MIAMILAW

RESEARCH PAPER SERIES

Family Deferred Payment Sales Installment Sales, SCINs, Private Annuity Sales, OID and Other Enigmas Elliott Manning
(w/Jerome Hesch)
Professor of Law 2009-29

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FAMILY DEFERRED PAYMENT SALES INSTALLMENT SALES, SCINS, PRIVATE ANNUITY SALES, OID AND OTHER ENIGMAS BY JEROME M. HESCH AND ELLIOTT MANNING1 200 Introduction Ten years ago, we wrote about the taxation of private annuity sales in an installment sale world.2 The article was written when the Installment Sales Revision Act of 1980 (the "1980 Act") was new and was viewed as a major reform establishing the installment method as the basic method for treating deferred payment sales.3 It was written to forecast and, frankly, to influence promised regulations dealing with the relationship between the 1980 Act and traditional private annuity sale treatment. In the intervening ten years, the promised regulations have not appeared, even in proposed form. There has been only one IRS pronouncement on the subject, and that one, General Counsel's Memorandum 39503,4 is not even officially published. There have, however, been a number of relevant developments. Amendments to the installment sale provisions have reduced the scope of installment reporting, so that it is now available primarily for casual sales of real estate and personal property, including only nonmarketable securities.5 These changes raise doubts whether the installment method remains the basic method of taxation for deferred payment sales.6
authors wish to acknowledge the contribution of Charles Schuetze (now practicing in Anchorage, Alaska), whose LL.M. thesis on private annuities provided research and other assistance with this paper.
2See 1The

Manning and Hesch, Private Annuities After the Installment Sales Revision Act, 6 J. INDIV. TAX. 20 (1982).

3Ginsburg,

Future Payment Sales After the 1980 Revision Act, 39 NYU ANN. INST. ON FED. TAX'N, Ch. 43 (1981); Lobenhofer, The Income Taxation of Exchanges of Property for Private Annuities: History and a Proposal, 21 PAC. L.J. 271 (1990); Lefrak, When to Use Private Annuities, 40 NYU ANN. INST. ON FED. TAX'N, Ch. 2 (1982). 39503, Jun. 28, 1985, CCH IRS POSITIONS REP. 1791. For convenience, the complete text of G.C.M. 39503 is included as Appendix A.
5 4G.C.M.

453(b)(2), (f)(2), (k) and (l).

6See

STAFF OF JOINT COMMITTEE ON TAXATION, GENERAL EXPLANATION OF THE TAX REFORM ACT OF 1986 at 490-91, 498-99 (1987) ("1986 BLUE BOOK") (relating to publicly-traded property); S. REP. NO.

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In addition, there have been major developments in the understanding of and treatment of the time value of money for federal income tax purposes. These include major revisions in the original issue discount ("OID") provisions and extension of the OID rules to sales of property.7 There are now prescribed minimum interest rates known as the applicable Federal rate ("AFR") for sales of property.8 Similar rules apply market discount for the holder of a debt obligation,9 OID rules apply to loans with below market interest rates,10 and compound-interest rules apply to debt premium.11 Needless to say, none of these developments simplify or clarify the relation between the private annuity sale and installment sale provisions. Collectively, they make deferred payment sales of business or other financial assets within a family a true challenge to the tax professional. Deferred payment sales of a business or other financial assets within a family can serve a variety of functions. In many families, there comes a time when it is appropriate to transfer management and control of a family business or other family financial assets, or even nonfinancial property, to the next generation. Although this time may be

appropriate occasion for the making of major family gifts, frequently, the older generation needs to retain some financial stake in the family business or other financial assets to finance its retirement after it is time to transfer control. At the same time, those taking over the closely-held business or other property usually do not have independent
313, 100th Cong., 1st Sess. 160-65 (1987) (relating to dealer dispositions and interest on deferral); Note, Fairness and Tax Avoidance in the Taxation of Installment Sales, 100 HARV. L. REV. 403 (1986).
7

1271 to 1275 and 483; see STAFF OF JOINT COMMITTEE ON TAXATION, GENERAL EXPLANATION OF THE REVENUE PROVISIONS OF THE DEFICIT REDUCTION ACT OF 1984 at 108-23 (1984) ("1984 BLUE BOOK").
8

1274(d)(1) and 1274A; see H.R. REP. NO. 432, Pt. 2, 98th Cont. 2d Sess 1241 (1984); S. REP. NO. 169 , 98th Cong., 2d Sess. 249 (1984); H.R. Rep. No. 87, 99th Cong., 1st Sess. 1 (1985); S Rep. No. 83, 99th Cong. 1st Sess. 1 (1985). 1276 to 1278; see 1984 BLUE BOOK at 93-100. 7872; see 1984 BLUE BOOK at 524-38. 171(b)(3); SEE STAFF OF JOINT COMMITTEE ON TAXATION, EXPLANATION OF TECHNICAL CORRECTIONS at 13-14 (1987).

9 10 11

TO THE TAX REFORM ACT OF 1984 AND OTHER RECENT TAX LEGISLATION

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financial resources to pay for them, and cannot, or are not willing to, obtain the necessary financing from third-party commercial sources. A seller-financed, deferred payment sale can fill the gap, and permits the future cash flow from the newly-acquired assets to provide the primary source of funds needed to satisfy the obligation undertaken by the purchasing younger family member. The deferred payment arrangement can be a

standard installment note, a self-cancelling installment note ("SCIN") or a private annuity sale. A standard installment note calls for a specified number of fixed payments over a set period with designated interest. A SCIN is simply a standard installment note that also provides that the payments terminate upon specified contingencies, usually the death of the selling senior family member or members. This termination feature means that the value of a SCIN is less than that of a standard installment note providing for equivalent payments over the maximum term. Accordingly, to provide an equivalent initial value, a SCIN must provide greater interim and potential total payments than a standard installment note. A private annuity sale provides for specified payments for a term of uncertain duration, usually the life of the selling senior family member. Although a private annuity sale, like any commercial annuity, involves an implicit interest factor, the interest usually is not expressly stated. Although there are significant differences in the financial terms and economic risks associated with the three types of deferred payment financing, in the final analysis all three provide economically equivalent payment arrangements for the assets transferred. Any difference in the risks related to the different payment terms should be taken into account, either by difference in the amounts provided as deferred payments for the assets or, if it is not, in the portion of the value of the assets transferred that is a gift, compensation, or other taxable event. Nevertheless, the current differences in the Federal income and transfer tax treatment of the three financing arrangements are disproportionate to the financial differences among them.

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Under traditional tax principles, the timing of reporting any gain realized by the senior family member seller under the annuity rules is significantly different from that under the installment method. There are similar differences in the basis of the property to the younger generation buyer. The buyer in a private annuity sale is entitled to an initial basis for the property purchased measured by the actuarial value of the annuity and capitalizes the amount treated by the selling senior family member as annuity income, but the younger generation buyer in an installment sale involving contingent payments includes the payments in basis only as made. Even greater differences apply to the income taxation of the interest or other time value of money factor inherent in each payment. Although the selling senior family member reports interest income as such in an installment sale and, implicitly, as annuity income in a private annuity sale, the reporting of the time-value of money is significantly different. Similarly, although the younger generation buyer is entitled to an interest deduction (subject to the investment interest or other interest limitations) in an installment sale, the buyer is not allowed any deduction for the amount the selling senior family member treats as annuity income in a private annuity sale. In addition, differences can occur because only an unsecured private annuity sale is governed by the private annuity rules, while a secured private annuity sale on identical terms is apparently governed by the installment reporting rules. Another distorting factor is the use of different interest rate and mortality assumptions for income tax purposes than those used for transfer tax purposes. This distortion is exacerbated by the apparent use of the income tax tables in determining whether a gift is made in installment sales, but not in private annuity sales. This paper seeks to provide a comparative analysis of the current income and transfer tax treatment of these three financing vehicles (in so far as it is clear) to show how the selling senior family member and younger generation buyer are taxed at the following crucial times:

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1. 2. 3.

the time of the initial sale; the time each payment is made; and the death of the senior family member seller during the payment period.

In so doing, the analysis questions how much of the traditional view, particularly the taxation of private annuity sales, is proper, in light of the 1980 Act and subsequent developments. This paper is divided into two parts. The first part provides a general comparative analysis of the income tax treatment of fixed installment sale obligations, private annuity sale obligations and SCINs under the existing cases, rulings and regulations. Part I addresses: (i) fixed deferred payment obligations under the installment method; (ii) traditional private annuity sale principles; (iii) contingent payment obligations under the installment method; and (iv) the application of contingent payment installment sale principles (a) to SCINs and (b) to private annuity sales. Part I also analyzes the transfer tax treatment applicable to each approach, and the, sometimes surprising, differences between similar transactions. It concludes with specific recommendations for the

treatment of all SCINs and private annuity sales as contingent payment installment sales, with some modification of the current treatment. Specifically, the transfer tax treatment of all such sales should be uniform, and should be determined under rules that are similar to those now provided the installment method for the sale portion of any intrafamily transfer. The analysis suggests, however, that the younger generation buyer's initial basis in the property should reflect the actuarial value of the annuity obligation. This analysis suggests that there may be a place for traditional private annuity sale income tax treatment in cases in which the taxpayer elects out of the installment sale method, and, possibly, for sales that do not qualify for the installment method. Part II provides a more comprehensive description of the current treatment of each of these types of transactions, including more detailed illustrations of the results of current law and of adopting the suggestions made.

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PART I COMPARATIVE ANALYSIS 201 201.1 Installment Method for Fixed Payment Obligations In General

The installment method defers taxes; it allows a selling senior family member who is to receive deferred payments on the sale of property to postpone reporting any gain realized on from the date of sale to the time when payments are received. The installment method spreads the reporting of gain over the taxable years of payment by linking the reporting of gain to the receipt of payment, Specifically, a fraction of each payment, the gross profit ratio, which is the gross profit divided by the selling price, is included in income. Example 1: A senior family member sells family financial assets worth $1,000 that have a basis of $100, for ten payments of $100 each, plus adequate stated interest. The gain, or gross profit, is $900 ($1,000 - $100). Under the installment method, the gross profit ratio is 90% ($900/$1,000). Thus, 90% or $90 of each $100 principal payment on the note is included in income as gain on the sale. 207.1 includes additional illustrations that show the effect of various payment arrangements. Regardless of the younger generation buyer's method of accounting, the obligation to make fixed principal payments is part of basis of the property acquired from the date of sale. With de minimis exceptions, a portion of any is OID characterized as interest unless interest, at prescribed rates, is payable at least annually.12 A selling senior family member can elect out of the installment method for a deferred payment sale,13 and report the entire gain in the year of sale for most fixed pay12 13

1273, 1274 and 1274A; Prop. Reg. 1,.1273-2, 1.174-1 and 1.1274A-1; see 201.7.

453(d); Temp. Reg. 15A.453-1(d).

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ment obligations and for many contingent payment obligations.14 A selling senior family member who elects out of the installment method is rarely is permitted to recover basis first.15 The senior family member can arrange for part or all of the family business interest to be redeemed by the corporation or partnership instead of being purchased by the younger generation family member. The redemption has the same economic effect as a sale if the younger generation already owns an interest in the business, or if such an interest is transferred as part of the transaction. A corporate redemption for deferred payments, including one by an S corporation, that qualifies as a sale or exchange, and is not a dividend, is an installment sale.16 Accordingly, the income tax treatment of the selling senior family member is the same as in a direct sale to the younger family member. Any interest deduction, however, belongs to the corporation (or S corporation shareholders). The corporation does not have any basis in the shares redeemed and the younger family members do not increase the basis of their shares for the redemption price.17 The taxation of a deferred payment redemption of a partnership interest is determined under special partnership provisions and not under installment method.18

14Temp. 15See

Reg. 15A.453-1(d)(2).

203.3 and 208.3.

Reg. 1.453-1(f)(4); see Stiles v. Commissioner, 69 T.C. 558 (1978), acq.; Priv. Ltr. Rul. 90-08065 (Nov. 29, 1989) (redemption with deferred payments must be reported as installment sale; see also E. MANNING, CORPORATE BUY-SELL AGREEMENTS, (CCH TAX TRANS. LIB.) 708 (1991). See id. at 108 for a discussion of when a redemption in a family corporation qualifies for sale or exchange treatment.
17See 18See

16Prop.

Manning, supra note 16, at 108.

Reg. 1,736-1(b)(5), (6) and (7). See MCKEE, NELSON AND WHITMIRE, FEDERAL TAXATION OF PARTNERS AND PARTNERSHIPS 22.02[4] (2d ed. 1990) and WILLIS, PENNELL AND POSTLEWAITE, PARTNERSHIP TAXATION 155.03 (4th ed. 1989) for further discussion of the timing issues in deferred payment of redemptions of partnership interests.

