Use of the Installment Method in Liquidations (Part II)

This two-part article explores the use of the Sec. 453 installment-sale method by corporations and shareholders in complete liquidations. Part I addressed definitions, mechanics and Sec. 453’s application to C corporations; Part II discusses, among other issues, S corporations, original issue discount and sales of inventory and other property.

Richard W. Harris, MBA, J.D., LL.M., CPA
Professor and Director, Graduate Tax Program
Grand Valley State University
Grand Rapids, MI

For more information about this article, contact Prof. Harris at harrisr@gvsu.edu .

Executive Summary

• Installment notes derived from bulk sales of inventory are eligible for Sec. 453(h) treatment.

• S shareholders can apply Sec. 453(h) to an installment note received in a Sec. 338(h)(10) deemed asset sale.

• Special rules apply to installment notes received in S liquidations.

This two-part article addresses whether and when shareholders can use the installment method when receiving liquidating corporate distributions. Part I, in the last issue, discussed Sec. 453(h) in the context of C corporation liquidations; Part II, below, examines S corporation liquidations, original issue discount (OID) and special property sales.

S Liquidations

Under Sec. 453B(h) (except as discussed below), an S corporation recognizes no gain or loss on the distribution, in complete liquidation, of a qualifying installment obligation. However, a recipient shareholder may report his gain on an exchange of his stock for an installment note on the installment method.¹⁹

Sec. 453B(h)(2), flush language, provides that Treasury can issue regulations providing that the character of the gain or loss to the shareholder shall be determined in accordance with Sec. 1366 principles. Generally under Sec. 1366(b), the character of income, gain or loss that flows through from the S corporation to its shareholders is determined as if such item were realized directly from the source, and in the same manner as realized by the corporation. Thus, Sec. 453B(h)(2) seems to suggest that the character of a shareholder's gain on the exchange of his S stock under the installment method (in accordance with Sec. 453(h)) is determined by the character of the transaction generating the installment note (i.e., at the corporate level). However, to date, no regulations explain this provision; such flowthrough treatment would seem to contradict Regs. Sec. 1.453-11(a)(2)(i), which provides that a shareholder treats a qualifying installment note (for all Code purposes) as if it were received from the person issuing it in exchange for the shareholder's stock in the liquidating corporation.

Further, flowthrough treatment seems entirely inappropriate when the S corporation has recognized the income or gain on the original sale because the installment method did not apply. For instance, an S corporation would recognize gain on the sale of inventory and/or property subject to depreciation recapture at the time of sale, and pass it through to the shareholders as ordinary income (thus increasing their stock bases). It would seem unjust to require the shareholder also to recognize ordinary income on distribution of the installment obligation.

On the other hand, when an S corporation would recognize short-term capital gain (but for its use of the installment method and Sec. 453B(h)), but a shareholder would recognize long-term capital gain on the sale of his S stock, passthrough treatment might be appropriate. Pending further guidance under the Sec. 453B(h)(2) flush language, the proper treatment is uncertain.²⁰

Example 1: J owns 100% of S corporation X, with a $450,000 stock basis. In 2002, X sells its only asset, equipment with a $575,000 original cost, a $450,000 adjusted basis and a $750,000 fair market value (FMV), for a $750,000 qualifying installment note, then liquidates by distributing the installment note to J. X recognizes $125,000 ($575,000 – $450,000) Sec. 1245 depreciation recapture income on the sale (under Sec. 453(i)), but not the $175,000 Sec. 1231 gain ($750,000 – $575,000), and has no further gain on the liquidating distribution. J has $175,000 gross profit on the liquidation ($750,000 – $575,000²¹), which will be recognized as gain on the exchange of his stock, with a 23.334% gross profit ratio (GPR) ($175,000/$750,000) on future note payments.

J's gain will be Sec. 1231 gain if Sec. 453B(h)(2) applies, but capital gain if Regs. Sec. 1.453-11(a)(2)(i) applies. However, none of J's gain should be converted to Sec. 1245 recapture income, because X already recognized it and passed it through to J, thus increasing his X stock basis.

If an S corporation sells an asset (or group of assets) for an installment note at a loss, it seems clear that a shareholder receiving the note in a liquidating distribution could use Sec. 453(h) to recognize gain, and that Sec. 1366(b) would not apply. Thus, even assuming Sec. 453B(h)(2) is in effect, there are situations in which it cannot (or should not) apply. The Service should clarify this point.

