Monetized Installment Sales – Proposed Regulations will Lead to Burdensome Reporting Requirements and Increased Scrutiny

Monetized Installment Sales, as previously written upon by Gray Edmondson,[1] have been subject to increased scrutiny by the IRS in recent years, making its “Dirty Dozen” list in each of the last three years.[2] The IRS remains on the offensive in scrutinizing such transactions, issuing proposed regulation under Internal Revenue Code Section 6011 in August of this year (“Proposed Regulations”).[3] The Proposed Regulations identify monetized installment sale transactions as listed transactions, which will subject participants in such transactions to increased reporting requirements in accordance with Section 6011. Furthermore, the Proposed Regulations would require material advisors with respect to monetized sale transactions to disclose such transactions and maintain lists in accordance with Sections 6111 and 6112, respectively.

Gain Recognition under the Installment Method[4]

Generally, gain from the sale of property must be recognized in the year of sale.[5] Section 453 provides an exception to this general rule, providing that income from an installment sale is accounted for under the installment method.[6] An installment sale is a sale where at least one payment is to be received after the close of the taxable year in which the disposition occurs.[7] Under the installment method, a taxpayer in an installment sale recognizes income from the sale as payments are actually or constructively received, such gain recognition being equal to payments received in that tax year multiplied by the proportion the gross profit of the installment sale bears to the total contract price.[8]

An Overview of Monetized Installment Sales

Monetized installment sales purport to convert a cash sale of appreciated property by a seller to a buyer into an installment sale from the seller to an intermediary. Typically, the intermediary purchases the property from the seller on an installment note, then subsequently sells the property to the buyer for cash, which the intermediary then places in escrow. The seller then obtains a nonrecourse loan, secured by the escrowed funds, from a third-party lender. The terms of the loan from the third-party lender usually mirror those of the installment note issued by the intermediary to the seller, typically interest only payments with a balloon payment of principal upon maturity. Seller will make payments to the third-party lender when Seller receives the identical (or almost identical) payment from the intermediary. Ultimately, the seller obtains approximately the total purchase price of the property in the year of sale while simultaneously deferring full recognition of gain under the installment method on the installment note issued by the intermediary.

IRS Scrutiny

If you believe the foregoing to be too good to be true (or in this case, in accordance with the Code and Treasury Regulations), the IRS would agree. Monetized installment sale transactions have been on the IRS’s radar as a potentially abusive transaction for years. In 2019, the IRS Office of Chief Counsel advised IRS attorneys of potential issues that could be used to scrutinize monetized sale transactions,[9] contending:

1. No genuine indebtedness exists in relation to the transaction, as a genuine nonrecourse loan must be secured by collateral, and a borrower who is not personally liable and has not pledged collateral would have no reason to repay a purported loan[10], and as such, the loan proceeds would be income;
2. The cash escrow is security for the loan to the seller, and if so, the seller economically benefits from the cash escrow and should be treated as receiving payment under the “economic benefit” doctrine for purposes of Section 453[11];
3. Alternatively, the loan from the third-party lender to seller is secured by the right to payment from the escrow under the installment note from the intermediary, and thus results in deemed payment under the pledging rule, under which loan proceeds are treated as payment of the dealer note[12];
4. The intermediary is not the true buyer of the property sold by seller, and Section 453(f) provides that only debt instruments from an “acquirer” can be excluded from the definition of payment, therefore not constituting payment for purposes of Section 453, and debt instruments issued by a party not an “acquirer” would be considered payment, requiring recognition of gain[13]; and
5. To the extent the installment note from the intermediary to the seller is secured by a cash escrow, seller is treated as receiving payment irrespective of the pledging rule[14].

In its 2023 “Dirty Dozen” list, the IRS described monetized installments sales as follows: “In these potentially abusive transactions, promoters find taxpayers seeking to defer the recognition of gain upon the sale of appreciated property. They facilitate a purported monetized installment sale for the taxpayer in exchange for a fee. These installment sales occur when an intermediary purchases appreciated property from a seller in exchange for an installment note. The notes typically provide for payments of interest only, with principal being paid at the end of term. In these arrangements, the seller gets the lion’s share of the proceeds, but improperly delays the recognition of gain on the appreciated property until the final payment on the installment note, often years later.”