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 201.2

Terms of the Sale

All initial cash amounts received, and the value of all assets initially received (other than the buyer's evidences of indebtedness), in a deferred payment sale of family business or other financial assets are treated as payments in the year of sale under the installment method. Demand obligations of the younger generation buyer, or obligations of a corporate buyer regularly traded on an active securities market, do not qualify as the buyer's evidence of indebtedness, so that the deferral under the installment method is not available for these notes.19 The installment method is also not available for various types of property.20 The buyer's evidences of indebtedness may be received in an installment sale without immediate gain recognition, regardless of the solvency of the buyer. The installment method is the basic approach to taxing deferred payment sales that qualify; its availability does not depend on the taxpayer's method of accounting or on lack of certainty of payment.21 All other amounts received, including any third party debt obligations, are payments in the year of sale and result in immediate recognition of gain.22 Gain realized on sale can be reported under the installment method even when the younger generation buyer's obligation is secured.23 Common forms of security include a mortgage on the property sold, a third-party guarantee or even a standby letter of credit.24

19

453(f)(4) and (5); Temp. Reg. 15A.453-1(b)(3)(i) and (e)(1). 201.9. Ginsburg, Taxing the Sale for Future Payment, 30 TAX L. REV. 469 (1975).

20See 21See 22

453(c) and (f)(3); Temp. Reg. 15A.453-1(b)(3)(i); see Holmes v. Commissioner, 55 T.C. 53 (1970) (third party note guaranteed by the buyer was payment).
23

453(f)(3); Temp. Reg. 15A.453-1(b)(3)(i) and (iii); S. Rep. 1000, 96th Cong. 2d Sess. at 18.

Rev. Rul. 82-122, 1982-1 C.B. 80, Rev. Rul. 74-157, 1974-1 C.B. 115; Rev. Rul. 74-557, 1974-2 C.B. 301 (dealing with modifications of terms of installment sales secured by the property sold); Temp. Reg. 15A.453-1(b)(3)(iii); S. Rep. 1000, 96th Cong., 2d Sess. at 18 (both relating to standby letters of credit); but cf. Holmes v. Commissioner, supra note 22.

24See

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It is possible to go too far. An obligation secured by an escrow or by a cash equivalent, for example, government securities, is treated as a payment in the year of sale.25 201.3 Liabilities Transferred

When liabilities are transferred as part of the sale of the family business or other financial assets, the liabilities are part of the selling price, included in both the selling senior family member's amount realized and the younger generation buyer's basis.26 When property is sold subject to liabilities, special rules apply under the installment method. The liabilities are, in effect, applied first against basis instead of simply being considered additional payments. The contract price instead of the selling price is used to calculate the gross profit ratio. It is defined as the selling price reduced by liabilities transferred that do not exceed basis.27 Example 2: A senior family member sells property worth $1,000 with a basis of $600, subject to a mortgage of $400, for ten principal payments of $60 each. Although the sales price is $1,000, the contract price is $600 ($1,000 - the $400 mortgage), and the gross profit ratio is 66-2/3% ($400 gross profit/$600 contract price). $40 of each $60 payment is included in income as gain on the sale. If the amount of the selling senior family member's transferred liabilities exceeds the basis for the business, the excess is "deemed" to be a payment in the year of sale, because otherwise the gross profit ratio would exceed 100%.28 Example 3: A senior family member sells property worth $1,000 with a basis of $100, subject to mortgage of $400, for ten principal payments of $60. The gross

25Temp. 26Reg.

Reg. 15A.453-1(b)(3)(i).

1.1001-2(a); Crane v. Commissioner, 331 U.S. 1 (1947); Commissioner v. Tufts, 461 U.S. 300 (1983) (amount realized on transfer of property subject to nonrecourse liability is amount of liability even if value of property is less). Reg. 15A.453-1(b)(2(iii). Reg. 15A.453-1(b)(2)(iii) and (iv).

27Temp. 28Temp.

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profit is $900 ($1,000 price - $100 basis), and the contract price would be only $600 ($1,000 price - $400 mortgage), resulting in a gross profit ratio of 133-1/3%. To prevent this, the mortgage offset in determining the contract price is limited to the $100 basis. Thus, the contract price is also $900, resulting in a gross profit ratio of 100%. The $300 excess is a "deemed" payment in the year of sale. This results in immediate recognition of gain in the amount of $300 because the entire basis has been fully recovered against the liabilities.29 Taxpayers have succeeded in avoiding immediate gain recognition when liabilities exceed basis by use of a wrap-around note.30 In a wrap-around note, the selling senior family member does not transfer the liability, but remains primarily liable, agreeing to make payment on the indebtedness as it becomes due.31 Although the IRS initially resisted this result,32 it has now conceded that it works.33 Example 4: The facts are the same as in Example 3. The senior family member may avoid the gain on the excess of the liability over basis in the year of sale by agreeing to pay off the borrowing himself. He then receives ten annual principal payments of $100 each, and must use part of each payment (or other resources) to make the payments on the mortgage. He reports $90 of his gain as he collects each principal payment, and has no deduction or other offset for the mortgage payments.

29Temp. 30See

Reg. 15A.453-1(b)(2)(iii) and (iv).

Professional Equities, Inc. v. Commissioner, 89 T.C. 165 (1987), acq.

notes are used for other purposes than avoidance of the payment in year of sale, most commonly to preserve for the selling senior family member benefit of a low interest rate loan. Cf. Prop. Reg. 1.1274-7(c) (wrapped-indebtedness not treated as assumed for purposes of OID rules).
32See 33It

31Wrap-around

Temp. Reg. 15A.453-1(b)(3)(ii).

has acquiesced in Professional Equities, supra note 30.

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 207.3 discusses the problems that may arise if the younger generation buyer insists on making a portion of the principal payments to the mortgagee to eliminate the risk of selling senior family member default. 201.4 Disposition

Because the deferral of tax under the installment method is considered an extraordinary benefit, almost any disposition by a selling senior family member of an installment obligation accelerates the unreported gain realized on the sale of the family business.34 Even a gift by the selling senior family member is an early disposition that accelerates the reporting of gain.35 A disposition occasioned by the selling senior family member's death, however, does not accelerate the unreported gain. Instead, the deceased selling senior family member's successor-in-interest steps into the decedent's shoes, and, in turn, is subject to the early disposition provisions.36 The amount included in the selling senior family member's gross estate should be the fair market value of the younger generation buyer's debt obligation, determined under normal valuation principles, and not the unpaid principal of the note.37 The results are the same if an installment obligation that is not a SCIN is cancelled by a bequest to the younger generation buyer.38

453B; see Examples in 207.4. A transfer of an installment obligation incident to a divorce that meets the requirements for nonrecognition under 1041 does not result in acceleration of gain, but transfers the unreported gain to the (often unsuspecting) transferee spouse. 453B(g).
35Rev. 36

34

Rul. 67-167, 1967-1 C.B. 107; see Examples in 207.4 A.

691(a)(2); see Examples 10, 11 and 12 in 207.4 B. Since the deferred gain is "income in respect of a decedent," 691(a)(4) and Reg. 1.691(a)-1(b), the successor-in-interest cannot obtain a tax-free step-up in basis for the unreported gain. 1014(c). G.C.M. 39503, Issue (3), supra note 4, determining that the unreported gain in a SCIN is income in respect of a decedent even though Issue (2)(A) concludes that no amount is included in the gross estate. This issue is discussed further in 207.4 A and 207.4 G.
38Reg. 37See

20.2033-1(b); see 207.4 B3.

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Finally, use of the installment note as collateral for a loan is treated the same as an early disposition to the extent of the loan proceeds,39 with the result that all or a portion of the deferred gain is reported at that time.40 201.5 Interest Charged by the Government

The benefit of the deferral of tax for large installment sales is lost, because the selling senior family member must pay interest on part of the deferred tax, beginning in 1989.41 This interest is calculated at the interest rate applicable to tax deficiencies.42 If the selling senior family member is an individual, the interest is, presumably, nondeductible.43 This makes payment of interest prohibitively expensive. 201.6 Interest Deduction

Interest paid by noncorporate family buyers for shares of a family C corporation is investment interest deductible only within the applicable limits.44 The character of interest paid by a noncorporate family buyer of an S corporation is determined by an allocation based on the nature of corporate assets, that is, business assets, investment assets, etc.45 When the family buyer is a C corporation, the interest should be fullydeductible as business interest.46

39 40 41 42 43 44

453A(d)(1). 453A(a)(1) and (b)(1); see Example 6 in 207.4. 453A(a)(1) and (b)(2); see 207.5. 453A(c)(2). 163(h); Reg. 1.163-9T(b)(2)(i). 163(d)(5); Reg. 1.163-8T(b)(3).

Notice 89-35, Sec. IV.A, 1989-1 C.B. 675, 676. In Priv. Ltr. Rul. 91-16-008 (Jan. 10, 1991), the IRS applied this approach to a redemption of an S corporation shares, determining the character of the interest by the nature of the corporate assets. 163(d)(1) and (h) (investment interest and personal interest limits apply only to taxpayers other than C corporations); see also 207.6.
46See

45See

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 201.7

Original Issue Discount and Unstated Interest

The face or principal amount of a family buyer's deferred payment obligation issued for family business shares (or other property) does not necessarily represent the true purchase price. The difference may represent difficulty in valuing the shares or a conscious attempt to disguise the true rate of return on the deferred payment obligation or the true consideration paid for the family business shares. A set of complex, and not wholly consistent, provisions is designed to prevent these considerations from distorting the tax consequences of the sale.47 The difference between the principal or redemption price of a debt obligation and its true value or issue price represents an additional charge for the use of the money represented by the debt obligation,48 and is called original issue discount ("OID") or unstated interest.49 A. Issue Price of Obligations Issued for Family Business Shares (or

Other Property) The first of the key concepts in measuring OID is the issue price of the family buyer's debt obligations. Although there are special rules when the shares of the family corporation or the family buyer's debt obligations are publicly traded,50 in the usual case when neither the family buyer's debt obligations nor family business's shares are publicly traded,51 OID is measured by prescribed rates. The prescribed rates are used to discount

1271 through 1275, 163(e), 171 and the regulations under them. See Lokken, The Time Value of Money Rules, 42 TAX. L. REV. 1 (1986) for a comprehensive analysis.
48

47

1274 and 1274A.

technical definition of OID is any excess of the redemption price over the issue price, 1273(a)(1), 483(b) and 163(e), or its equivalent in below-market related-party loans (including loans between a corporation and its shareholders), 7872(e). 1273(b)(3); Prop. Reg. 1.1273-2(c)(1). Public trading generally means there is no installment sale. See 201.9 and 207.9.
51 50

49The

1273(b)(3); Prop. Reg. 1.1273-2(c),

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all obligations except when regular interest payments are made, at least annually, at the prescribed rate.52 In essence, the sales price of the family business's shares is determined indirectly by use of the prescribed rates. The use of prescribed rates assumes that the time value of money is easier to determine than the value of the property transferred.53 The prescribed rates are based on the rate of interest on government obligations and are known as the Applicable Federal Rate ("AFR"). The AFR varies depending on whether the period is short- (three years or less), mid- (over three to nine years) or long- (over nine years) term.54 B. Redemption Price

The second key definition, the stated redemption price, is a bit trickier. The redemption price includes all payments other than qualified interest, that is, express annual interest at an unvarying rate (including certain floating rates).55 Accordingly, any

"interest holiday"56 provided in a family buyer's debt obligation (whether or not there is public trading) of more than one year automatically results in OID.57 Thus, all payments, whether labelled principal or interest, become stated redemption price. Similarly,

because contingent payments cannot provide for steady interest, any contingent payments

1273(a)(a) and (2); Prop. Reg. 1.1273-1(a)(1) and (b)(1)(b). There is also a de minimis exception. 1273(a)(3). Philadephia Park Amusement Corp. v. United States, 126 F. Supp. 184 (Ct. Cl. 1954) (in an exchange of assets, amount realized and basis determined by using the value of property whose value is easiest to determine).
54 55 53Cf.

52

1274(d)(1); see 207.7 A. 1273(a)(2); Prop. Reg. 1.1273-1(B).

56An

interest holiday is any period during which no interest is paid, even though it may accrue for later payment. Example 13 in 207.7 B.

57See

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of purchase price more than one year after closing also inevitably involves OID, whether or not there is public trading.58 C. Effect of AFR

Similarly, because the AFR determines issue price, there is OID whenever the family buyer's debt obligation provides for interest at a rate below the AFR, even if payable at least annually.59 As a practical matter, the OID provisions relating to the AFR are of no concern if interest is paid at least annually at a rate at least equal to the AFR. Moreover, when the family sale agreement provides for interest at less than the AFR, the amount of the younger generation buyer's debt obligation, discounted at the AFR, and not the principal amount of the obligation, determines the selling price of the family business shares and the basis of those shares to the younger generation buyer.60 D. Effect of OID

Thus, there is OID whenever the deferred payment terms of the acquisition: (1) do not provide for interest at a rate at least equal to the AFR; (2) provide for changes in interest rate (other than under certain approved variable interest rate formulas); (3) provide any interest holiday; or (4) provide contingent payments.61 When there is OID, both the younger generation buyer and selling senior family member amortize the OID over the life of the debt obligations on daily compound-interest accrual basis regardless of their usual method of accounting.62 When interest (and principal) are paid annually at
58See 59The

Prop. Reg. 1.1275-4 (c) to (f); see also 203.4 B and 209.4 B.

appropriate AFR is that in effect at the time of the contract, not at the time of closing. Prop. Reg. 1.1274-6(e).
60See

Example 14 in 207.7 C.