BIG and PII Taxes

Special rules apply when an installment note (1) arises in connection with a corporate sale of an asset with Sec. 1374 built-in gain (BIG)²² or (2) triggers Sec. 1375 excess passive investment income (PII) tax.²³ In the first case, any BIG attributable to the asset sold (and thus, embodied in the installment note) must be recognized by the corporation under Sec. 1374 on distribution to the shareholder(s) in complete liquidation, under Regs. Sec. 1.1374-4(h).²⁴ In the second case, the corporation must include any PII attributable to the original sale (and embodied in the note) in its PII tax calculation for the year.²⁵ In either case, however, a shareholder can still use Sec. 453(h) to recognize gain attributable to the receipt of the installment note.

Deemed Asset Sales

Sec. 453(h) may also apply when S stock is acquired in a Sec. 338 qualified stock purchase and the selling shareholder(s) elect(s) under Sec. 338(h)(10) to treat the transaction as a deemed asset sale and deemed liquidation. The Service has recently made it clear that an S shareholder can apply Sec. 453(h) to an installment note received in a Sec. 338(h)(10) transaction. The shareholder is deemed to have received the installment note from the liquidating corporation in exchange for his stock under Sec. 453(h) and can use the installment method.²⁶

Example 2:²⁷ S corporation T's sole asset is real estate with a $110,000 FMV, a $35,000 basis and a $10,000 mortgage. F, a 40% shareholder, sells his T stock (with a $10,000 basis) for a $25,000 note and $15,000 of real estate. The other shareholders sell their stock for a total of $60,000; a Sec. 338(h)(10) election is made.

Old T is deemed to have sold its assets to New T for $110,000 ($25,000 note + $75,000 cash and property + $10,000 mortgage relief). Old T reports its gain under the installment method; its gross profit is $75,000 ($110,000 – $35,000), the contract price is $100,000 ($110,000 – $10,000), and the GPR is 75% ($75,000/$100,000). Old T is deemed to have $56,250 gain ($75,000 x 75%).

Under Sec. 1366, F reports $22,500 gain (40% x  $56,250); his stock basis increases (under Sec. 1367) to $32,500 ($10,000 + $22,500). In T's deemed liquidation, F is deemed to have received the $25,000 note and the $15,000 real estate. Applying Sec. 453(h), F's gross profit is $7,500 ($40,000 –  $32,500), the contract price is $40,000, and the GPR is 18.75% ($7,500/$40,000). F's resulting gain at liquidation (attributable to the receipt of the real estate) is $2,813 ($15,000 x 18.75%); his gain to be reported on receipt of note payments will be $4,688 ($25,000 x  18.75%). F's total gain recognition is $7,500.

    

OID

A qualifying installment note can have an issue price that differs from its face amount if it contains inadequate stated interest. The difference is OID or unstated interest under Secs. 1272 and 1274, or Sec. 483 (not both), depending on the selling price and the property sold.²⁸

Under Secs. 1272 and 1274, interest is generally imputed for a debt instrument used in a property sale or exchange when at least one payment is due more than six months after the transaction, and the instrument's maturity price exceeds the stated or imputed principal amount (whichever applies).²⁹ Under Sec. 1274(b)(1) and (2), the issue price of an installment note containing inadequate stated interest is the sum of the present values of all the payments due on the debt, discounted at the applicable Federal rate, compounded semiannually.³⁰

According to Regs. Sec. 1.453-11(a)(5), Example 1(iv), if a qualified installment note with unamortized OID is distributed to a shareholder in a complete liquidation, the shareholder would be deemed to have received the note directly from the payer; he or she would include the note's issue price at the time of distribution in the selling price and contract price for the shares surrendered. Under Regs. Sec. 1.453-11(a)(2)(ii), the issue price is the adjusted issue price (the original issue price adjusted for payments and/or OID amortization under Regs. Sec. 1.1275-1(b)(1)), plus any accrued (but unpaid) qualified stated interest at the distribution.³¹ In effect, the shareholder inherits the discount remaining in the note.

Thus, if the installment note in Example 3 is the sole distribution to K (with a $125,000 stock basis) in 2003, immediately after the corporation has received the first payment on the note, K would be deemed to have received the note's adjusted issue price on the liquidation ($273,569) and would report the same interest (stated plus imputed interest) the corporation would have reported had it retained the note and collected payments.

