Monetized Installment Sale Transactions (a.k.a. Deferred Sales Trusts)

When business or real estate owners sell assets, the Internal Revenue Service generally wants the seller to pay taxes on the sale proceeds during the year of the sale. Congress provided one route to escape paying a huge tax bill in a single tax year, the installment sale.

An installment sale can involve as few as two parties [the seller and buyer] or as many as five [seller, buyer, dealer, lender, and escrow agent]. In a simple example, the sale involves a business or property owner selling an asset directly to the buyer and receiving payments from the buyer over a period of time. As a general rule, the seller reports the interest and accompanying gain from the sale as received. This type of arrangement defers the recognition of gain until the seller receives an actual payment of income.

One of the primary risks with this type of sales arrangement is that the seller’s assumed role as a lender. As a result, the tradeoff for deferring gain through an installment sale is the seller’s risk of the buyer defaulting on the terms of the purchase agreement.

In an attempt to solve this problem, a new business model developed – the deferred sales trust, also known as a monetized installment sale transaction. At its simplest, the transaction works as follows: 1) seller sells the business/asset to an intermediary trust in exchange for an installment note; 2) the trust re-sells the business to an unrelated third party; 3) the seller borrows from a third party lender the value of the installment note; and 4) the trust pays the seller per the terms of the installment note which in turn is used to satisfy the loan between the seller and the third party lender.

While numerous permutations exist, depending upon the needs of the seller and the specific model developed by the facilitator (referred to by the I.R.S. as the promoter), the IRS believes that the transaction is abusive. In summary, the IRS opposes the transaction because the seller through the mechanism of borrowing against the installment note has access to almost all of the sales proceeds but has deferred the accompanying recognition of gain.

The Internal Revenue Service identified this general type of transaction in the 2021 Dirty Dozen list (IR-2021-144, July 1, 2021). In the Internal Revenue Service’s view, “… Promoters find taxpayer seeking to defer the recognition of gain upon the sale of appreciated property and organize an abusive shelter through selling them monetized installment sales. These transactions occur when an intermediary purchases appreciated property from a seller in exchange for an installment note, which typically provides for payments of interest only, with principal being paid at the end of the term. In these arrangements, the seller gets the lion’s share of the proceeds but improperly delays the gain recognition on the appreciated property until the final payment on the installment note, often slated for many years later.”

Fortunately for taxpayers, the I.R.S. tipped their hand in a Chief Counsel Advisory (CCA2019103109421213), where the I.R.S.’s attorney provided legal analysis to the I.R.S. agent regarding the auditing of a monetized installment sale. Specifically, the I.R.S. attorney identified six areas of purported weaknesses in the transaction: 1) no genuine indebtedness due to lack of recourse or collateral from the lender; 2) debt secured by escrow is the security for the loan made by the seller; 3) debt secured by the right to payment from escrow under the dealer note; 4) the intermediary trust is not a true buyer as required by I.R.C. 453(f); 5) cash escrow is used as security for the installment note; and 6) the I.R.S. attorney attempted to pre-emptively distinguish NSAR 20123401F due to the imposition of an intermediary into the transaction.

The I.R.S. has already started auditing monetized installment sale transactions and we believe the I.R.S. will audit a significant number of these transactions established by various facilitators of the transaction. We expect the I.R.S. to attempt to apply the step transaction or substance over form doctrines when attacking these transactions. We further expect the I.R.S. to take an aggressive approach to penalties and attempt to assert a 40% non-economic substance penalty to certain permutations of the transaction pursuant to I.R.C. 6662(i).

If you are being audited by the I.R.S. for a deferred sales trust or similar transaction, the selection of a qualified representative is critical. In addition to defending the deferred sales transaction itself, care must be taken to minimize the chances of a full-blown audit and preparing the appropriate defenses to any possible I.R.S. imposed penalties. At Kaczmarek and Jojola, our former I.R.S. senior trial attorneys have extensive experience representing clients throughout the United States in transactions classified as tax shelters by the I.R.S. Please call us at 602-899-6200 or email derek@kjtaxlaw.com to discuss options for representation and defense during an I.R.S. audit, appeal, or litigation.

1 Technically, additional options exist, such as I.R.C. 1031, also known as a like-kind exchange, which permits a taxpayer to defer gain on the sale of real estate so long as the taxpayer uses a qualified intermediary and purchases a qualifying replacement property within 180 days, among other requirements.