The Proposed Regulations

Proposed Regulation § 1.6011-13(a) provides that a transaction that is the same as, or substantially similar to, a monetized installment sale transaction described in Proposed Regulation § 1.6011-13(b) is a listed transaction for the purposes of § 1.6011-(4)(b)(2) and Sections 6111 and 6112. Proposed Regulation § 1.6011-13(b) describes a monetized installment sale transaction as a transaction which 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 gain property for cash or other property (buyer cash);
2. The seller enters into an agreement to sell the gain property to a person other than the buyer (intermediary) in exchange for an installment obligation;
3. The seller purportedly transfers the gain property to the intermediary, although the intermediary either never takes title to the gain property or takes title only briefly before transferring it to the buyer;
4. The intermediary purportedly transfers the gain property to the buyer in a sale of the gain property in exchange for 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 the beneficiary. The lender agrees to repay these amounts to the intermediary over the course of the term of the installment obligation; and
7. On the seller’s Federal income tax return for the year of the purported installment sale, the seller treats the purported installment sale as an installment sale under Section 453.”

By designating monetized installment sale transactions, as well as transactions substantially similar to such[15], as listed transactions, the Proposed Regulations, if finalized, will require taxpayers who have participated in monetized installment sale transaction, and importantly, transactions substantially similar to monetized installment sale transactions, as well as those taxpayers who enter into such transactions after the Proposed Regulations are finalized, to disclose such transactions to the IRS, past or future, unless the statute of limitations for all tax years in which the transactions were entered has lapsed, as further stipulated below.

Proposed Regulations § 1.6011-4(d) and (e) provide that the disclosure statement Form 8886, Reportable Transaction Disclosure Statement, must be attached to the taxpayer’s Federal tax return for each taxable year for which a taxpayer participates in a reportable transaction, and a copy of the same must be sent to the Office of Tax Shelter Analysis (“OTSA”) at the same time such Form is filed with the tax return. Additionally, Taxpayers who have participated in monetized installment sale, or substantially similar, transactions and filed their respective Federal tax returns in years preceding the finalization of the Proposed Regulations, but for whom the statute of limitations has not yet lapsed for assessment for such respective tax year(s), must file Form 8886 with OTSA disclosing such transaction within ninety (90) calendar days from the date the Proposed Regulations are finalized.[16]

Fines and Penalties for Failure to Comply with Proposed Regulations

Taxpayers who fail to disclose such transactions under § 1.6011-4 are subject to penalties under Section 6707A. Section 6706A(b) provides that the amount of the penalty is seventy-five percent (75%) of the decrease in tax shown on the return as a result of the reportable transaction, or which would have resulted from such transaction if such transaction were respected for Federal tax purposes, subject to a minimum penalty amount of $5,000 in the case of a natural person and $10,000 in any other case and a maximum penalty amount of $100,000 in the case of a natural person and $200,000 in any other case.

As if the fines and penalties above are not enough, additional penalties may also apply. Section 6662A imposes a 20 percent (20%) accuracy-related penalty on any understatement[17] attributable to an adequately disclosed reportable transaction. Further, if the taxpayer is required, but does not adequately disclose participation in a reportable transaction in accordance with the regulations under Section 6011, the imposed penalty increases to thirty percent (30%) of any understatement.

Extended Statute of Limitations

Taxpayers who are required, but fail, to disclose participation in a listed transaction are subject to an extended statute of limitations.[18] The time of assessment of any tax with respect to the transaction will not expire before the date that is one year after the earlier of the date the taxpayer discloses the transaction or the date a material advisor discloses the participation pursuant to a written request under Section 6112(b)(1)(A). In essence, for transactions entered into prior to finalization of the Proposed Regulations for which the state of limitations has not yet lapsed, such statute of limitations will be tolled until the taxpayer, or such taxpayer’s material advisor, adequately discloses the transactions pursuant to the foregoing.