Example 3: K sells real estate in 2002 with a $500,000 FMV and $310,000 basis for $100,000 and a $400,000 installment note payable at $100,000 per year for four years, plus 3% simple interest. The applicable Federal rate is 8%, compounded annually.^* The present value of the principal and interest payments is $357,008; the OID is $42,992. The future note payments are:

In addition, K would recognize installment-sale gain, based on his GPR calculated under the deemed contract price (i.e., adjusted issue price at the time of distribution) as applied to his receipt of future principal payments (excluding any OID amortization applied against nominal principal payments). K's GPR is 54.308% (($273,569 – $125,000)/$273,569). Thus, K would recognize interest and installment-sale gain as depicted in Exhibit 1.

Inventory Sales

Although Sec. 453(b) bars use of the installment method for a corporate sale of inventory, a shareholder who receives (in a liquidating distribution) an installment note attributable to such a sale may be able to use Sec. 453(h). According to Sec. 453(h)(1)(B), the note must result from a sale (within the 12-month period generally applicable) of inventory to one person in one transaction involving substantially all of such property attributable to a corporation's trade or business (i.e., a bulk sale). The bulk-sale rule is applied separately to each separate trade or business. Thus, a corporation with more than one trade or business must sell substantially all of the inventory of one business to one person in a single transaction to meet the rule.

If a liquidating corporation sells inventory in a bulk sale (with or without other assets) for an installment note, a shareholder receiving the note may use Sec. 453(h). If it sells the inventory in other than a bulk sale (i.e., a broken-lot sale) with noninventory assets, the installment note qualifies only partially. Under Regs. Sec. 1.453-11(c)(4)(i), the portion of the note attributable to the broken lot is not eligible for Sec. 453(h) treatment, but the portion of the note attributable to the noninventory assets is.

Example 4: Z Corp. sells $100,000 of inventory and $200,000 of noninventory assets for a $300,000 installment note with adequate stated interest, in a broken-lot sale. Y, a Z shareholder with a $60,000 stock basis, received the installment note in a liquidating distribution. Y's gross profit is $240,000, her GPR is 80% ($240,000/ $300,000) and her immediate gain is $80,000 ($100,000 x  80%). Y recognizes $160,000 gain on future note payments ($240,000 –  $80,000 gain recognized on the receipt of the broken-lot portion of the installment note).³²

Under Regs. Sec. 1.453-11(c)(4)(iii), the future note payments (except stated interest payments) are applied first, in full, against the note's nonqualified portion (on which the seller has already recognized gain). Thus, in Example 4, Y treats the future principal payments as a nontaxable return of basis (up to $100,000), then under the installment method in accordance with her 80% GPR; she recognizes stated interest in the normal way.

If a buyer assumes debt on a sale of a broken lot with other assets, Regs. Sec. 1.453-11(c)(4)(ii) provides that he or she treats the installment note as acquired in exchange for the broken lot (and, thus, not qualified for Sec. 453(h) treatment) to the extent the lot's FMV exceeds the sum of the (1) unsecured liabilities assumed by the purchaser, (2) secured liabilities encumbering the broken lot (whether assumed by the buyer or taken subject to) and (3) cash, plus the FMV of other property the seller received.

Example 5: The facts are the same as in Example 4, except that, in addition to transferring the installment note, the buyer pays Z Corp. $12,500, assumes $40,000 of unsecured liabilities and takes the inventory subject to $25,000 of secured debt. The portion of the $300,000 installment note not qualified under Sec. 453(h) is $22,500 ($100,000 (FMV of the broken lot) – ($12,500 + $40,000 + $25,000)).

Y will receive the $12,500 and the $300,000 installment note, thus realizing a $252,500 gross profit ($312,500 – $60,000 (basis)), an 80.8% GPR ($252,500/$312,500) and a $28,280 immediate gain (($12,500 x  80.8% ) + ($22,500 x  80.8%)). After receiving $22,500 in note payments as a return of basis, Y recognizes $224,220 in installment gain on the remainder of the note ($277,500 x  80.8%). Her total gain recognition is $252,500.

