Installment sale/imputed interest

Interest is imputed when it isn't specifically paid.

If I sell you a business for $2 million, paid in installments of $1 million after 1 and 2 years, then the IRS imputes interest as part of those payments. If you put the $2 million in a bank account, and I receive the interest on it, then I'm getting real actual interest and there's no reason to impute any.

But it _is_ stated: the bank pays it on the escrow account.

Since you, the seller, get cash later, there must be interest included. Since you're getting the cash interest on the escrow account and paying taxes on that, that's your interest, right there.

If the buyer kept the interest paid by the bank, some of the money you receive would be imputed interest.

Seth

Is "the income [from] the escrow account" the same as "the interest paid on the escrow account by the escrow agent"? Is there some kind of income other than interest?

-Mark Bole

There are dividends, municiple box interest, capital gains (well, losses...), and a small amount of interest. Very little actual interest.

Does that make a difference?

In my opinion, yes. What you keep on calling an "escrow" account does not match the conventional meaning. I'm not sure what you have, but it doesn't sound to me like an installment sale, more like a double-or-nothing gamble.

I suspect someone will elaborate or correct me if I'm wrong.

-Mark Bole

The value of the company was uncertain because of the lawsuit, and finding a buyer was difficult. This allows the buyer to pay a set price and essentially leaves the uncertain liability with me. It is really not that different than when the buyer buys all the assets instead of buying the company, because the company has problems the buyer doesn't want.

When the escrow account was set up, I thought the stock market was a better place to park the funds than a bank account; might as well make some money on the funds while they are hanging. In hindsite it was a bad choice, but why couldn't it still be an escrow account?

And when payout from an escrow account is uncertain, it is an installment sale. At least that is the way I understand it. If that is incorrect, I would dearly like to be corrected.

It seems strange that you could do that.

Who loses if the escrow account doesn't have enough funds to pay the lawsuit? If it's the buyer, then you have a perverse incentive: you should gamble the escrow account, because you get to keep the winnings, and the buyer gets to pay the losses.

Seth

No kidding. Sounds like some lawyer or bank manager did not know anything about escrow accounts.

Steve

The buyer loses if the escrow account is drained, as my risk is only the escrow account. However, the escrow amount is at least double the expected costs. Besides the investments were conservative; the account never lost more than 25% of its value at market bottom.

Are you saying this is strange because stock investments are not allowed in escrow accounts, or because the buyer was foolish to allow it?

But back to my question, is imputed interest appropriate in this situation. If not, is there a reference to that effect?

That still says that you gain in expected value from gambling. Suppose the escrow were $2 million, with $1 million expected cost, and $1 million left for you. You gamble it, double or nothing. Half the time, you lose, and have $0. Half the time, you win, and the account has $4 million, leaving $3 million for you. So your expected result is $1.5 million, exceeding the $1 million you expect now.

Just because you didn't gamble doesn't mean you didn't have a perverse incentive to do so.

The buyer was foolish to allow it.

No, it isn't: the *real* return is taxable to the recipient (you).

Imputed interest comes in when a loan is made with _no_ (or too low) interest. That's not the case here; the escrow account pays market returns.

Seth

That is sensible, but my lawyer and accountant both say otherwise. Can you refer me to something authoritative that supports your point. (They agree it is sensible, but say the IRS doesn't have to be sensible...)

I'm not sure if this strictly applies in your situation, but IRS Publication 544 says, among other things, at

"If, in accordance with an escrow agreement, trust agreement, or exchange agreement, an exchange facilitator holds exchange funds for you and keeps some or all the earnings on the exchange funds in accordance with the escrow agreement, trust agreement, or exchange agreement, you will be treated as if you loaned the exchange funds to the exchange facilitator. You must include in income any interest that you receive and, if the loan is a below-market loan, you must include in income any imputed interest."

That is suggestive of the IRS's attitute, but what's true for a deferred eschange isn't necessarily true for an installment sale. I don't know why it shouldn't be, but... But, I appreciate the help.