Analyzing the Complex New Proposed Regs. on Imputed Interest and Original Issue Discount, 65 J. TAX'N 14, 19 (1986); Davis, Buying and Selling Property: The Determination and Treatment of Imputed Interest, 44 NYU INST. ON FED. TAX'N, Ch. 33 at 33-8 (1986). 1272(a); OID was amortized on a straight-line amortization for obligations issued between 1969 and 1982; 1272(b), Reg. 1.163-4; and on a cash basis for those issued between 1954 and 1969, 1272, but the deduction may be determined on a compound-interest basis, Reg. 1.163-3(a) and (b). There are similar rules treating market discount, that is, the difference between the basis of a debt obligation and its
62

61Moore,

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a low rate, the effect of the OID rules is to recharacterize the payments made so that part of what is called principal is taxed as interest.63 E. Small Transactions

The OID accrual provisions do not apply for transactions of under $250,000.64 The similar unstated interest rules require that interest, at a maximum of 9%, be taken into account for both income and deduction purposes at the time of payment, without regard to the taxpayer's method of accounting.65 Selling family members can elect the cash method of reporting OID for certain obligations with a stated principal not more than $2,000,000.66 To qualify, the selling shareholder must not be an accrual basis taxpayer; and the election must be joined the younger generation buyer.67 F. Liability Transfers

The OID rules do not apply to pre-existing liabilities transferred by the selling senior family member to the younger generation buyer, for example, an old mortgage with an interest rate below current interest rates that gives it a value significantly different from the unpaid principal amount or adjusted issue price. The OID rules do apply, however, if the terms of the liability are modified as part of the transaction or the liability is in excess of $10,000,000.68 The distortions this can create are discussed in 207.1 F.

redemption price as ordinary income, but only on sale, exchange or redemption unless the taxpayer elects current inclusion. See 1276 and 1278; Lokken, supra note 47; see also 207.7 D.
63See

Examples 15, 16 and 17 in 207.7 D. by aggregating the amount of the sale. Prop. Reg. 1.1274-1(b)(4)(iii).

64Determined 65 66

483; Reg. 1.483-2(a)(1)(ii). 1274A(c). Example 18 in 207.7 E.

67See 68

1274(c)(4); Prop. Reg. 1.1274-7.

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G.

Possible Unintended Gift for Gift Tax Purposes

When a senior family member seller takes back the younger generation buyer's note as part of the sales price, he generally charges interest at the appropriate AFR in order to avoid any OID or unstated interest problems. If the bona fide business exception does not apply,69 the selling senior family member may find that he has made a gift for purposes of the gift tax even though no gift was intended.70 The reason for this anomaly is that 7520(a)(2) requires that an interest rate equal to 120% of the mid-term AFR be used for transfer tax purposes in valuing any annuity and any interest for a term of years. If the buyer and seller are unrelated, it is highly likely that the transaction avoids any gift issue as an "ordinary business transaction."71 When the buyer is a family member, it is more difficult to establish that the sale is an ordinary business transaction. This may be particularly difficult if the transfer is a part-sale, part-gift.72 Nevertheless, G.C.M. 39503 states that there is no requirement to use the transfer tax valuation tables in determining the gift taxation of an installment sale. This position implicitly treats an installment sale, even among family members, as a business transaction.73 Under this approach, 7520 has no application. A possible limitation on this analysis is that the G.C.M. preceded the enactment of 7520.74 A similar and more persuasive argument is that an installment note is not an annuity interest nor an interest for a term.75
69See 70See

Reg. 25.2511-1(g)(1) and 25.2516-8 Example 20 in 207.7 G. 25.2512-8.

71Reg. 72See 73See

201.10.

Prop. Reg. Prop. Reg. 25.7872-1 (taxing gift loans under 7872, which uses the AFR to value the loan); Cf. Prop. Reg. 1.7872-2(a)(2)(ii) (excluding sales of property from loans under the belowmarket loan provisions). 7520 was enacted by 5031(a) of P.L. 100-647, the Technical and Miscellaneous Revenue Act of 1988, while G.C.M. 39503 was published in 1985. 1275(a)(1)(B) (defining annuity contracts excluded from the OID rules as ones dependent on the life expectancy of an individual).
75Cf. 74

2-17

H.

Premium

The provisions for amortization of premium, which is the mirror image of discount, are elective for the selling family member,76 but apparently are mandatory for the younger generation buyer if on the accrual basis,77 and, possibly, on the cash basis as well. If the selling senior family member does not elect to amortize the premium, the excess of the basis of the family buyer's debt obligation over the amount received on sale or retirement generally is a capital loss.78 Unlike the OID provisions, the premium provisions do not provide for the use of the AFR (or any other prescribed rate) to determine the amount of premium in the selling price of the family corporation shares.79 Accordingly, it is not clear whether premium can arise when the family buyer issues deferred payment obligations for the family business.80 201.8 Convertible Obligations

Debt obligations convertible into shares of the family corporate buyer can qualify for the installment method in the same manner as straight debt obligations.81 Although conversion of a convertible security is normally not a recognition event,82 the IRS has

76

171 and the regulations under it.

1.61-12(c). Amortization of premium attributable to a conversion privilege is not permitted for either the issuer or the holder. 171(b)(1); Reg. 1.61-12(c)(2); see 207.8.
78See 79

77Reg.

1271(a)(1) providing that retirement is a sale or exchange.

171. Example 21 in 207.7 H.

80See 81The

value of the conversion privilege of convertible obligations does not give rise to OID, but the value of any stock or warrants issued as part of a package does give rise to OID. Reg. 1.1232-3(b)(2)(ii) (these regulations should continue to apply although issued before the 1984 amendments). Rul. 72-265, 1972-1 C.B. 222; see Fleischer and Cary, The Taxation of Convertible Bonds and Stock, 74 HARV. L. REV. 473, 476-88 (1961).
82Rev.

2-18

ruled that the entire value of shares received on conversion is taxable as a disposition of an installment obligation.83 201.9 Exclusions

When the family sale is of business assets rather than corporate stock, the installment sale rules (including contingent payment rules), are applied separately to each asset.84 The ordinary income portion of the gain realized upon the sale under the depreciation recapture rules is not eligible for deferral under the installment method.85 Instead, the recapture portion of the gain must be reported in the year of sale. In addition, gain on (i) sales of personal property that is inventory, (ii) sales by dealers,(iii) sales of depreciable property between related parties, and (iv) sales of marketable securities, are all not eligible for installment reporting.86 There is no installment reporting of loss.87 When property eligible for installment reporting and ineligible property are both sold in a single transaction, the price must be allocated to determine the portions eligible for the installment method.88 201.10 Part-Sale, Part Gift

The senior family member may not find it necessary to receive full value for family business or financial assets transferred to the younger generation. If any installment note is worth less than the value of the property transferred, the transaction is a part-sale, part-gift. When this is the case, the senior family member seller can apply her entire basis in the property transferred to the sale portion, in determining gain realized on

83Rev. 84See 85 86

Rul. 72-264, 1972-1 C.B. 131; G.C.M. 34595 (Aug. 25, 1971); see Example 22 in 207.8.

Williams v. McGowan, 152 F.2d 570 (2d Cir. 1945).

453(i); see Example 23 in 207.9. 453(b)(2), (f)(2), (k) and (l). Rul. 68-13, 1968-1 C.B. 195. Rul. 68-13, supra note 87.

87Rev. 88Rev.

2-19

the transaction.89 Similarly, the younger generation buyer's basis in the property is the greater of the price paid or the senior family member's basis.90 A transferred basis may be increased by any gift tax paid.91 202 Private annuity sale Obligations Private annuity sales are arrangements that permit a senior family member to receive a fixed amount periodically for the remainder of the seller's life or some other period. The traditional tax treatment of private annuity sales developed in a series of rulings and cases as an application of cash accounting principles in combination with some of the rules that apply to primarily commercial annuities, all without specific statutory authority.92 202.1 Tax Treatment of Annuities in General

An individual having a savings account with a bank must report the annual interest earned under the doctrine of constructive receipt even when he does not withdraw any monies from the account.93 If the same individual saves by purchasing an annuity from an insurance company, the reporting of the interest income is deferred until withdrawals are made.94 Under an annuity arrangement, the insurance company receives one or more premium payments and agrees to make a prescribed series of future payments, usually measured by the annuitant's life, a specified term or some combination. The payments represent not only return of the premium but also an implicit interest element for the
89 90 91

1011(a); Reg. 1.1001-1(e); see Example 24(a) in 207.10. 1015(a), Reg. 1.1015-4; see Example 24(b) and (c) in 207.10. 1015(d); Reg. 1.1015-5. 202.2. Example 25 in 208.1.

92See 93See

94Under

the tax rules that apply to life insurance companies, the insurance company also avoids tax on the income set aside for annuities. See 805(a)(2) and 807(b)(2) and (3).

2-20

annuity term. Under 72, a portion of each annuity distribution is treated as a tax-free return of the annuitant's initial deposit by use of a mechanism called the "exclusion ratio," and the balance, representing the time value of money, is annuity income.95 In effect, any distributions representing the annuitant's cost in the annuity contract, referred to as the "investment in the contract,"96 is a tax-free return of basis.97 This investment in the contract, the numerator of the exclusion ratio, is the total of premiums the annuitant paid the insurance company. The denominator of the exclusion ratio is the total of all amounts the annuitant expects to receive under the annuity contract (without discounting to present value) determined by actuarial tables,98 referred to as the "expected return."99 The exclusion ratio in annuity taxation has a function similar to that of the gross profit ratio in the installment method as the mechanism for defining the recovery of basis.100 The exclusion ratio, like the OID and unstated interest rules, determines the amount of income that effectively represents the time value of money. It differs in that it provides a straight-line allocation of the income on a cash basis rather than the compound-interest accrual approach of the OID and unstated interest rules. When annuity payments are payable for a period measured by a life, the annuitant can die before or after the actuarial provided in the mortality table. An annuitant dies exactly when his actuarial life expectancy ends, excludes from income an amount exactly equal to the premiums paid. An annuitant who dies prematurely, is permitted to deduct

95 96 97

72(b)(1); Reg. 1.172-4. 72(c)(1); Reg. 1.72-6. 72(b)(1); Reg. 1.72-3. Reg. 1.72-9.

98See 99

72(c)(3); Reg. 1.72-5. Example 26 in 208.1.

100See

2-21

the unrecovered "investment in the contract" on the final income tax return.101 An annuitant who survives beyond the table's life expectancy, recovers the entire investment in the contract and can no longer exclude any portion of subsequent annuity payments.102 202.2 Private Annuity Sales

When a senior family member sells family business or other financial assets to a junior family member on terms that measure the payments by the selling senior family member's (or another person's) life, the transaction is a private annuity sale. Traditional private annuity sale treatment is a special application of cash accounting principles, in which the gain on the sale is allocated over the payment period using the principles of annuity taxation.103 A redemption by a family corporation can be a private annuity sale.104 During the actuarial life expectancy of the selling senior family member in a private annuity sale, the annuity payments are divided into three parts: (1) a basis recovery element, determined by allocating the basis of the shares over the selling shareholder's life expectancy under the income tax annuity tables; (2) a (capital) gain element, measured by any excess of the value of the annuity under the gift tax actuarial tables over the basis of the shares, which is also allocated over the income tax life expectancy; and (3) an annuity (or interest) income element, measured by the difference between the

72(b)(3)(A); H.R. Rep. No 426, 99th Cong., 1st Sess. 731 (1985); S. Rep. NO. 313, 99th Cong. 1st Sess. 607 (1986). No deduction for unrecovered basis is permitted if the annuitant dies before the annuity starting date. 72(b)(2). Prior to 1987, the annuitant could exclude a portion of all annuity payments, including the mortality gain payments, and no deduction was permitted for unrecovered basis if there was a mortality loss. See Manning and Hesch, supra note 2, at 27. Rul. 69-74, 1969-1 C.B. 43. The IRS revoked its earlier position in Rev. Rul. 239 where it applied the open transaction approach and allowed all principal payments to first be a recovery basis. See also Rev. Rul. 55-119, 1955-1 C.B. 352, dealing with the family buyer's basis. Fehrs Finance Co. v. Commissioner, 487 F.2d 184 (8th Cir. 1983), cert. den. 416. U.S. 938 (applying 304 to a redemption through a related corporation with the price paid in the form of a private annuity).
104Cf. 103Rev. 102

101

2-22

amount of the payment and the first two items, using the lower of the fair market value of the shares or the present value of the annuity.105 Thus the recovery exclusion in a private annuity sale is divided between the recovery of the selling senior family member's basis in the family assets transferred and any unrealized gain inherent in those assets. Accordingly, private annuity sale treatment parallels the installment method, but with significant differences.106 If the selling senior family member outlives his life expectancy, all subsequent payments are ordinary annuity income.107 If the family seller dies before recovering his entire basis, the reporting of gain stops,108 and he is entitled to a loss deduction on the final income tax return for the unrecovered basis.109 The same considerations apply to the timing and character of the deduction and its possible eligibility for election under 1341(a)(5) as for contingent payment installment sales.110 Traditional private annuity sale treatment is not available for secured private annuity sales.111 Although G.C.M. 39503 seems to assume that being ineligible for private annuity sale treatment means immediate recognition of gain,112 this is questionable. The

Rul. 69-74, 1969-1 C.B. 43; G.C.M. 39503, Issue (2)(C)(1)(a), supra note 4; see Reg. 1.10112(c) Example (8); see also Example 29 in 207.2.
106See 107

105Rev.

generally, Manning and Hesch, supra note 2 at 23-27.

