Imputed interest on installment sales

Okay.... I posted this question before, but need some urgent help!
I sold my business and some of the proceeds were put into an escrow account to be available to the purchaser for legal fees in a pending lawsuit against
the business; ie, the lawsuit is my problem, not theirs. The funds are held by an investment manager and invested in equities. I pay income tax on the income and get it at the end, if there is any money left in the escrow account at the end.
My lawyer and accountant both say there is imputed interest on the escrow account because there is ALWAYS imputed interest on an escrow account when no actual interest is paid by the buyer to the seller.
When I posted before several people here told me that I was getting a fair market return on my money, and that was equivalent to, so there was no imputed interest. The buyer wasn't getting anything on the money, so why would he pay interest?
My lawyer and accountant say that makes good sense, but good sense doesn't matter. There is ALWAYS imputed interest on an escrow account regardless of whether is it sensible or not; they have never heard of an exception.
So, has anyone heard of an exception? My return is due next Thursday, and I have to go one way or another. Thanks.
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Except for a couple of things. First, the money is yours. It's not a loan. If you put your own money in an escrow account for yourself, there is no imputed interest. There is no tax effect of paying money to yourself.
Second, there is actual interest that you are paying tax on. So no additional interest is necessary.

Exactly.
There may be some facts we're not aware of. But based on the story you've told, your lawyer and accountant are just wrong.
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wrote:

But can you cite a code or a case where an escrow account didn't pay either imputed interest or actual interest? They acknowledge this should be an exception, but can't see the IRS treating it as such since there are NO exceptions.
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The escrow account is his money. So the investment income and the actual interest are his income. Unless he is on an accrual basis, imputed interest is straw man. So, as usual, I agree with Stu.

The geneal rule is "cash basis taxpayers do not pay imputed anything". The major exception to my limited knowledge is Zero Coupon Bonds. Are you a cash basis taxpayer? That's a very important question because the rules are different for accrual basis taxpayers.
Dick
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On Wed, 7 Oct 2009 17:06:17 EDT, snipped-for-privacy@panix.com (Dick Adams) wrote:
snip

Cash basis taxpayers are on the accrual basis, sometimes, when it comes to interest. If interest is not paid at least annually it will be accrued. That is why you pay tax annually on a CD with over a year term.
With imputed interest there may or may not be any actual interest paid. What is imputed may be part of what non-tax law considers to be principal. For example, I sell a lot to Mr. Doe for $100,000. $50,000 to be paid at closing (10/07/2009) and $50,000 to be paid on 12/31/2011. No interest is charged in the contract. IRS considers the $50,000 scheduled to be paid 12/31/2011 to be part interest and part principal at the October 2009 Applicable Federal Rate for short-term loans. I would then accrue part of that interest ratably over the life of the loan and pay tax on it when it accrues.
In this case, if the amount in escrow is restricted in such a way as to make it an installment payment taxable when received, then I could see where imputed interest might be required. With rates as low as they were for most of 2008, I have to wonder how much interest we are really talking about.
But if Kevin has enough control of the escrow that the actual (i.e. not the imputed) interest income it earns is taxable to him in the year the interest is earned, then it would seem that the amount in escrow does not qualify as an installment payment taxable in a later year. Perhaps he does not have an installment sale after all.
There are some expections to imputed interest - short time and diminimis amount.
I think that without the contract and other details, we really cannot advise him. If he does not believe his current accountant and current lawyer, then he needs to consult another local professional who can have access to all the documents and facts. If it is so much money that the amount of imputed interest is bothering him this much, he certainly should be able to afford to pay another professional to look at it.
Drew Edmundson, CPA Cary, NC
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It is a substantial amount of money, and will stretch out over 4 or 5 years. So it adds up.

I have no control over the money, except to dispute payments that aren't really related to the lawsuit. That has happened a few times. Otherwise it is just a matter of hanging on until the matter is resolved and getting what is left.

There are no other details. They point to Publication 537 "If an installment sale does not provide for adequate stated interest, part of the stated principal amount of the contract may be recharacterized as interest." My agreement does not provide for any stated interest. They say they have never seen an installment sale in which this principle was not followed, regardless of circumstances. They doubt either the IRS or a court would make me the first exception.
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Since you do not believe the professionals you have hired, consult another. I still feel uncomfortable giving a good answer without seeing the documents. Something that may seem of no importance to you could make the entire transaction taxable now and not an installment sale.
For my purposes I will assume the following:
Sale for $xxxx but $xx is put in an escrow. The balance is paid to you immediately and the escrow qualfies for installment treatment.
In this case, the escrow account is the buyer's and he/she should pay the interest on what it earns. An aside, this is where your facts don't jive. If the interest earned by the escrow account is taxable to you, then it seems you do not have an installment sale.
You would have imputed interest income (although that is not quite the right name as far as I am concerned. What you do is enter the payment amounts, payment dates, and applicable federal rate into your favorite present value software (Excel works great) and calculate the actual principal amount of the deferred payment. So lets say the sale was in September 2009. Payment of $5,000 per year are due for 5 years on the anniverssary of the sale. The AFR for mid-term loans from September 2009 with an annual payment requirement is 2.87%.
Excel gives us a principal value today of is $22,983.78. The balance of the payments $25,000.00-$22,983.78=$2,061.22 is interest income. Formula is (PV,0.0287,5,5000). Run an amortization schedule to get the interest per year.
Drew Edmundson, CPA Cary, NC
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wrote:

I agree with Stuart. I think you should be asking YOUR experts to show you the law supporting their position. I think the law they will find will say if you make a loan to another, and you are paid less than FMV interest, there will be imputed interest. That is a far cry from what is occurring in this case. In this case, there is no loan, and thus no interest flowing to the other party to test whether it is FMV interest.
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On Wed, 7 Oct 2009 17:21:27 EDT, "Wallace"

According to the OP, there is a loan - the deferred installment payments due in future years is considered a loan.
Drew Edmundson, CPA Cary, NC
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A loan from whom? It was paid to him as the purchase price, and he recognizes the taxable income from it. It's held in escrow because of a dispute, but it's still his.
As far as installment treatment, based on information supplied recently I'm not sure that it's proper. But even if it is, I'm not convinced that it's not all his from a legal standpoint, and that no imputed interest is necessary.
At this point my question is, how much interest is the fund actually earning? Even if there were imputed interest, it would only be the difference between what is actually earned and the Applicable Federal Rate.
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On Fri, 9 Oct 2009 12:39:10 EDT, "Stuart A. Bronstein"

He appears to think it is a purchase money loan. If his interpretation is correct, then he has loaned money to the buyer to finance part of the purchase price. For example, I sell a lot to you for $50,000. You give me $10,000 down and promise to pay me $1,000 a month for 40 months. I have effectively loaned you the balance of the purchase price as far as IRS is concerned. Thus I need to consider part of each $1,000 payment as interest and part as principal. Using the AFR and Excel I can calculate the adjusted selling price and use that, the AFR, the payment, and the term to calculate an amortization schedule.

Based on other things he has said, I agree with you that he does not have an installment sale.

This is part of the problem. If he has enough control of the escrow that the interest it earns is taxable to him, then I think he has enough control that the sale is complete and there is no installment due in a later year.
Drew Edmundson, CPA Cary, NC
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Then they're lazy or don't think they'll get you to agree to pay enough money for them to do proper research. Send me $7500 and I'll give you the most authoritative answer you could get.
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wrote:

Would private letter rulings be more authoritative? The cost is
$275 - director ruling $625 - if income under 250k $2500 - if income under 1M $10000 - otherwise
http://www.irs.gov/pub/irs-irbs/irb07-01.pdf page 70 using PDF page numbers
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A letter ruling is good in theory. But in addition to the IRS fee, you'll also incur lawyers' or accountant's fees. And I'd suggest a tax lawyer who knows what he's doing.
Then you risk the IRS not agreeing - there are some real idiots there, though there are a lot of really good people, too.
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kevin wrote:

There is nothing to impute when you are the owner of the funds. You sold your business. You report the sale and any gain based on the total amount received (not an installment sale). You set up an escrow account as a contingency against future legal expenses that you are on the hook for. The escrow account may or may not throw off income. If it has income, you declare it. If it has no income, you declare no income. If you incur legal expenses paid out of the escrow account, you take a business deduction for those expenses.
So, I say to you and your advisors, give me a citation that says you have to impute interest on your own money!
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I failed to ask "How much money are we discussing?"
Dick
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snipped-for-privacy@panix.com (Dick Adams) wrote:

If he's willing to pay my exhorbitant rates to dig up some authority, I don't really care. ;-)
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I wasn't calling you a price gouging ambulance chaser. If you recall, I promised not to do that again. ;)
It would make a lot of sense to know the bottom line before spenging time discussing this further.
To repeat myself (which I like to do), I still do not see why he would report imputed interest unless he is an accrual basis taxpayer.
Dick
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snipped-for-privacy@panix.com (Dick Adams) wrote:

Oh, but I wish I could get away with being a price gouging ambulance chaser.

I agree.

As I like to say, double your pleasure! ;-)

As I recall, the IRS imputes interest even on cash basis taxpayers when the actual interest rate is less than the minimums they come up with each month as the Applicable Federal Rate.
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Ok, I feel sorry for you. Here's a bit. In FRAZEE v. COMMISSIONER OF INTERNAL REVENUE, 98 T.C. 554, 586 (1992) the Tax Court said,
"The rationale behind sections 483 and 1274 is to prevent the use of below-market loans to avoid Federal income taxes in seller- financed transactions."
In your case there are no loans, no current debts. If there is any imputed interest to be paid, it will be the other party who will get paid by you later. Because of the delay in his getting paid, part of what you pay him may be imputed interest, for which you should get a deduction.
Then the Tax Court determined that there was no imputed interest in MARSH v. COMMISSIONER OF INTERNAL REVENUE, 73 T.C. 317, 328 (1979), saying,
"Here there is no gain resulting from an exchange of property, payment of indebtedness, relief from liability, or other profit realized from the completion of a transaction, to paraphrase from Helvering v. Bruun, 309 U.S. 461 (1940)."
And see Rev. Rul. 70-120, 1970-1 C.B. 124 where deferred stock payments held in escrow or in reserve were not charged with imputed interest. This actually seems pretty close to your situation in some ways.
Have your lazy or negligent attorney and accountant show you cases where imputed interest was charged on escrow funds that were not for the purchase or sale of something. Section 483 only calls for imputed interest in the case of a sale or exchange.
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