Certain Property Sales

Regs. Sec. 1.453-11(c)(5)(i) denies Sec. 453(h) treatment to an installment note to the extent attributable to the sale of "covered property" in certain tax-avoidance situations:

• Dealer dispositions and other personal property dispositions (Sec. 453(b)(2)).
• Sales of property subject to depreciation recapture (Sec. 453(i)).
• Dispositions under a revolving credit plan and/or a sale of stock or securities traded on an established market (Sec. 453(k)).

Regs. Sec. 1.453-11(c)(5)(ii) defines "covered property" as property owned by any shareholder during the 12-month period before or after liquidation-plan adoption, and which was, in the shareholder's hands, any of the following:

• Personal property of the same type as that regularly sold or disposed of by the shareholder on the installment plan.
• Real property held by the shareholder for sale to customers in the regular course of business.
• Subject to depreciation recapture of 50% or more of the FMV at the time of sale by the corporation.
• Stock or securities traded on an established market.
• Property for sale under a revolving credit plan.

The rule appears to prevent a related person from transferring substantial property (the sale of which is not eligible for installment reporting) to a corporation that sells its assets (including the property) for an installment note it distributes to a shareholder in liquidation. If the note is then eligible for Sec. 453(h) treatment in the shareholder's hands, the original ban on use of the installment method on the sale is nullified. Thus, installment treatment is denied for a sale of covered property.

Example 6: M owns all the stock of N Corp., which has substantial net operating loss (NOL) carryovers. In early 2002, M contributes equipment with a $300,000 FMV and $52,000 basis to N tax free under Sec. 351. Later that year, N, with total assets of $1 million, sells the equipment for an installment note and distributes it to M and the other shareholders. N's NOLs absorb the depreciation recapture income and any other gain on the sale; a principal purpose of M's Sec. 351 contribution was to avoid Sec. 453(j) depreciation recapture. The installment note does not qualify for Sec. 453(h) treatment in M's hands.³³

This rule does not apply, according to Regs. Sec. 1.453-11(c)(5)(iii), to any corporate distribution if, on the date the plan of complete liquidation is adopted (and at all times thereafter), the FMV of such assets is less than 15% of the corporation's total asset value.

Subsidiaries

Sec. 453(h)(1)(E) addresses installment sales by liquidating subsidiaries; it provides generally that a controlling shareholder (as defined in Sec. 368(c)) receiving an installment note from its 80% subsidiary (on a sale or exchange of the subsidiary's assets) is treated as if it acquired the note directly by sale or exchange. Under Regs. Sec. 1.453-11(c)(3)(i), the transferee corporate parent "steps into the shoes" of the transferor subsidiary as to the installment note. Sec. 453B(d) provides a complementary rule; an installment note transferred by a subsidiary to its parent in a complete liquidation of the subsidiary under Secs. 332 and 337³⁴ is exempted from Sec. 453B(a)'s general taxability rule.

Finally, a subsequent liquidating distribution of the installment note by the corporate parent to a qualifying individual (or nonparent) shareholder under Sec. 331 qualifies for Sec. 453(h) treatment. The parent recognizes gain or loss on the liquidating distribution under Sec. 336. However, a recipient shareholder (absent an election out) reports the transaction on the installment method as if the note (and any other assets) had been received in an installment sale of the parent's stock.³⁵ To qualify under Sec. 453(h), the corporate parent presumably must adopt a plan of liquidation before the subsidiary's installment sale, and complete the liquidation within 12 months of plan adoption (it would seem advisable for the subsidiary to do so, too).

Example 7: P owns 100% of R Corp., which owns 100% of Q Corp. In preparation for a complete liquidation, Q sells real estate with a $500,000 FMV and $210,000 basis to unrelated-party A for $100,000 and a $400,000 installment note with adequate stated interest. In the sale year, Q recognizes $58,000 gain ($100,000 x 58% GPR). If Q liquidates immediately, distributing all its assets (including the installment note) to R, Q has no gain on the liquidation.

R takes Q's basis in the note and recognizes the attributable gain the way Q would have.³⁶ If R subsequently liquidates, it would recognize gain or loss on the assets distributed to P (including the installment note). However, P can use Sec. 453(h) for his gain on the liquidation of his R stock; the installment note qualifies.

   

Conclusion

Sec. 453(h) can be very useful in structuring a sale of a corporation's business, by allowing a shareholder receiving a qualified installment note in liquidation (or deemed liquidation) to defer all or part of his stock gain. A tax adviser representing a liquidating corporation or a recipient shareholder should be alert to any Sec. 453(h) opportunities available.