72(b)(2). There was previously a conflict between Rev. Rul. 69-74, supra note 103, and Reg. 1.1011-2(c) Example (8) about what happened if the selling family member lived beyond the actuarial period.
108G.C.M. 109

39503, Issue (2)(C)(1)(b)(iii), supra note 4.

72(b)(3)(A). 202.1 and 208.1.

110See 111See

Estate of Bell v. Commissioner, 60 T.C. 469 (1973); 212 Corp. v. Commissioner, 70 T.C. 788 (1978); G.C.M. 39503, Issue (2)(C)(1)(a), supra note 4, but see Priv. Ltr. Rul. 81-02-029 (Oct. 14, 1980) (applying traditional private annuity sale analysis to basis determination in a secured private annuity sale without comment).
112G.C.M.

39503, Issue (2)(C)(1)(A), supra note 4.

2-23

cases requiring immediate recognition for secured private annuity sales did so as an application of cash accounting principles and did not discuss installment sales, because, at that time, contingent deferred payment sales were not eligible for installment sale treatment. This is no longer true.113 Accordingly, the IRS position may create an anomaly in that an unsecured SCIN or private annuity sale is taxed under annuity principles, while an identical secured one is an installment sale. This distinction is questionable and should be eliminated.114 The buying family member is not entitled to any interest deduction even though the portion of the payment representing the time value of money is annuity income for the selling family member.115 On the other hand, the buyer's initial basis of the family assets transferred is measured by the anticipated payments to the extent of the fair market value of the annuity obligation.116 Both of these results are inconsistent with those that apply to contingent payment installment sales,117 but are consistent with the exclusion of annuity transactions from the OID rules.118 Even with that exclusion, the denial of an interest deduction for the younger generation buyer is questionable.119

113See 114See 115See,

203. 206.1 F. e.g., Dix v. Commissioner, 392 F.2d 313 (4th Cir. 1968); G.C.M. 39503, Issue (2)(C)(3), supra

note 4. Rul. 55-119, supra note 103; G.C.M. 39503, Issue (2)(C)(2)(a), supra note 4. As the buying family member makes further payments, they are added to basis, apparently without regard to fair market value of the property. This converts the excess payment, a substantial part of which represents the time value of money, into a capital loss on disposition of the family business or financial assets.
117See 118 116Rev.

203.2 and 203.4 B; Example 28 in 208.2 A.

1275(a)(1)(B) (debt obligation does not include amounts taxed as annuities). In G.C.M. 39503, supra note 4, and Priv. Ltr. Rul. 90-09-064 (Dec. 8, 1989), the IRS indicated that it will continue to apply the 72 annuity rules instead of the 453 installment method to private annuity sales. Manning and Hesch, supra note 2, at 37-38.

119See

2-24

The younger generation buyer's initial tentative basis for the property is increased when payments exceed the initial basis estimate.120 Because there is no interest

deduction, this occurs well before the end of the selling senior family member's actuarial life expectancy.121 If the family seller dies before payments equal the tentative basis, the basis is reduced to payments already made.122 A younger generation buyer who disposes of the property during the selling family member's lifetime, generally computes gain or loss using the tentative basis at the time of the sale; subsequent payments are additional losses on sale of the family assets.123 When a private annuity sale provides the consideration for a transfer that is partsale, part-gift, the IRS view is that gift portion of the transaction is determined using the transfer tax tables instead of the AFR. Otherwise, the principles are the same as for partsale, part-gift in a fixed payment installment sale.124 202.3 Impact of Chapter 14

When the intended source of payment for the deferred payment obligation to purchase the family business (or other family financial assets) is the income generated by the assets purchased, and the payment is dependent on the selling senior family member's life, there is an appearance of a retained interest in the property transferred. Nevertheless, the family financial assets sold should not be included in the gross estate of the selling senior family member as a retained life estate under 2036(a) or as a retained interest under Chapter 14. Under former 2036(c) such interests required inclusion of the transferred property unless the interests met the requirements as qualified debt, which
120Rev. 121See

Rul. 55-119, supra note 103; G.C.M. 39503, Issue (2)(C)(2)(a), supra note 2.

Manning and Hesch, supra note 2, at 26-27; Example 30 in 208.2 B.

Rul. 55-119, supra note 103; G.C.M. 39503, Issue (2)(C)(2)(a), supra note 4; see Example 32 in 208.2 B.
123See 124See

122Rev.

Rev. Rul. 55-119, supra note 103; see also 208.2. 201.10 ad 207.10; Example 33 in 207.2 C.

2-25

annuity interests could not do.125 Section 2701 applies only to retained equity interests, and, thus, does not apply to debt obligations. Accordingly, a bona fide deferred payment sale should fall outside of 2701 even when the payment is in the form of a private annuity sale, but not if the payments are dependent on earnings.126 203 Contingent Payment Installment Sales To deal with valuation and other uncertainties, a family sale arrangement may include terms making part or all of the price for the family business contingent on future gross income, net profits or some other measure of performance.. To the extent the sale is intended to provide financial security for the senior family member, payments may also be dependent on his or her life.127 Contingent price sales qualify as installment sales.128 203.1 Recovery of Basis

When an installment sale of family financial assets involves a contingent price, a significant problem is allocating the selling shareholder's basis in the property among the contingent payments. The three basic approaches for basis recovery under the temporary regulations determine the gross profit based on the terms of the contingency, that is, whether there is a maximum price, a maximum payment period or neither.129 A. Stated Maximum Selling Price

If the agreement for the sale of the family business provides a maximum selling price, computation of the gross profit ratio assumes that the maximum price will be re-

125See 126See

Notice 89-99, Part V(C), 1982-2 C.B. 422,430.

Leimberg, Johnson, Doyle and Kurlowicz, Sections 2701-2704: Good Motives But A Tough Law To Follow, 16 Tax Management Est. Gifts & Tr. J. 83, 88 (1991).
127See 128

202 and 204.

453(j); Temp. Reg. 15A.453-1(d)(2)(iii); Under prior law, the selling price had to be fixed and determined in order to be eligible for installment reporting. In re Steen, 509 F.2d 1398 (9th Cir. 1975).
129Temp.

Reg. 15A.453-1(c).

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ceived, and that, in estimating imputed interest or original issue discount,130 all contingent payments will be received on the earliest possible date.131 These dual rules have the effect of maximizing the estimated selling price and gross profit. This, in turn, means that a larger portion of the early payments is gain, and a smaller portion is recovery of basis because a portion of basis is reserved to be allocated to the last possible dollar of contingent payment.132 If less than the maximum contingent payment is received

ultimately, any unrecovered basis at the end is deducted as a loss.133 The loss should be characterized as a loss on the property sold, not a loss on the annuity obligation.134 B. Maximum Payment Period

If there is no maximum selling price for the family financial assets, but there is a maximum term, the selling family member's basis in the property sold is allocated ratably over the term.135 In other words, the portion of the annual principal payments that is recovery of basis is determined by dividing the selling senior family member's basis for the family financial assets transferred by the fixed term of the buyer's obligation.136 All principal payments for each year that exceed the annual basis allocation are gain realized from the sale of the asset. If in any year the payments received are less than the basis allocated to that year, the excess basis is not a loss, but is carried forward.

130See

201.7. Reg. 15A.453-1(c)(2).

131Temp. 132See

Example 34 in 208.1 A. Reg. 15A.453-1(c)(2)(iii) Example (8).

133Temp. 134See

209.1 A. Reg. 15A.453-1(c)(3).

135Temp. 136See

Examples 35 and 36 in 209.1 B.

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C. Period

Neither Stated Maximum Selling Price Nor Maximum Payment

If the sales contract does not limit the amount of the younger generation buyer's obligation and does not limit the periodic payments to a fixed period, the selling senior family member can recover basis ratably over an arbitrary 15-year period, commencing with the date of sale.137 This also has the potential for distorting basis recovery.138 The temporary regulations also caution that the transaction may not constitute a sale.139 D. Special Basis Recovery

To deal with the basis recovery problems highlighted above, the regulations make a limited provision for adjustment of the systems provided for basis recovery under the maximum-price, maximum-time and 15-year provisions by the IRS either on its own initiative or upon a taxpayer ruling request.140 The IRS has been relatively liberal in allowing realistic adjustments when there are both fixed and contingent payments.141 203.2 Determining the Buyer's Basis

The temporary installment sale regulations determine only the tax consequences to the selling senior family members; the younger generation buyer's basis is determined under the proposed regulations relating to original issue discount ("OID") and unstated interest. These regulations apply because contingent payments almost inevitably involve OID or unstated interest.142 Those proposed OID and unstated interest regulations, in

137Temp. 138See 139See 140See

Reg. 15A.453-1(c)(4).

Example 37 in 209.1 C. 209.1 C.

Temp. Reg. 15A.453-1(c)(2)(i), (c)(3)(i), (c)(4) and (c)(7); (allow use of other methods to prevent substantial acceleration or deferral of basis recovery).
141See

208.1 D.

Reg. 1.483-5 and 1.1274-4; see 203.1. If the terms of the sale provide for interest payable at the time of a principal payment at a fixed or qualified variable rate in excess of the AFR, there is technically no OID or unstated interest. Cf. Temp. Reg. 15A.453-1(c) Example (4) (providing a payment

142Prop.

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contrast to the temporary installment sale regulations, take the approach that younger generation buyer cannot obtain any basis for undertaking a contingent obligation, but that basis includes payments only as they become fixed.143 This approach is inconsistent with the rules contained in the contingent payment installment sale regulations for determining the selling senior family member's gain and basis recovery.144145 Although the proposed regulations recognize the inconsistency, they does not explain or justify it.146 203.3 Electing Out of Installment Method

A selling senior family member who desires to recognize the entire gain realized on a sale in the year of the sale, instead of deferring the gain under the installment method, can accelerate reporting gain by electing out of the installment method.147 The entire gain is realized in the year of sale, with the fair market value of the contingent obligation presumed to be at least equal to the fair market value of the family business or other assets sold or the fair market value of the contingent payment obligation itself.148 203.4 OID and Unstated Interest

The contingent payment OID and unstated interest regulations provide radically different approaches to determining the inherent interest when the family business or other financial assets are publicly traded and when they are not.

recharacterization provision to avoid the penalty interest rate under 483 prior to amendment by the Tax Reform Act of 1984). Reg. 1.483-5(b)(3)(iv), 1.483-5(d) Example (3)(i); 1.1275-4(d)(2). See Albany Car Wheel v. Commissioner, 40 T.C. 831, aff'd per curiam, 332 F.2d 653 (2d Cir. 1964) denying the buyer a basis for his contingent obligation. Payments contingent only as to time may provide basis. Reg. 15A.453-1(c); see 203.1, Example 39 in 209.2, 203.4 B and 209.4 B. See also G.C.M. 39503, Issue (2)(C)(2)(b) discussed in 204.3 B3.
145See 144Temp. 143Prop.

203.4 B and 209.4 B. Reg. 1.1275-4(d)(2)(i).

146Prop. 147

453(d). Reg. 15A.453-1(d)(2)(iii); see 209.3.

148Temp.

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A.

Publicly-Traded Property

It is the rare family situation in which either the shares of the family business or a family corporate buyer's debt obligations are publicly traded, but less rare for other family assets to be traded. When they are, generally there is no installment sale.149 For sales of such assets, the market prices determine the sale price of the property sold and the related issue price of the buyer's debt obligation.150 If the buyer's debt obligations are publicly traded, their market price controls. If they are not traded, but the family

business shares are, the share price controls. The timing of the recognition of the inherent interest then depends on whether any fixed payments exceed the issue price.151 B. Property That Is Not Publicly Traded

When the agreement for the sale of a family business or other financial assets provides for contingent payments, it is difficult to provide for qualified interest payments.152 When there is no public trading to establish the issue price, it is impossible to accrue the corresponding original issue discount on the younger generation buyer's obligations until the contingencies are resolved and the payments become fixed.153 When the contingencies are resolved, the proposed OID regulations provide that for sales of family business shares where this is no public trading of the shares or the debt obligations, each payment, when made, is allocated between principal and interest with the portion equal to the discounted value of the payment made as of the initial sale date

149 150

453(k)(2); see 201.9. 1273(b)(3); Prop. Reg. 1.1273-2(c)(1). Reg. 1.1275-4(e)(1) and (f)(1); see Example 40 in 209.4 A.