Reporting Requirements for Material Advisors

Material advisors with respect to monetized installment sale, or substantially similar, transactions are also subject to reporting requirements. A material advisor is any person who provides any material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out any reportable transaction, and directly or indirectly derives gross income in excess of the threshold amount as defined in § 301.6111-3(b)(3) for the material aid, assistance, or advice.[19] Material advisors must disclose transactions on Form 8918, Material Advisor Disclosure Statement,[20] and such disclosure statement for a reportable transaction must be filed with OTSA by the last day of the month that follows the end of the calendar year in which the advisor becomes a material advisor with respect to a reportable transaction or in which the circumstances necessitating an amended disclosure statement occur.[21] A material advisor who fails to file a timely disclosure, or files an incomplete or false disclosure statement, is subject to a penalty.[22] For listed transactions, the penalty is the greater of $200,000 or fifty percent (50%) of the gross income derived by the material advisor with respect to aid, assistance, or advice which is provided with respect to the listed transaction before the date the return is filed.[23]

Furthermore, a material advisor with respect to any reportable transaction must maintain a list identifying each person to whom the advisor was a material advisor with respect to such transaction and containing such other information as the Secretary may by regulations require.[24] A material advisor may be subject to a penalty[25] for failing to maintain a list under Section 6112(a) and failing to make the list available upon written request to the Secretary in accordance with Section 6112(b) within twenty (20) business days after the date of such request. The penalty, under Section 6708(a), for failing to provide such list is $10,000 per day for each day of the failure to provide such list after the twentieth (20^th) day. Here, material advisors are given some reprieve, as no penalty will be imposed with respect to the failure on any day if such failure is due to reasonable cause.

Conclusion

On their face, monetized installment sales appear to be a crafty maneuver to defer recognition of gain on the sale of property. They have, however, been on the IRS’s radar as ripe for potential abuse for the last several years, evidenced by the Chief Counsel Memorandum mentioned herein. The issuance of the Proposed Regulations further display the IRS’s attitude towards such transactions. As is the case with other listed transactions, if the Proposed Regulations are finalized, taxpayers participating in monetized installment sales will be required to report such transactions, in essence notifying the IRS of participation in a transaction that will likely be subject to audit. As the IRS continues its offensive attack of potentially abusive transactions, taxpayers may need to reassess their risk tolerance of transactions promoted to mitigate taxes but may likely be subject to scrutiny by the IRS.

[1] https://esapllc.com/monetized-installment-sale-2021/

[2] See Devin Mills’s article on the IRS’s 2023 Dirty Dozen List: https://esapllc.com/irs-dirty-dozen-2023/

[3] The Proposed Regulations can be found at the following link: https://www.federalregister.gov/documents/2023/08/04/2023-16650/identification-of-monetized-installment-sale-transactions-as-listed-transactions

[4] For more on the installment method under Section 453, see Charles J. Allens’ previous articles: https://esapllc.com/installment-sale-basics-2021/; https://esapllc.com/453a-interest-on-large-installments-2021/; https://www.esapllc.com/disposition-of-installment-obligations-where-income-reported-under-installment-method/

[5] Section 1001(c).

[6] Section 453(a).

[7] Section 453(b)(1).

[8] Section 453(c).

[9] As seen in CCA 2019103109421213, released May 7, 2021.

[10] See Estate of Franklin v. CIR, 544, F.2d 1045 (9th Cir. 1976).

[11] Reed v. CIR, 723 F.2d 138 (1st Cir. 1983).

[12] Section 453A(d).

[13] See Rev. Rul 77-414, 1977-2 C.B. 299; Rev. Rul. 73-157, 1973-1 C.B. 213; and Wrenn v. CIR, 67 T.C. 576 (1976).

[14] Treas. Reg. § 15a.453-1(b)(3).

[15] The Proposed Regulations specifically state that to be substantially similar, the installment sale does not necessarily need to include all of the seven elements provided above. Many commentators have concerns that the Proposed Regulations, particularly with the inclusion of “substantially similar” transactions, are overbroad, resulting in taxpayers participating in legitimate installment sales (and their material advisors) being subject to the reporting requirements and penalties provided herein.

[16] § 1.6011-4(e)(2)(i).

[17] As defined in Section 6662A(b)(1).

[18] Section 6501(c)(10).

[19] § 301.6111-3(b)(1).

[20] § 301-6111-3(d) and (e).

[21] § 301-6111-3(e).

[22] Section 6707(a).

[23] Section 6707(b)(2).

[24] Section 6112(a); §301-6112-1(e).

[25] Section 6708.