Installment Sales Treatment Generally Unavailable for Related Party Sales

Part 2 – Denial of Installment Sales Treatment

The benefit of installment method reporting is not available if the transaction involves the sale of depreciable property to a related party (see § 453(g)). If this rule applies, the entire taxable gain must be recognized by the selling taxpayer in the year of the sale. For the rule to apply, the property must be depreciable in the hands of the transferee (the buyer) (§ 453(f)(7)).  It does not matter whether the property was being depreciation by the seller. Amortization of an intangible is treated as depreciation. 

Related parties include those specified in §1239(b) (discussed in Part 1) including:  

1. The seller and any corporation in which the seller owns, directly or indirectly, more than 50% of the value of the outstanding stock;
2. The seller and any partnership in which the seller owns, directly or indirectly, a more than 50% interest in the capital or profits;
3. Two or more partnerships, if the same persons own, directly or indirectly, more than 50% of the interests in the capital or profits in each partnership;
4. Two corporations that are members of the same controlled group;
5. A corporation and a partnership if the same persons own more than 50% in value of the outstanding shares of the corporation and more than 50% of the interests in capital or profits in the partnership;
6. Two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation;
7. An S corporation and a C corporation if the same persons own more than 50% in value of the outstanding stock of each corporation;
8. The seller and any trust in which the seller or seller's spouse is a beneficiary, unless the interest in the trust is a remote contingent interest (defined below); and
9. An executor of an estate and the beneficiary of such estate, except in the case of a sale or exchange in satisfaction of a pecuniary bequest.

Spouses are not listed as persons subject to ordinary income treatment under the related party rules. With respect to property transfers incident to divorce or separation, the Code provides for nonrecognition treatment. 

Sales of depreciable property at a gain between relatives are NOT covered by the statute although a sale by an individual to an ENTITY controlled by certain family members may trigger ordinary income treatment of any gain. While two individuals are not considered “related parties” (even if they are family members) for purposes of the ordinary income rule, two individuals may be related persons for purposes of the so-called second disposition rule discussed in Part 3. As a result, installment sales treatment may not be available for sales between family members (although the gain on such sales will not be recharacterized as ordinary income). 

Example:  Father owns 51% of a C corporation that is a manufacturer. Father forms a new 100% owned S corporation to operate a new business venture and purchases equipment from the C corporation. The equipment is purchased for $500,000 with the payments spread over five years with adequate interest. The original cost of the equipment was $400,000 and $300,000 of depreciation had been taken on the equipment.

$400,000 of total gain is generated as a result of the sale (i.e., $500,000 contract price less $100,000 remaining basis). Of this gain, $300,000 must be recaptured in the year of the sale as ordinary income under the §1245 recapture rules. The remaining $100,000 would qualify for installment reporting if the sale were not made to a related party. However, because the C and the S corporation are more than 50% owned by the same person and the equipment is depreciable in the hands of the S corporation, the remaining $100,000 gain must be recognized in the year of the sale (and such gain will be taxed as ordinary income). 

An exception to the immediate recognition rule applies if the sale did not have as one of its principal purposes the avoidance of income tax. The taxpayer has the burden of proving the lack of a principal tax avoidance purpose. There is very little guidance as to when this exception may apply. The legislative history indicates that the exception applies if no significant tax deferral benefits will be derived from the sale.  We have never seen this exception used to otherwise permit the use of the installment sales method. 

If an installment sale between related parties involves both depreciable and nondepreciable property, the seller should allocate the sales proceeds between the two types of property. Any gain attributable to the depreciable property must be recognized in the year of sale, but gain attributable to the nondepreciable property may be deferred if the installment sales rules otherwise apply. See PLR 9001013.

In Part 3, we’ll address yet another prohibition on the use of the installment sales method; the second disposition rule.