151Prop. 152A

provision for an additional payment equal to interest at a fixed or qualified variable rate on the amount of the payment from the date of sale technically is qualified interest. Cf. Temp. Reg. 15A.4531(c)(4) Example (4) (providing a payment recharacterization provision to avoid the penalty interest rate under 483 prior to amendment by the Tax Reform Act of 1984). The effect is the same as not providing a separate interest calculation.
153See

Prop. Reg. 1.1275-4((a)(3).

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treated as principal and the balance as interest.154 This method of computing interest treats a greater portion of the earlier payments as principal than would be the case if interest were computed on the entire stated principal, that is, it back-load the interest. When the terms of sale provide a maximum price, the stated maximum price limits the amount of the contingent payments that is principal and the younger generation buyer's maximum potential basis.155 The approach of the proposed OID regulations is different from that of the temporary installment sale regulations dealing with maximum price contingent payment sales.156 Under the temporary installment sale regulations, the maximum price is to be determined by discounting deferred payments at the prescribed rate for what is called "internal interest" and on the assumption that the maximum payments will be made at the earliest possible date.157 This also has the effect of back-loading the interest, but, in addition, maximizes the potential sales price and defers the recovery of basis. 204 204.1 Self-Cancelling Installment Notes When Used?

A family seller not primarily concerned about building up her estate for tax or other purposes, may desire a sale in which the payments are limited by her life expectancy. When the arrangement involves a fixed term with a limit based on life, it is sometimes called a self-cancelling installment note ("SCIN"). When the payment period extends throughout the selling family member's life with no other limit even if it has a minimum number of payments, it is a private annuity sale.

154Prop. 155Prop. 156The

Reg. 1.1275-4(c)(3) and 1.483-5(b)(3); see Examples 41 and 42 in 209.4 B. Reg. 1.1275-4(c)(3)(ii) and 1.483-5(b)(3)(iii).

proposed regulations recognize the inconsistency, but do not explain or justify it. Prop. Reg. 1.1275-4(d)(2). See 209.4 B.
157Temp

Reg. 15A.453-1(c)(2)(i)(A) and (c)(4) Example (2).

2-31

A SCIN is appropriate when the selling family member does not feel the need to receive payments for his or her entire life, as long as he or she receives an adequate capital value. The maximum term places a cap on how much the younger generation buyer pays, but limits the selling senior family member's life-time security. A SCIN is a hybrid, using the installment approach in determining the maximum amount the younger generation buyer will pay, and the private annuity sale approach in the event the selling senior family member dies before the end of the payment term. Because the selling senior family member no longer has a right to payment when the SCIN is terminated by its own terms on death, no amount is included in the gross estate.158 A major advantage of a private annuity sale to the senior family member seller is that the periodic payments for the life continue to fund his retirement even if he or she survives beyond the actuarial life expectancy age. The corresponding advantage to the younger generation buyer is that if the selling senior family member dies sooner than actuarially indicated, he or she may receive a bargain, paying less for the property than it is worth. Because of this risk, private annuity sales and SCINs are generally used only in sales between family members. The IRS apparently resolves the ambiguity created by the hybrid nature of a SCIN by classifying SCINs as private annuity sales when the maximum period exceeds the selling senior family member's actuarial life expectancy and as contingent payment installment sales when it does not.159 204.2 Valuation of a SCIN

Because there is both a cap on the amount the younger generation buyer will pay and a possibility the buyer will pay less than the maximum, the amount of each annual payment, and the potential total price if the seller lives to receive all payments, under a

158Estate 159See

of Moss v. Commissioner, 74 T.C. 1239 (1980). acq; Cain v. Commissioner, 37 T.C. 185 (1961)..

204.3.

2-32

SCIN must be greater than the annual payments under an installment sale to have the same present value.160 In other words, the risk factor attributable to the fact that the selling senior family member may die prematurely creates a premium that must be reflected if the parties want the present value of a SCIN obligation to equal the value of the property purchased. And, since there is a maximum term for the payments, this factor must also be recognized, resulting in an annual payment for a SCIN that is also larger than for a private annuity sale payment that extends throughout the selling senior family member's life.161 Comparing installment sales, private annuity sales and SCINs is complicated because the transfer tax valuation tables162 use shorter life expectancies in determining the value of a deferred payment obligation than the annuity tables under 72, and because 7520 mandates use of a discount rate of 120% of the AFR.163 Therefore, the principal amount of a deferred payment obligation determined for income tax purposes using the AFR and, if applicable, the annuity tables under 72, may be greater than the value determined for transfer tax purposes. The IRS position is that the transfer tax mortality tables and discount rates determine whether a gift has been made in the private annuity sale.164 However, the IRS goes on to state that there is no requirement to use these transfer tax tables in valuing an installment sale, including a contingent payment sale, but that facts and circumstances
and Hartz, Sales of Property: Will Self-Cancelling Installment Notes Make Private Annuities Obsolete?, 59 TAXES 499, 501 (1981)
161See 160Banoff

Example 43 in 210.1.

20.2031-7(f) and 25.2512-5(f) and Actuarial Values Alpha Volume: Remainder, Income and Annuity Factors for One Life, Two Lives, and Term Certains. Interest Rates from 2.2 Percent to 26.0 Percent. For Use in Income, Estate, and Gift Tax Purposes including Valuation of Pooled Income Fund Remainder Interest, IRS PUBLICATION 1457 (889) (the "ALPHA VOLUME") Table 80 CNSMT page 6-1 (using 1980 census data).
163See

162Reg.

201.7 G. 39503, Issue (2), supra note 4.

164G.C.M.

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approach may be used.165 The anomaly is that a SCIN treated as an installment sale can use the AFR and the longer life expectancy multiples found in Reg. 1.72-9 in determining its value for transfer tax purposes than a SCIN treated as a private annuity sale.166 204.3 Income Tax Treatment of a SCIN

It is not entirely clear when a SCIN is taxed under the installment reporting rules of 453 or under the annuity rules of 72. The IRS position is that if the selling senior family member's life expectancy, using the mortality assumptions in Reg. 1.72-9, is less than the maximum term of the SCIN, it is a private annuity sale under 72, and if the seller's life expectancy is greater than the loan term, it is taxable as an installment sale with a contingent sales price under Temp. Reg. 15A.453-1(c).167 In addition to the effects of life expectancy and discount rate differences,168 there are several crucial income tax differences between these two approaches. The timing of the selling senior family member's gain and ordinary income, the buyer's deductions for the time value of money, the buyer's basis, and the effect of the seller's premature death all differ. There is further confusion because a private annuity sale cannot be secured,169 but an installment sale can.170

165Id. 166See

204.3.

39503, supra note 4. In Rev. Rul. 86-72, 1986-1 C.B. 253, the IRS discussed how the installment sale rules under 453B and 691(a) applied upon the death of a seller under a SCIN. The maximum term of the obligation in this ruling was 4 years and the seller's life expectancy was 21 years. See Example 44 in 210.3.
168See 169See 170See

167G.C.M.

204.3 and 210.3. 202.2. 201.2.

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A.

Under the Annuity Rules

The annuity rules applied to a SCIN are the same as for a straight private annuity sale with only minor modifications to reflect the maximum term. 1. The seller. In calculating the "expected return," the two factor life ex-

pectancy multiple under Reg. 1.72-9, Table VIII must be used. A SCIN is a "temporary life annuity" because it has a maximum duration. The "exclusion ratio" so determined allocates the same amount of principal and annuity income to each payment.171 2. The buyer. Even though the income tax consequences are determined

using the annuity tables of 72, the younger generation buyer uses an initial tentative basis equal the present value of the SCIN obligation under the transfer tax valuation tables. As for a standard private annuity sale, the younger generation buyer is not permitted an interest deduction.172 3. When the SCIN is cancelled. When the annuity rules apply, and the

SCIN is cancelled by the selling senior family member's death before the maximum payment term, the younger generation buyer's final basis under the annuity rules is limited to payments made.173 Neither the selling senior family member nor the estate reports the remaining gain inherent in the cancelled payments because the early disposition rules of 453B apply only to obligations reported on the installment method. The annuity reporting rules permit the selling senior family member to deduct any remaining basis on his final income tax return.174

171See 172See 173See 174

Example 45 in 210.3 A. Examples 46 and 47 in 210.3 B. Example 48 in 210.3 C.

72(b)(3)(A); see 202.1; see also Example 49 in 210.3 C.

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B.

Under the Installment Method When a SCIN is treated as an installment sale under the IRS approach, the in-

stallment method as applied to contingent payment sales,175 employs dramatically different rules from those that pertain to a SCIN classified as a private annuity sale. 1. The seller. A SCIN is a contingent payment sale with a stated maximum

selling price.176 The maximum selling price is the "selling price" that is used in the denominator of the "gross profit ratio," and determines the "gross profit" used in the numerator.177 It is not clear whether the entire premium representing the risk that the selling senior family member will die before the end of the note term must be treated as additional principal, or can be treated as additional interest as long as the interest does not become so high as to be excessive.178 The IRS has not issued any guidance on this issue.179 2. The buyer. The proposed contingent payment regulations, Prop. Reg.

1.1275-4(d)(2), take the position that a younger generation buyer does not have any initial basis for undertaking a contingent payment obligation. Instead, basis is obtained only as principal payments under the contingent payment obligation become fixed.180

175See

204 and 209. Reg. 15A.453-1(c)(1) and (2). Reg. 15A.453-1(c)(2)(i)(A),(b)(2)(ii) and (b)(2)(v).

176Temp. 177Temp. 178See

207.7 H.

has been a debate on the treatment of this risk premium. Compare Blum, Self-Cancelling Installment Notes -- The New SCIN Game?, 60 TAXES 183 (1982), with Banoff and Hartz, It's No Sin to SCIN! A Reply to Professor Blum, 60 TAXES 187 (1982). See Examples 50 to 53 in 210.3 B
180See

179There

Example 54 in 210.3 B.

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3.

When the SCIN is cancelled. If the tax treatment of a SCIN is governed

by the contingent payment installment reporting rules, the remaining capital gain is accelerated upon cancellation of the obligation of a related party.181 Although the entire capital gain inherent in the deferred payment obligation is reported even though the obligation is cancelled, there may be no symmetrical treatment for the younger generation buyer's basis. Under the proposed contingent payment

regulations, the buyer undertaking a contingent payment obligation may obtain basis only for principal payments actually made.182 This anomalous result should not apply and the younger generation buyer's basis should equal the principal amount of the obligation.183 4. Treatment as contingent payment sale with a maximum selling price.

If a SCIN is taxable as an installment sale, it is a contingent deferred payment obligation with a maximum selling price, and the tax consequences are governed by the treatment described in Temp. Reg. 15A.453-1(c)(2).184 204.4 Comparing SCINS as Installment Sales and Private Annuity Sales

The selling senior family member's interest income and the younger generation buyer's potential interest deduction are matched when the installment method applies, but the buyer does not deduct the equivalent of the selling senior family member's annuity income for a private annuity sale. The younger generation buyer is allowed a tentative initial basis when the SCIN is taxed as private annuity sale, but not when it is an installment sale.

181Rev.

Rul. 86-72, supra note 167, and G.C.M. 39503, supra note 4; see 201.4.

Reg. 1.483-5(b)(3)(iv) and 1.1275-4(c)(4) Example (1)(iii); but see G.C.M. 39503, Issue (2)(C)(2)(b), supra note 4 allowing the buyer who purchases for a contingent price to include the maximum principal amount of the obligation in basis.
183See 184See

182Prop.

Examples 55 and 56 in 210.3 B. Examples 57 and 58 in 210.3 B.

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Nothing is included in the selling senior family member's gross estate when a SCIN is taxed under the installment method or as a private annuity sale. The remaining unreported capital gain is accelerated when the related party buyer's SCIN obligation terminates on the senior family member's death under the installment method, but not under the private annuity sale rules. To maintain symmetry, the related buyer's basis should equal the principal amount of the SCIN under the installment method, but is limited to payments made in a private annuity sale. Because of the lack of anything resembling an interest deduction for the buyer under the private annuity sale rules, the buyer's ultimate basis may greatly exceed the fair market value of the property under any reasonable assumption if the senior family member seller lives for any significant period after the sale.185 205 Private Annuity Sales as Installment Sales Just as a SCIN can (and should) qualify under the installment method, a standard private annuity sale can also qualify under the statutory definition of an installment sale as: [A] disposition of property where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs.186 The IRS, picking up on a portion of the legislative history of the 1980 Act that stated that the Act "does not deal directly" with private annuities,187 has stated that it will not treat private annuity sale transactions under the installment method.188 As is

185See 186

Example 59 in 210.4.

453(b)(1). See Temp. Reg. 15A.453-3(d)(2)(iii).

