The installment method under Internal Revenue Code (IRC) § 453 offers taxpayers a way to defer the recognition of gains from certain property sales when payments extend beyond the year of purchase. However, large installment sales over $150,000 can trigger an interest charge under § 453A if the taxpayer’s installment obligations exceed $5 million at year-end.
Installment Sales Under Internal Revenue Code § 453
The installment method of accounting allows a taxpayer to defer the recognition of gain on a sale of qualifying property (not including sales of inventory) if at least one payment is received in a taxable year after the year of sale pursuant to Internal Revenue Code § 453 (all references to “§” or “Section” refer to the Internal Revenue Code). The installment method generally allows a taxpayer to defer payment of taxes on the entire amount of the sale when proceeds will not be received in the same tax year. The installment method is not available with respect to any “dealer dispositions” including any disposition in personal property by a taxpayer who regularly sells or otherwise disposes of personal property of the same type on the installment plan, and any disposition of real property which is held by the taxpayer for sale to customers in the ordinary course of the taxpayer’s trade or business under § 453(l). In the mergers and acquisitions context, the installment method may be applicable to earn out payments that are considered a “contingent payment sale.”
Interest Charge on Large Installment Sales Under § 453A
To the extent a seller structures a sale, such that payment may be received in a tax year after the tax year in which the sale occurs, consideration should be given to the interest charge on large installment obligations under § 453A. Generally, taxpayers may opt out of the installment method and instead recognize the taxable gain on a transaction in the year of sale to avoid any potential interest charge under § 453A.
Generally, § 453A imposes an interest charge on any sale of property for a sales price over $150,000 that is reported under the installment method if the total amount of all installment sale obligations that arose during the tax year and were outstanding at the end of the tax year for a respective taxpayer exceed $5 million. The interest charge is assessed in exchange for the taxpayer’s right to pay the tax on the installment sale income over time. The interest charge is assessed each year the installment note is outstanding as of the end of the year, and the outstanding balance exceeds the $5 million threshold amount.
The interest charge is calculated on the applicable percentage of the deferred tax liability at the end of each year. The interest charge is based on the § 6621(a)(2) IRS underpayment rate in effect in the last month of the taxpayer’s tax year. The applicable percentage is calculated by dividing the aggregate face amount of all installment sale obligations outstanding at the end of the year over $5 million by the aggregate amount of the installment sale obligations outstanding at the end of the tax year.
The deferred tax liability is calculated on the installment note obligation over $5 million outstanding at the end of the tax year. Deferred tax liability is defined as the amount of unrecognized gain on the installment note obligation as of the close of the tax year multiplied by the maximum tax rate in effect for the taxpayer. The maximum tax rate depends on the type of income subject to tax (i.e., ordinary income or capital gain treatment). The IRS and the Department of Treasury provide limited guidance regarding “contingent payment sales”. Most practitioners agree that a “lookback” method should be applied to determine the applicable interest charge under § 453A in a given tax year once the amount becomes determinable.
Exceptions to the § 453A Interest Charge
Notably, § 453A does not apply to the sale of personal use property as defined by §1275(b)(3) or any property used or produced in the trade or business of farming as defined by §§ 2032A(e)(4), and (5). Section 1275(b)(3) defines personal use property as any property substantially all of the use of which by the taxpayer is not in connection with a trade or business of the taxpayer or an activity described in § 212 (income-producing activity). Section 2032A(e)(4) and (5) cover activities that one might consider to be farming-related, including the raising of livestock, crops, fruits, fur-bearing animals, and any agricultural or horticultural commodity. In addition to the exception for personal use and farm property, § 453A does not apply to the sale of residential lots or timeshares sold by a dealer (i.e., a taxpayer who holds such property for sale to customers in the ordinary course of the taxpayer’s trade or business). Instead, the reporting of a sale of such property by a dealer is subject to interest under § 453(l)(3).
JAH Can Help
The applicable interest charge provided by § 453A can be substantial depending on the specific facts of an installment sale transaction. This rule should be considered in any large transactions involving an installment sale. The experienced corporate tax attorneys at Johnston Allison Hord can help you navigate the complexities of the interest charge on large installment sale obligations and can be reached through our General Contact Form.
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