Is this an installment sale?

That which you quote can be found in the IRS Pub on Installment Sales (Pub 537). Below this post is the entire section from the Pub. Note that the premise is that an installment payment plan exists. The section is describing the events that happen if and when you have an installment arrangement with an escrow account. Note that in the section on Substantial Restriction, it says you can report the sale as an installment sale "provided it otherwise qualifies." I leave it to others to define what that means.

I think that what all of this comes down to is:

1. Without further research on this subject, one is going to get more than one opinion as to whether the seller has or doesn't have an installment sale. There may not even be anything on point on this particular set of circumstances.
2. The seller always has the option (as previously reported) to treat it as not on an installment basis by just reporting all the gain in the year of sale.
3. Actual interest paid on any funds in the escrow account is taxable interest to the seller.

Escrow Account

In some cases, the sales agreement or a later agreement may call for the buyer to establish an irrevocable escrow account from which the remaining installment payments (including interest) are to be made. These sales cannot be reported on the installment method. The buyer's obligation is paid in full when the balance of the purchase price is deposited into the escrow account. When an escrow account is established, you no longer rely on the buyer for the rest of the payments, but on the escrow arrangement.

Example.

You sell property for $100,000. The sales agreement calls for a down payment of $10,000 and payment of $15,000 in each of the next 6 years to be made from an irrevocable escrow account containing the balance of the purchase price plus interest. You cannot report the sale on the installment method because the full purchase price is considered received in the year of sale. You report the entire gain in the year of sale. Escrow established in a later year. If you make an installment sale and in a later year an irrevocable escrow account is established to pay the remaining installments plus interest, the amount placed in the escrow account represents payment of the balance of the installment obligation.

Substantial restriction. If an escrow arrangement imposes a substantial restriction on your right to receive the sale proceeds, the sale can be reported on the installment method, provided it otherwise qualifies. For an escrow arrangement to impose a substantial restriction, it must serve a bona fide purpose of the buyer, that is, a real and definite restriction placed on the seller or a specific economic benefit conferred on the buyer.

Alan, your citation kung fu is very strong. I've been meaning to ask you, what's your technique for finding [what sound to me like] very authoritative references to tax code, etc, in so many of your postings here? (if you care to share)

Except that, due to the substantial restriction on the escrow, he says he probably won't get very much of the total proceeds. So if pays tax now on all the gain including what's in escrow, does he get a deduction later on from the anticipated lawsuit payout? Maybe a Sec. 1231 loss (I'm totally guessing here...)? Given that he still has some say-so over the disbursement of escrow funds ("I get to approve anything they do"), it still feels to me like he hasn't really ended his involvement with the business.

That's the heart of the OP's question. So whether or not it is an installment sale, actual interest income on the escrow account should obviate the need for calculating unstated (imputed) installment interest income. The OP mentioned "income from the account", so we'd need to know whether that is just interest income.

-Mark Bole

As I am retired, other than volunteering my services to AARP Taxaide and Taxhelp New Mexico as an instructor and volunteer, I no longer maintain my monthly subscription service from Tax Analysts. Therefore my sources are now:

1. Annual purchase of Quickfinder Handbooks for Small Businesses,

1. Annual copy of RIA Federal Tax Handbook.

1. I still have my Tax Analyst's federal tax library database that ended June 2005.
2. I rely upon the Tax Almanac & Cornell Law School websites for current versions of Title 26 Code and Regs.
3. I rely upon the daily tax news posted at Tax Analysts, BNA and the tax group at CCH.
4. I also still have various paper files and/or computer files by category.
5. I search the database at Legal_bitstream.
6. I use the Everything search software to search my hard drive.

See below for various links:

I think we are confusing two different interests. One is the interest (along with capital gains and dividends) the escrow account is earning. The contract requires me to put those on my tax return.

The second is interest on the money I must pay to the purchaser. As it is explained to me, since the purchaser is effectively loaning me the money until the escrow account terminates and they actually owe me the money, I must pay the purchaser interest. Since the contract does not mention interest, the IRS reclassifies part of the payment as imputed interest. I have to pay a higher tax on it, and the purchaser gets to deduct it. The contract clearly says they are paying it to me NOW and depositing it the escrow account on my behalf; so I just don't see how it is payments in more than one year when the contract says they are paying it all to me now. My lawyer says the IRS is not bound by the contract language.

It is a rather large amount, and I might not actually get any of it. Perhaps I could take it all as income now and claim the shortfall as an expense, but I would probably not have enough income in subsequent years to actually use the expense; so taking it all now is not a viable option. Fortunately no one says I have to do that.

Let me make up some numbers to attempt to clarify what I believe is happening.

Seller sold a business that had a contingent liability (a lawsuit against it). Purchaser was willing to pay $5 million for the business without that liability. So, Purchaser paid Seller $3 million cash, plus put $2 million in escrow to cover the contingent liability.

As the escrow account earns interest, that gets paid directly to Seller, who (of course) pays income tax on that interest.

Huh? That doesn't make sense. There is no loan; Purchaser is buying the business net of the liability for $5 million. You don't receive your share immediately, because the split between you and the plaintiff has not yet been determined.