H.R. Rep. No. 1042, 96th Cong., 2d Sess. 10, note 12 (1980); S. Rep. No. 1000, 96th Cong., 2d Sess. 12, note 12 (1980) (emphasis added). G.C.M. 39503, the IRS took this position because it felt that the intent of the 1980 Act was to cover only those cases where the contingency relates to the profitability of the property purchased. In Priv. Ltr. Rul. 90-09-064 (Dec. 8, 1989), the IRS ruled that a private annuity sale of a remainder interest in property is subject to the 72 annuity rules described in Rev. Rul. 69-74.
188In

187See

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discussed later in this paper, there are compelling reasons to treat private annuity sales as contingent payment installment sales eligible for the installment method. 205.1 In General

The application of the installment method to pure private annuity sales is no more difficult than doing so for SCINs, either theoretically or practically. The only additional complication is the absence of a maximum price. 205.2 Annuity Sales If it is classified as an installment sale, a private annuity sale appears to be one with neither a maximum price nor a maximum payment period.189 Nevertheless, it is not unreasonable to tax it by analogy as one with a tentative fixed period based on the actuarial life expectancy or with a maximum price computed on the same basis as is done under the traditional private approach.190 A. Treatment as an Installment Sale with Neither Maximum Price nor Application of the Contingent Payment Regulations to Private

Fixed Period Under the terms of a private annuity sale, the payments are not limited to a maximum term and there is no limitation on the aggregate of the payments. Therefore, treatment as a contingent payment installment sale requires the use of a 15-year amortization period to determine the return of basis inherent in each principal payment.191 Under a parity of reasoning, the contingent payment OID and unstated interest rules apply to treat each payment as a separate OID debt obligation for purposes of determining the interest inherent in the payment with the consequent back-loading of interest.192
189See 190See

203.1 and 209.1 Manning and Hesch, supra note 2, at 27 to 32. Reg. 15A.453-1(c)(4); see Example 60 in 211.2.

191Temp. 192Prop.

Reg. 1.483-5(b)(3)(i) and 1.1275-4(c)(3)(ii).

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B.

Treatment as an Installment Sale with a Maximum Selling Price or

Fixed Term Since the contingent payment installment sale regulations presume that the value of a contingent payment obligation equals the value of the property sold,193 a private annuity sale can be viewed as a contingent sale with a maximum selling price. In other words, the value of the property, or, in a part-sale, part-gift, the actuarial value of the buyer's annuity obligation, can be treated as the maximum selling price. Further, as for a contingent sale having a maximum stated principal amount, once the aggregate of the portion of the contingent payments treated as principal equals this maximum amount, any additional contingent payments are treated entirely as interest.194 Similarly, the actuarial life expectancy can be viewed as a fixed payment period. Under this approach, the selling senior family member's basis in the property is spread ratably over the actuarial life expectancy in a manner similar that now provided for a private annuity sale.195 Either of these approaches appears to provide a more sensible approach to basis recovery than the arbitrary 15-year period. Accordingly, either should be available under a liberalized version the regulation's provision for alternate methods.196 Although the proposed contingent payment regulations under 1275 do not permit the younger generation buyer to obtain an initial basis for incurring a contingent

193Temp. 194Prop.

Reg. 15A.453-1(d)(2)(iii) takes this view for election out purposes under 453(d).

Reg. 1.483-5(b)(3)(iii) and 1.1275-4(c)(3)(ii); see Example 61 in 211.2 B. This approach should be contrasted with a contingent payment sale having neither a maximum selling price nor a fixed term where the principal portion of all payments continues to be treated as additional amount realized, thereby generating capital gain.
195See 196See

203.1 B, 209.1 B and 202.2. 203.1 D and 209.1 D.

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obligation,197 this approach should not apply to a private annuity sale treated as a contingent payment installment sale with a maximum selling price.198 C. Private Annuity Sale of Publicly-Traded Property

A private annuity sale of publicly-traded property cannot qualify under the installment method.199 Nevertheless, it is more appropriate to apply the publicly-traded contingent payment sale regulations that use the AFR to determine the accrued interest, than to use the 7520 rate.200 205.3 Comparison of Installment Method and Annuity Treatment

As set forth in 211.3, we have identified at least eighteen differences between private annuity sale and installment sale treatment. Some are the result of the historic development of the private annuity sale as a special application of cash accounting as discussed above, but many are attributable to the inapplicability of recent limitations on installment reporting to private annuity sales. We are not so vain as to suggest that our list of eighteen is comprehensive. We do suggest that most of these differences simply should not exist in a sound tax system. Moreover, the IRS can correct most of the problems without further legislation if it abandons the positions it has taken in G.C.M. 39503 and makes the installment method applicable to all deferred payment sales, even those measured by one or more lives.201 206 Recommendations for Changes in the IRS's Position All private annuity sale obligations and all SCINs should be treated as contingent installment sale obligations with the same limitations and other rules. Since all of these
Reg. 1.483-5(b)(3)(iv) and 5(d) Example (3)(i), and 1.1275-4(c)(4) Example (1)(iii); see 203.2 and 209.2.
198See 199 197Prop.

204.3 B2 and 210.3 B2.

453(k)(2)(A); see 201.9. Example 63 in 211.2 C. 206.

200See 201See

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deferred payment vehicles are similar and have similar financial objectives, the tax treatment of all three should be consistent. Consequently, all three financing vehicles should be subject to the subject to the temporary contingent payment installment sale regulations,202 including the exclusions from deferral of gain,203 and to the proposed contingent payment OID and unstated interest regulations.204 Simply stated, private annuity sales and SCINs should no longer be treated as annuities subject to the 72 annuity rules, even if they do not qualify under the installment method. A possible compromise approach is to make private annuity sale treatment available for those electing out of the installment method and possibly for sales that do not qualify under the installment method, relying on the denial of the interest deduction to limit abuses.205 Treating private annuity sales and all SCINs as contingent payment obligations under the temporary and proposed regulations would achieve three objectives. The first is symmetrical treatment between the younger generation buyer and the selling senior family member in the same transaction, so that both the younger generation buyer and the selling senior family member would treat the time value of money and the gain and basis aspects of the transaction consistently. The second eliminates the valuation disparities between the income tax and transfer tax treatment of the same transaction. The third maintains the integrity of the various safeguards and eligibility requirements found in the 453 installment reporting rules. 206.1 Symmetrical Treatment of the Buyer and Seller

Treating private annuity sales and all SCINs as contingent payment installment sales would have the following results:

202Temp. 203See

Reg. 15A.453-1(c).

201.9. Reg. 1.483-5 and 1.1275-4.

204Prop. 205See

Manning and Hesch, supra note 2, at 21.

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A.

Eliminate the Application of 72

If 72 does not apply to a transaction, the OID and unstated interest rules do.206 This provides for consistent reporting of the selling senior family member's interest income and the younger generation buyer's possible interest deduction. As a contingent payment obligation the interest element inherent in a private annuity sale obligation is reported, either back-loaded or front-loaded as the case may be, as it is deemed to have accrued.207 B. Sales Elimination of private annuity sale treatment and the application of the OID and unstated interest provisions apparently denies the younger generation buyer a tentative basis for the value of the annuity obligation, and provide basis only as payments become fixed.208 Nevertheless, the experience with the private annuity sale rules shows that a tentative basis is feasible and does not raise the same type of problems as other types of contingent obligations, particularly the transfer of contingent liabilities.209 Accordingly, the proposed OID and unstated interest regulations should be amended to provide such a tentative basis for SCIN and private annuity sale obligations, particularly in light of the fact that the application of the installment method to related party sales insures that the inherent gain will be reported. Permit the Buyer a Tentative Basis for SCINS and Private Annuity

206See 207See 208See 209See

202.2. 203.4 A and B. 203.2. 202.2.

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C.

Report Gain on Obligations Terminated by Death on the Seller's

Final Return for Related Party Sales Rev. Rul. 86-72 requires the selling senior family member's estate to treat the cancelled payments from a related party as having been received by the estate.210 If the capital gain inherent in the cancelled payments is to be reported, the IRS is wrong in requiring that the capital gain be reported by the selling senior family member's estate. Instead, that gain should be reported on the seller's final income tax return.211 This places the gain where it belongs, and when the related party rules do not apply, permits the proper loss deduction for any unrecovered basis. It is also consistent with not including anything in the selling senior family member's gross estate. The provisions of 691 should not be applicable since, following the seller's death, the SCIN is neither included in the seller's gross estate nor transferred to or possessed by the estate.212 D. Apply the Same Rules to All SCINS

The distinction used in G.C.M. 39503 to determine when a SCIN is treated as an installment sale and when it is treated as a private annuity sale makes no sense.213 Treating private annuity sales as contingent payment installment sales gives this distinction a proper burial.

note 163. G.C.M. 39503, supra note 4, consistently gives the buyer a basis is the property equal to the amount of the note. See 203.2. This G.C.M. was issued in 1985, a year before the proposed OID and unstated interest regulations were issued and may be superseded on this point by the regulations if they become final in their present form. The inconsistency only affects related party sales under which the seller is required to report the gain in all events. If the buyer is an unrelated party, the unreported gain disappears if the obligation is cancelled by its terms. See 210.3 A.
211 212

210Supra

453B(f). See Banoff and Hartz, supra note 160, at 150.

691 is applicable only when income in respect of a decedent is not reported on the final income tax return.
213See

204.2 and 204.3.

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E.

Eliminate the Disparity Between Secured and Unsecured Private

Annuity Sales Under present case law and IRS views, a secured private annuity sale probably is eligible for installment reporting while an unsecured private annuity sale is not.214 Treating all private annuity sales as contingent payment obligations eliminates another unjustified distinction. F. Sales. Treating all SCINs and private annuity sales as contingent payment sales with a maximum selling price, provides a sensible front-loading of interest,215 an appropriate allocation of basis,216 eliminates the SCIN-PRIN, SCIN-INT quandary,217 and is consistent with providing a tentative basis.218 The maximum selling price approach requires that the principal amount of the obligation be equal to the value of the property purchased, which is the actuarial value of the annuity. Consequently, the risk factor for all SCINs is interest. G. Limit Basis to Fair Market Value Treat All SCINS and Private Annuity Sales as Maximum Price

Treating all SCINs and private annuity sales as contingent payment sales with a maximum selling price limits the younger generation buyer's basis to the value of the property purchased.219 Once the aggregate of the principal payments reaches this

maximum, any subsequent payments are interest. Therefore, the buyer's basis for assets purchased is properly related to its value.
214See 215See 216See 217See 218See 219See

202.2 and 203. 203.4 A and B. 204.3 B and 205.2 B. 210.3 B. 206.1. 203.4 B.

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H.

Clarify Character of Loss on Unrecovered Basis Upon Cancellation

In a SCIN or private annuity sale treated as a contingent payment installment sale, if the selling senior family member has not recovered all of his basis in the asset sold before the payments terminate, the selling senior family member deducts any unrecovered basis when the sale is not to a related party.220 The character of that deduction should be determined by reference to the character of the asset sold and not as a loss on an independent obligation.221 206.2 Eliminate Valuation Anomaly

The same valuation rules should be used for all types of intra-family deferred payment sales. A. Eliminate Unintended Gift Issue

Treating all SCINs and private annuity sales as installment sales means that the AFR determines the discount rate.222 If the same valuation principles are used for both income and transfer tax purposes, valuation disparities for the same transaction can be avoided. Therefore, 7520 does not apply. Consequently, the unintended gift problem and other distortions can be avoided.223 B. Use Uniform Mortality Tables of 72

Treating all SCINs and private annuity sales as installment sales also means that the more realistic and longer mortality assumptions found in the 72 regulations apply.224 Consequently, the same valuation approach is used to determine the proper payment for income and transfer tax purposes.
220See 221See 222See

204 B3. Arrowsmith v. Commissioner, 344 U.S. 6 (1952); see also 204.3 B3 and 209. 201.7 G and 204.2.

if the income and gift tax use the same mortality assumptions and the same interest rates, this disparity can be reduced but not eliminated entirely. See Temple, Real and Apparent Anomalies in the Private Annuity Tables, 2 TAX LAW J. 147, 156-62 (1985).
224See

223Even

204.2.

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C.

Eliminate Abuses in Private Annuity Sales

An approach not rigidly tied to the transfer tax tables that allows resort to facts and circumstances in valuations, results in more realistic valuation and eliminates the abuse found in some private annuity sales. Frequently, a private annuity sale is used when the selling senior family member is expected to die before reaching his actuarial life expectancy age. The installment sale approach allows the IRS to take into account the selling senior family member's health in determining the real value of the private annuity obligation for gift tax purposes, instead of relying strictly upon the mortality assumptions used in the transfer tax valuation tables.225 206.3 Maintain the Integrity of the 453 Rules

There is no statutory support for denying deferral under the 72 annuity rules for situations that are not eligible for deferral under the 453 installment rules. Further, there are other safeguards in the 453 installment rules not found in the 72 annuity rules. Treating private annuity sales and all SCINs as a contingent payment installment sales, applies the installment sale eligibility rules and other safeguards. Specifically, the following eligibility rules and safeguards are preserved: 1. 2. 3. 4. 5.
225See 226 227 228

The anti-Rushing rule applies.226 Dealer and inventory sales do not qualify.227 Sales of publicly-traded securities do not qualify.228 Depreciation recapture cannot be deferred.229 The early disposition rules apply.230

207.7 G.

453(e); see G.C.M. 39503, Issue (2)(C)((1)(ii). 453(b)(2); see 201.9.

