6011-13(b) would have disclosure and list maintenance obligations under IRC Sec. 6111 and 6112. See Reg. Sec. 301.6111-3 and 301.6112-1.
[vii] Whether a taxpayer has participated in the listed transaction described in Prop. Reg. Sec. 1.6011-13(b) would be determined under Reg. Sec. 1.6011-4(c)(3)(i)(A). Participants would include the seller, the intermediary, the purported lender, and any other person whose Federal income tax return reflects tax consequences or the tax strategy described in Prop. Reg. Sec. 1.6011-13(b), or a substantially similar transaction.
Under the proposed regulations, the buyer of the property that provides the buyer cash or other consideration would not be treated as a participant in the listed transaction described in Prop. Reg. Sec. 1.6011-13(b) under Sec. 1.6011-4(c)(3)(i)(A).
[viii] Participants required to disclose listed transactions under Reg. Sec. 1.6011-4 who fail to do so are subject to penalties under IRC Sec. 6707A. They are also subject to an extended period of limitations for assessment of additional tax under IRC Serc. 6501(c)(10). Material advisors required to disclose listed transactions and to maintain lists of investors but who fail to do so are also subject to penalties.
[ix] S. Crow Collateral Corp. v. U.S., Case No. 1:24-cv-00346-AKB (U.S.D.C. Idaho).
In its opinion, the Court refers to Plaintiff as one who facilitates transactions between sellers and buyers by purchasing capital assets from sellers through installment obligations that mature in later tax years, then immediately reselling the properties to buyers for cash.
[x] See also, https://www.forbes.com/sites/peterjreilly/2021/05/22/monetized-installment-saleirs-finally-says-it-does-not-work/ ; https://www.jdsupra.com/legalnews/cash-in-hand-tax-deferral-monetized-9004410/ ; https://www.taxslaw.com/2022/05/selling-your-business-take-the-money-but-defer-the-tax/ .
[xi] Nonetheless, according to Plaintiff, the IRS does “not like these transactions” and has waged “a years-long public relations campaign” designed to discourage taxpayer participation with businesses like Plaintiff’s as “promoters” of “tax scams”. This campaign, Plaintiff alleged, has taken multiple forms: publishing annual press releases since 2021 that list MIS transactions among the “Dirty Dozen” tax scams; representing to the Tax Court that Plaintiff promotes abusive tax avoidance transactions; and pursuing an ongoing “promoter investigation” against Plaintiff.
Plaintiff contended these actions shared a “clear purpose” – to “chill taxpayer participation” in MIS transactions while tainting the Tax Court’s perception of them.
Plaintiff added that despite these efforts to malign Plaintiff and its business, “[t]he IRS has yet to convince a court that Plaintiffs’ business dealings violate the law.”
[xii] Reg. Sec. 1.6011-4.
[xiii] Reg. Sec. 1.6011-4(e)(2)(i), 301.6111-3(b)(4)(iii), 301.6111-3(e).
[xiv] This campaign, Plaintiff alleged, had already inflicted concrete harm by deterring clients from pursuing legal installment sales, thereby causing immediate damage to Plaintiff’s business. According to Plaintiffs, this lost business “cannot be restored until a court rightfully determines that the IRS’s widely disseminated pronouncements regarding so-called MIS Transactions are not in accordance with the law”.
[xv] Plaintiff asked the Court to “take judicial notice of statements the IRS had made in a brief to the Tax Court that the IRS has “identified monetized installment sales as a ‘listed transaction,’ and that the IRS’s purpose in issuing the Notice was to alert taxpayers and practitioners to the problematic nature of these deals”. The Court acknowledged that courts have routinely held that a court may take judicial notice of (1) the existence of a motion or brief filed by a party in another judicial proceeding; and (2) the fact that a party made a representation in that court filing. The Court took judicial notice of the existence of the brief and the representations made in that brief.
[xvi] The Court then addressed the “ripeness doctrine” which, the Court stated, posed an additional bar to Plaintiff’s claims seeking to set aside the NPRM.
The ripeness doctrine serves to “prevent the courts, through avoidance of premature adjudication, from entangling themselves in abstract disagreements.” In the administrative agency context, the doctrine serves the additional purpose of protecting “agencies from judicial interference until an administrative decision has been formalized and its effects felt in a concrete way by the challenging parties.”
A challenge to agency action is ripe when the government issues a final decision that inflicts concrete, particularized, and actual or imminent injury.
Because the NPRM’s proposed regulations were not yet final, they did not yet inflict any actual or imminent injury. The IRS may modify the proposed regulations substantially based on public comments, may withdraw them entirely, or may finalize them in a form that does not apply to Plaintiff’s transactions. These contingencies rendered any current injury speculative. For these same reasons, Plaintiff’s challenge to the reporting Regulations were also unripe, as their application to Plaintiff depended on the MIS transaction being designated a listed transaction. If the regulations proposed by the NPRM never become final, the reporting Regulations will not apply to Plaintiff, and Plaintiff would not suffer any injury that would give them standing to challenge these regulations.
Prudential ripeness has a “twofold aspect, requiring us to evaluate both the fitness of the issues for judicial decision and the hardship to the parties of withholding court consideration.” An administrative action is fit for judicial review when an agency’s decision is at an “administrative resting place.” As the NPRM’s proposed regulations have not undergone each step of the rulemaking process, they have not yet reached an “administrative resting place.” Further, the hardship to Plaintiffs was minimal because the proposed regulations imposed no current legal obligations. Any business disruption or reputational effects flowed from market responses to proposed regulations, not from any legal compulsion.
Because no legal consequences presently attached to the regulations proposed in the NPRM, it was premature for the Court to consider Plaintiff’s claims. Plaintiff may renew their challenge if and when the IRS’s rulemaking “generates concrete, legal ramifications” for Plaintiff.
[xvii] Other than the Federal income tax deferral provided by the installment method, the sole economic effect of entering the monetized installment sale transaction from the perspective of the seller is to pay fees to the intermediary and the purported lender in an amount that is substantially less than the Federal tax savings purportedly achieved from using the installment sale rules to defer the realized gain on the sale. In other words, the seller’s only purpose for entering into an agreement with the intermediary is to defer recognition of the gain on the sale of the property to the buyer.
[xviii] Under IRC Sec. 453A.
[xix] The step transaction doctrine and conduit theory may also apply to recharacterize MIS transactions.