Wait a minute. If Purchaser is lending Seller money, then Seller _pays_ interest. You don't pay tax on interest you pay, and the recipient of the interest doesn't get a deduction, he pays tax on it.

If you pay money to me now, I can spend it. Since you can't spend that money, it is not paid to you; rather, it is paid to a trust (the escrow) which has you as _a_ beneficiary (the residual beneficiary after the primary beneficiary, the plaintiff, gets paid).

In order not to claim it all now, you have to have an installment sale. Some of the money you _receive_ later would be classified as interest, but since the escrow account is actually paying interest at a market rate, that isn't an issue.

Seth

You are absolutely correct, it does not make sense. I should not try to think past midnight. Any interest is paid by the purchaser to the seller to account for the time value of money on a delayed payment. Still...

Well, who does the money belong to? If it belongs to me, then it was paid to me and there was no installment sale. If it belongs to the purchaser, then I should not be paying taxes on the income since the income belongs to the purchaser.

I believe in the next paragraph you are suggesting there is a third possibility; that the money belongs to the purchaser, but they are assigning inome on the money to me, so I have to pay income tax on it. Since they have assigned the income to me, then they do not also have to pay me interest and there should be no imputed interest. Is that correct?

If so, you have been very helpful. If not, then I am still confused.

That can't be done (else lots of people would "assign income" to their children to get a lower tax rate).

Rather, the money belongs to a third party, the escrow account (a trust) that has you as a beneficiary, entitled to the income and residual principal.

Seth

I appreciate your bearing with me. The money belongs to a third party? Who, if not me or the purchaser?

Since I am the beneficiary entitled to the income and residual principal, there is no imputed interest. Is that correct? It is logical; if I get the benefit of the money, I don't deserve interest; but the IRS isn't always logical. At the risk of putting your good will too far, is that concept documented somewhere? My lawyer is dubious.

Right. Interest is only imputed if the agreement itself specifies no (or insufficient) interest is payable.

Well that's certainly true. If everything were logical there would be no use for lawyers.

I'd be happy to document it for you for a fee of $4500. If your own lawyer can't do that, get a new lawyer.

Stu

I might have to do one of those.

What if you move to another state while receiving installment payments?

What are the tax rates on the trust? Are they they trust rates (which are 35% on income above $11,150), and if so is the exemption of $600 allowed. Or is the income tacked on the person's personal return?

What concerns me is what if the person pays more than the original value in the escrow account? Say they account starts off with $2 million. After 3 years the interest perhaps $180,000. The person who is the beneficiary of the account pays tax on this 180k. But if the settlement 3 years later requires him to pay $2,180,000 to settle the case, then he gets nothing from the account. It means he paid tax on this 180k but never got to deduct it as an expense.

And suppose 3 years later he settles for $2 million, leaving 180k in the escrow account. The 180k was already taxed so it's his to keep. Another possibility is that the $2 million is paid from the following sources: $1,820,000 from the original $2 million, 180k from the interest, which leaves a capital gain of 180k. In other words, the

If the sale involved real or tangible personal property, or intangible property with a business situs in the state, the gain element of the sale is income from a source in that state and continues to be taxable there whether the recipient is a resident or a nonresident.

Income from intangible personal property that has no business situs anywhere is sourced at the residence of the owner. It would make sense to say that if you sold an intangible (stock, for example) on an installment sale while a resident of State X, and subsequently moved to State Y while still collecting on the note, the gain recognized after the move would be sourced to State Y, not State X. However, states may take the position that the source of the income is fixed at the date of the sale, regardless of the residence of the seller when the payments are collected. California has a fairly new regulation to that effect.

The interest income from an installment note should be treated as income from an intangible, sourced to the residence of the holder of the note at the time the interest is paid or accrues. Some states, however, treat the interest as sourced in the state where the underlying property (real or tangible personal) was located. Massachusetts and Oregon are examples of that.

Katie in San Diego

There is no tax on the trust; the income items just get added to my tax return.

I "believe" I get a capital loss in that situation.

As it was explained to me (by the very same people whose judgement I now have reason to doubt) the 180k is after tax money.

I considered moving just to avoid the state tax. I could have bought a nice condo in Florida for less than the state tax. I was told that the state would insist that I had earned the money while a resident, so moving in the year that I actually recieved it would not help.

A trust is taxed on its income except when it's a grantor trust, or when the income is properly to distributed to a beneficiary (who is then taxed on that income).

If it is considered a grantor trust, as I think I mentioned earlier, that would mean that you should probably pay tax on the capital gain, even though your actual profit won't be known until later.

Stu

The trust (escrow account). The terms of that trust are that the plaintiff gets what the court awards, and you get the residual (and all interest until the suit is settled).

That's correct. There's no need to impute interest because nobody is making an interest-free (or low-interest) loan. Money is being deposited in a bank which is paying the market rate (more or less by definition).

Look up the IRS regs about "imputed interest". There's no loan in this transaction that would invoke them.

Seth

And you should receive the income in cash as it's paid.

What happens if the award is $3 million? Where does the extra $1 million come from?

Seth

The trust files for bankruptcy.