453(k)(2); see 201.9. 453(i); see 201.9. 453B; see 201.4.

229 230

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6. loan.231 7. 8.

Gain is accelerated when an obligation is pledged as collateral for a

Interest must be paid on deferred gain on large sales.232 The basis first approach is not available.233

231 232

453A(d); see 201.4. 453A(a)(1). Reg. 15A.453-1(d); Rev. Rul. 69-74, supra note 103; 202.2 and 203.3.

233Temp.

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PART II COMPREHENSIVE DESCRIPTION 207 207.1 Installment Method for Fixed Payment Obligations In General

It is easy to compute the gross profit ratio and apply the installment method to simple sales. When the facts become more complicated, particularly when the property is mortgaged, so does the computation. Example 1 sets forth the basic facts that are used in many of the examples that follow. S is a senior family member who wishes to transfer control of family financial assets to B, a younger family member. Example 1: S owns land held as a capital asset with a basis of $1,700,000 and a value of $2,500,000. The land is subject to a $1,750,000 mortgage. B purchases the property from S on December 31, 1989, paying no cash at the December 31 closing. The sales contract requires B to pay $150,000 cash one day later on January 1, 1990, and take the property subject to the outstanding mortgage. At closing B delivers a note with a face or principal amount of $600,000, providing annual payments of $50,000, starting on January 1, 1991. The note also requires B to pay 10% interest on the unpaid balance with each annual payment. The long-term AFR at the date of sale was 8.75%, so there is no imputed interest. The amount realized of $2,500,000 is composed of the $150,000 cash received the following day, the $1,750,000 mortgage, and the $600,000 principal of B's note. Accordingly, S's realized gain on the sale is $800,000. For purposes of reporting the $800,000 capital gain under the installment method, the gross profit ratio is 100%. Even though the gross profit is $800,000 and the "sale price" is $2,500,000,234 it is the "contract price" that is used as the

234Temp.

Reg. 15A.453-1(b)(2)(ii); see also 201.2 and 207.2.

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denominator of the gross profit ratio. The contract price is defined as the selling price reduced by the portion of the qualifying indebtedness which does not exceed S's basis in the property.235 In other words, the amount of the mortgage is subtracted from the selling price, but the maximum reduction in the denominator cannot be more than S's basis in the property sold. The remaining $50,000 of the mortgage is treated as a deemed payment at the time of sale. Therefore, the gross profit ratio is 100%, computed as follows: (i) (ii) $2,500,000 - $1,700,000 = $800,000, contract price $800,000/$800,000 = 100%, gross profit ratio

In effect, the entire $1,700,000 basis in the land is applied against $1,700,000 of the outstanding mortgage. In other words, the deemed receipt of $1,700,000 is treated in its entirety as a return of basis. S's basis in the installment note is zero. Accordingly, the $800,000 gain is reported as follows: At time of sale (excess liability) Jan. 1 of next year (down payment) Annually (as payments received) Total Gain $ 50,000 150,000 600,000 $800,000

Postponing receipt of actual payments does not postpone reporting of the deemed payment attributable to the excess liability transferred. If S elects out of the installment method under 453(d), she reports the entire $800,000 capital gain in year of sale,236 so that her basis in the $600,000 note is equal to its face amount. Thus, all principal payments on the note are a nontaxable recovery of basis.

235Temp. 236Temp.

Reg. 15A.453-1(b)(2)(iii); see also 201.3 and 207.3. Reg. 15A.453-1(d)(2)(i) and (ii); see also 203.3 and 209.3

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B's basis in the land is $2,500,000 from the date of sale, whether S uses the installment method or elects out. A. Standard Installment Sale

In a standard installment sale with interest on the entire balance paid with each principal payment, the portion of each payment that is gain remains constant, but the amounts of total payments and of interest are greater in the earlier years. Example 2: Following the sale described in Example 1, S collects all principal and interest payments on the $600,000 note. The following schedule shows the amount, character and timing of the income reported by S under the installment method: Year 1989237 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Totals Total Payments 150,000 110,000 105,000 100,000 95,000 90,000 85,000 80,000 75,000 70,000 65,000 60,000 55,000 $1,190,000 Basis $ 50,000 -0-0-0-0-0-0-0-0-0-0-0-0-0-0Capital Gain -0150,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 $800,000 Interest $ 50,000 -0$60,000 55,000 50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 $390,000 -0-

In this and the following examples, the gain is labelled capital gain for convenience in distinguishing it from the interest income (or in private annuity sales, the annuity income). If the family business or financial assets transferred are not

the $1,750,000 mortgage exceeds S's $1,700,000 basis by $50,000, that excess amount is treated as a fictional payment of cash received in the year of sale. Temp. Reg. 15A.453-1(b)(3)(i); see 201.3, 207.1 and 207.3.

237Because

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capital assets, the gain may be ordinary income.

In some cases the assets

transferred may not qualify for the installment method.238 B. Installment Sale with Level Annual Payments

Generally, interest is reported as it financially accrues.239 Accordingly, the annual payments for a deferred payment sale with level principal payments decrease each year as the unpaid balance and the interest accruing on it decline. This type of installment sale is referred to as a "decreasing payment" obligation. The selling senior family member may prefer level annual payments over the term of the note. This type of installment sale is called a "level payment" obligation. Residential mortgages are examples of level payment obligations. Although the younger generation buyer's obligation is, in effect, equivalent to guaranteed annuity for a fixed term, it is not an annuity subject to annuity treatment under 72 for purposes of the OID and unstated interest rules.240 It is not dependent on anyone's life nor is it issued by an insurance company. Since the value of this level payment obligation is the same as in a decreasing payment sale, the realized gain on the sale is the same. It is a self-amortizing installment obligation under the OID rules,241 that does not involve OID or unstated interest as long as the stated interest rate used to determine the payments is at least equal to the AFR.242 Nevertheless, the reporting of interest resembles a mortgage amortization table or an OID
238See 239In

201.9 and 207.9.

Example 2, the $60,000 of interest for 1990 represents the interest accrued during the 1990 calendar year on the $600,000 principal outstanding during that 12-month period and paid on January 1, 1991. If B and S are cash basis taxpayers, they are eligible to elect to report the interest income and interest deduction in the year paid under 1274A(c) because the principal amount of the note does not exceed $2,000,000. Therefore, S can defer reporting the interest income by one year but only if B defers the interest deduction. For a method of reporting the interest that is more realistic with financial principles, see Bankman and Klein, Accurate Taxation of Long-Term Debt: Taking into Account the Term Structure of Interest, 44 TAX L. REV. 335 (1989).
240Prop. 241Reg. 242Reg.

Reg. 1.1275-1(b)(2).

1.1273-1(b)(iii) and (iv). 1.1274-2(b)(1).

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computation, with an increasing portion of each subsequent payment treated as a principal payment on the note. The gross profit ratio is applied to the principal payments received each year. The total amount of the payments and interest is greater than with level principal payments because the principal is amortized more slowly. Example 3: The facts are the same as in Examples 1 and 2, but B agrees to pay the $600,000 balance over 12 years in level annual payments. In determining the level annual payment necessary to purchase an asset worth $600,000 at a 10% rate of interest over a 12-year term, the factor is 6.8137.243 Therefore, the annual payment is $88,058 per year for 12 years ($600,000 divided by 6.8137). This produces a deferred payment obligation (using a 10% discount rate) with a present value of $600,000. S's amount realized is $2,500,000 (the $150,000 cash, the $1,750,000 mortgage and the $600,000 value of the level payment obligation). S's realized gain is the same $800,000 as for a decreasing payment obligation. For purposes of reporting gain under the installment method the gross profit ratio is 100% because the liability transferred exceeds the basis of the property transferred. The following schedule shows the amount, character and timing of the income reported by S:

243See

Reg. 20.2031-7(f) (fixed-term annuity tables); ALPHA VOLUME, supra note 162, Table B, page 3-

20.

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Year 1989245 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Totals

Total Payments Received $ 50,000 150,000 88,058 88,058 88,058 88,058 88,058 88,058 88,058 88,058 88,058 88,058 88,058 88,058 $1,256,696

Capital Gain.244 $ 50,000 150,000 28,058 30,864 33,950 37,345 41,080 45,188 49,707 54,677 60,145 66,160 72,775 80,781 $800,000

Interest -0-0$ 60,000 57,194 54,108 50,713 46,978 42,870 38,351 33,381 27,913 21,898 15,283 7,277 $456,696

A comparison of the financial consequences of the two types of installment sales shows that the level payment approach results in additional payments of $66,694.56 over the 12-year term. This additional amount is interest and is attributable to the fact that the level payment does not amortize the principal on the loan as quickly as does the decreasing payment illustrated in Example 2. The outstanding principal during the term of the note for both payment arrangements is as follows:

principal payment on the note and the capital gain reported under the installment method are the same because the gross profit ratio is 100%. When there is basis to be recovered, the principal portion of the payment is divided between gain and basis recovery using the gross profit ratio.
245Fictional

244The

payment because liability exceeds basis.

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Principal Balance on the Note Decreasing Payments Example 2 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 $600,000 550,000 500,000 450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 -0Interest Income Reported Decreasing Payments Example 2 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Totals $ 60,000 55,000 50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 -0$390,000 Level Payments Example 3 $ 60,000 57,194 54,108 50,713 46,978 42,870 38,351 33,381 27,913 21,899 15,283 7,277 -0$456,696 Level Payments Example 3 $600,000 571,942 541,078 507,128 469,783 428,703 383,516 333,810 279,133 218,988 152,829 80,780 -0-

The choice of deferred payment arrangement depends on the financial needs of the parties. Although the level payment arrangement defers more of the income until the later years, it does not provide as large an annual payment for the earlier years of the term. In Example 3, the income reported for 1992 by the selling senior family member using a decreasing payment obligation totals $105,000 ($55,000 interest and $50,000

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gain), while a selling senior family member using a level payment obligation reports only $88,058 of income for 1992 ($57,294 interest and $30,864 gain). 207.2 Terms of Sale

Although the installment method is available even when the younger generation buyer's obligations are secured,246 certain forms of security can convert the buyer's obligation into a current payment. Specifically, security in the form of a cash equivalent, such as a certificate of deposit, loses the deferral privilege.247 The same is true for any form of escrow.248 Later substitution of an escrow or cash equivalent terminates the deferral for a previously qualified installment sale.249 On the other hand, a standby letter of credit is permissible security.250 Thus, as a practical matter, when security other than the property sold is needed, a qualifying standby letter of credit should be used. A selling senior family member may have suspended passive losses, for example, losses of an S corporation owned by a shareholder who does not materially participate or passive losses that were suspended when an activity was contributed in a 351 transaction.251 A sale reported under the installment method is not a complete disposition that permits immediate deduction of suspended passive losses.252 Instead, the suspended

246

453(f)(3); see 201.2.

Reg. 15A.453-1(b)(3)(i). This regulation effectively overrules Porterfield v. Commissioner, 73 T.C. 91 (1979) (installment sale qualified even though the buyer's note was secured by escrow when court found escrow was intended as security not source of payment); see also Sprague v. Commissioner, 627 F.2d 1044 (10th Cir. 1982) (impractical to evaluate security and whether its quality creates risk). v. Commissioner, 56 T.C. 569 (1971) (certificates of deposit placed in escrow); Pozzi v. Commissioner, 49 T.C. 119 (1967) (escrow); Rev. Rul. 73-451, 1972-2 C.B. 158 (cash in escrow).
249Rev. 248Oden

247Temp.

Rul. 77-294, 1977-2 C.B. 173, revoking Rev. Rul. 68-246. 1968-1 C.B. 198, amplified by Rev. Rul. 79-91, 1979-1 C.B. 179 (installment sale ceased to qualify when escrow substituted for mortgage security). Reg. 15A.453-1(b)(3)(iii); S. Rep. 1000, 96th Cong. 2d Sess. at 18.

250Temp. 251See 252

R. LIPTON AND D. EVAUL, PASSIVE ACTIVITY LOSSES II (CCH TAX TRANS. LIB.) 1303.02 (198 ).

469(g).

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passive losses are deducted as gain is recognized.253 By a parity of reasoning, losses suspended under the at-risk rules254 should be deductible only as gain is recognized.255 Losses of a partnership or S corporation that have been suspended because the selling senior family member's basis was not sufficient,256 do not become deductible at the time of disposition. The sale does not provide the requisite basis. This is not inappropriate, since if deduction of the loss is taken, basis in the shares is reduced,257 and gain on the sale is equivalently larger. 207.3 Liabilities Transferred

Liabilities relating to shares in a family corporation may include purchase money indebtedness, funds borrowed by the shareholder to contribute to the corporation,258 or other liabilities related to the corporate business,259 that may be transferred at the time of the sale.260 Any transfer to the family buyer of obligations incurred by the selling shareholder in connection with the sale, such as any of the seller's legal or accounting fees, is a payment, and does not receive the benefit of being deducted in determining the contract price.261 Similarly, any borrowing immediately before the sale to take advantage

253See 254

1986 BLUE BOOK at 226.

465. Prop. Reg. 1.456-66.

255See 256 257

704(d) and 1366(d).

1367(b)(2)(B).

Estate of Leavitt v. Commissioner, 875 F.2d 420 (4th Cir. 1989) (borrowing by S corporation guaranteed by shareholder not treated as individual borrowing and contribution to capital); Selfe v. Commissioner, 778 F.2d 769 (11th Cir. 1985) (such borrowing may be treated as shareholder borrowing and contribution).
259Cf. 260See

258Cf.

Rev. Rul. 73-555, 1973-2 C.B. 159 (liabilities related to going business transferred). 201.3. Rul. 76-109, 1976-1 C.B. 125.

261Rev.

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of the application of liabilities first against basis, is a sham.262 Thus, the selling senior family member cannot receive tax-free cash in the transaction by borrowing immediately before the sale. Cancellation of any obligation owed by the selling shareholder to the family buyer is a payment rather than transfer of a liability.263 Any transfer of liabilities, whether recourse or nonrecourse, is part of the purchase price. This means that the liabilities transferred are part of the amount realized by the selling senior family member, and part of the basis for the buyer.264 There is some dispute whether a recourse liability is transferred if the selling senior family member remains primarily or secondarily liable. The IRS takes the position that a liability is transferred when the buyer agrees to pay it even if the seller is not released.265 The courts have been more reluctant to ignore retained liability, and have occasionally allowed the seller to avoid the consequences of the transfer of the liability at least at the time of the asset transfer.266 Although the cases cannot be completely reconciled, the better view is

262Temp. 263

Reg. 15A.453-1(b)(3)(i).

453B(a); Temp. Reg. 15A.453-1(b)(3)(i); Big "D" Development Corp. v. Commissioner, 30 T.C.M. (CCH) 646 (1971), aff'd per curiam, 453 F.2d 1365 (5th Cir. 1972), cert. den. 406 U.S. 945; but see Kniffen v. Commissioner, 39 T.C. 553 (1962), acq. (liability to controlled corporation transferred in 351 transaction treated as assumed and not boot); Connell v. Commissioner, 42 T.C.M. (CCH) 423 (1981) (30% initial payment limited under prior law not violated by mutual pledging of notes of buyer and seller; notes did not offset each other). 1.1001-2(a); Crane v. Commissioner, supra note 26; Tufts v. Commissioner, supra note 26 (amount realized on transfer of property subject to nonrecourse liability is amount of liability even if value of property is less); see 201.3. 1.1001-2(a)(4)(ii); but cf. Reg. 1.752-1(d) (partner assumes partnership liability only when creditor is aware of assumption and has direct rights against partner). Jackson v. Commissioner, 708 F.2d 1402 (9th Cir. 1983) (transferor shareholder does not recognize gain under 357(c) on transfer of joint venture interest where corporate transferee did not assume primary liability and transferor remained liable); Maher v. Commissioner, 469 F.2d 225 (8th Cir. 1972) (taxpayer did not recognize gain under 304 on transfer of shares subject to liability to controlled corporation even though corporation assumed liability, since shareholder remained secondarily liable; taxpayer did realize dividend when corporation paid liability); Weeden v. Commissioner, 685 F.2d 1160 (9th Cir. 1982) (donor recognizes gain on "net gift" when transferees pay tax, not in year of transfer since donor remained liable until tax paid). The Jackson opinion has been severely limited if not overruled in Owen v. Commissioner, 881 F.2d 832 (9th Cir. 1989), cert. denied 101 S.Ct. 1113 (1990) (partnership recognizes gain on transfer to wholly owned corporation measured by full amount of liabilities not reduced for liabilities guaranteed by
266See 265Reg. 264Reg.

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that a liability is transferred unless the transferor expressly agrees to make the required payments as in a wrap-around note.267 When a wrap-around note is used to avoid immediate gain recognition for the selling senior family member, the younger generation buyer obviously wants to be sure that the wrapped indebtedness will be paid when due and may seek to make a portion of the payments on account of the wrap note directly to the creditor. If the buyer is successful, the wrapped indebtedness probably is transferred despite the form of the transaction.268 Example 4: The facts are the same as in Example 2. S may avoid the gain on

the excess of the liability over basis in the year of sale by agreeing to pay off the mortgage himself. He receives the $150,000 down payment and a wraparound note for the entire $2,350,000 balance. The tax results at the time of sale are the same as for a sale of unmortgaged shares. The gross profit percentage is 32% ($800,0000/$2,500,000). Accordingly, S reports 32% of the $150,000 down

payment ($256,000) and 32% of each subsequent principal payment on the wraparound note as gain, even though he is obligated to use a portion of the payments (or other funds) to pay the mortgage. If S and B agree that B will pay directly to the mortgagee the amount of the mortgage payments, to assure B that these payments are made, the wraparound note is likely to be disregarded and the mortgage treated as transferred, with the tax results described in Example 2.

partners or for which they remained liable). installment sales.

267See 268See

See also 201.3 relating to wraparound liabilities in

Professional Equities, Inc. v. Commissioner, supra note 30; cf. Prop. Reg. 1.1275-7.

Voight v. Commissioner, 68 T.C. 99 (1977), aff'd, 614 F.2d 94 (5th Cir. 1980); Goodman v. Commissioner, 74 T.C. 684 (1980); Lamberth v. Commissioner, 31 T.C. 302 (1958).

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A selling senior family member who does not account for the liability at the time of the transfer has additional tax consequences if the younger generation buyer subsequently pays the liability.269 In most cases, the buyer's payment is an additional payment on account of the sale price, treated as a payment on account of the installment sale,270 unless the selling senior family member has elected out or is not eligible.271 A portion of the younger generation buyer's liability payment is likely to be interest under the OID and unstated interest rules.272 Obligations that represent accrued expenses that have been deducted by the selling senior family member are also part of amount realized.273 The transfer should not invoke the tax-benefit doctrine, which treats a previously deducted item as ordinary income when an event that is fundamentally inconsistent with the deduction occurs.274 Certain of the obligations transferred may not have been deducted or otherwise taken into account for tax purposes by the selling family member by the time of the

Maher v. Commissioner, supra note 266; Weeden v. Commissioner, supra note 266; Professional Equities, Inc. v. Commissioner, supra note 30.
270See 271See

269See

Reg. 1.1060-1T(f) providing for allocation of adjustments in consideration.

201.1,203.3 and 209.3 concerning election out; 201.9 and 207.9 concerning exclusions from the installment method. 203.4 B B and 209.4 B B.

272See 273See

Commercial Security Bank v. Commissioner, 77 T.C. 145, (1981) (cash basis corporation which sold it assets under 337 entitled to deduct cash basis obligations not deducted prior to sale; transfer of assets tantamount to payment since purchase price reduced to reflect obligations); Commissioner v. Allan, 856 F.2d 1169 (8th Cir. 1988) (interest and taxes accrued and deducted by partnership but paid by mortgagee to protect its interest and added to mortgage is part of amount realized on surrender of the property in lieu of foreclosure; not ordinary income under tax-benefit principle). Hillsboro National Bank v. Commissioner, 457 U.S. 1103 (1983) (tax-benefit gain recognized in former 333 liquidation on distribution of feed properly deducted when purchased but still on hand when distributed by farming corporation; leaves open question whether gain measured by original cost or basis to shareholder). The sale is fundamentally inconsistent with the deduction. Manning, The Service Corporation--Who is Taxable on Its Income: Reconciling Assignment of Income Principles, Section 482 and Section 351, 37 U. MIAMI L. REV. 657, 672-74 (1983).
274See

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transfer.275 These include such items as accounts payable and accrued expenses of cash basis taxpayers, and items where deduction is subject to delay under 404(a)(5) or (d),276 461(h),277 or similar provisions.278 When these payables or similar obligations are transferred in connection with a family sale, the obligations should be included in the amount realized. When obligations that have not been deducted are transferred, the corollary of including them in the amount realized is that the selling senior family member should be entitled to a deduction at the time of transfer,279 unless the deduction is delayed under one of the special provisions described above. Such obligations cannot be deducted by the buyer when paid.280 When the obligation is fixed, the delay in the selling family

members deduction may cause a similar delay inclusion in the amount realized.281 There is no reason for a similar delay in including the liability in the buyer's basis. If the

357(c)(3) (such obligations are not liabilities for purposes of the liability over basis rule of 357(a)); 704(c) (similar rule for partnerships); former Reg. 1.752-1T(g) (definition of liabilities that does not include amounts that have not given rise to a deduction; this provision was deleted without explanation in the final regulations); Rev. Rul. 80-198, 80-2 C.B. 113 (applies rule similar to 357(c)(3) prior to the effective date). 404(a)(5) and (d) postpone deductions for amounts of deferred compensation to employees or independent contractors until the recipient includes the amount in income. 83(f) delays the deduction for property transferred in connection with performance of services at the time the recipient recognizes income. 461(h) postpones deductions by accrual basis taxpayers until "economic performance" has occurred, which, in many cases means payment. See Prop. Reg. 1.461-4(g)(i). e.g., 267(a)(2) postponing deductions for payments to related taxpayers, and 467 (providing for a special accrual method for certain payments for goods and services. Commercial Security Bank v. Commissioner, supra note 273; Crane, Accounting for Assumed Liabilities Not Yet Accrued by the Seller: Is a Buyer's Deduction Really Costless?, 48 TAX NOTES 225 (1990); Shoukup, Accounting for Assumed Liabilities Not Yet Accrued by the Seller: A Response, 48 TAX NOTES 637 (1990).
280See 281See 279See 278See, 277 276

275See

David R. Webb Co. v. Commissioner, 837 F.2d 309 (7th Cir. 1983).

Prop. Reg. 1.461-2(g)(ii)(C) (indicating that payment and inclusion in amount realized are simultaneous).

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deduction is delayed and the selling family member dies, the deduction may be lost,282 but it should be a deduction in respect of a decedent under 691(b). Example 5(a): The facts are the same as in Example 2 except that the mortgage includes $25,000 of accrued interest. The transfer of the accrued interest is as much a transfer of a liability as the transfer of the principal obligation. S is entitled to deduct the accrued interest at the time of the sale without regard to when B makes the mortgage payment. B cannot deduct the interest when he makes the payment. Instead, B's basis in the land includes the entire $1,725,000 principal plus the $25,0000 accrued interest on the mortgage. Example 5(b): The facts are the same as in Example 5(a) except that the

$1,750,000 liabilities transferred includes an obligation to make annual payments of $5,000 per year for five years (plus interest) to a slip-and-fall victim. The $25,000 liability may not be deducted by S or included in basis by B at the time of the transfer, but only when paid to the victim. S apparently includes the $5,000 payments in his amount realized and the interest payments in his income when B makes the payments. S should be entitled to deduct the damages and interest at the same time. B cannot deduct either the damages or the interest. Instead, the $25,000 liability should be part of his basis from the time of the sale. 207.4 Disposition

Although the statutory language "[i]f an installment note is . . . otherwise disposed of," generally requires gain recognition on any disposition of an installment obligation,283 this does not apply when the installment obligation is transferred by the selling family shareholder to a controlled corporation in a transaction under 351 or in certain
Tech. Adv. Mem. 87-41-001 (Jun. 16, 1989) (hypothetical seller under 338 election has gain at time of election with no offsetting deduction because not in existence when deduction arises at time of payment) and Tech. Adv. Mem. 89-39-002 (Jun. 15, 1989).
283See 282See

generally Hesch, Disposition of Installment Obligations by Gift or Bequest, 17 TAX MANAGEMENT EST. GIFTS AND TR. J. 137 (1991)

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other transfers in nonrecognition transactions with a transferred basis.

Instead, the

deferred installment gain is transferred and reported by the transferee when the obligation is collected or otherwise disposed of.284 If a family shareholder who made an installment sale during lifetime dies, transmission of the obligation at death does not accelerate the unreported gain. Instead, the unrealized gain in the installment obligation is shifted to and eventually reported by her estate or other successor as income in respect of a decedent that does not receive a step-up in basis at death.285 This is discussed further in 207.4 B. A gift, on the other hand, is a disposition. This is discussed in more detail in 207.4 A. If the senior family member's estate uses the note to satisfy an obligation of the estate, such as to fund a pecuniary formula marital deduction bequest, an early disposition occurs, because the estate is treated as having sold the note and the previously deferred gain is immediately reported in estate income.286 The amount of gain accelerated upon an early disposition is (a) either (i) the amount realized if the note is sold or used to satisfy an obligation, or (ii) the value of the note, if transferred for no consideration, over (b) the selling senior family member's remaining unrecovered basis.287 Unrecovered basis is the excess of the face amount of the note over the income that would have been reported if all remaining payments under the note had been received by the selling senior family member.288 If the aggregate sales price for the selling family member's shares is more than $150,000, the taxpayer loses the right to defer gain under the installment method for sales

284Reg. 285 286Cf. 287 288

1.453-9(c).

453B(c), 691(a)(4) and (5) and 1001(c); Reg. 1.691(a)-2(b) Example (4). Rev. Rul. 55-159, 1955-1 C.B. 391, Shannon v. Commissioner, 29 T.C. 702 (1958).

453B(a). 453B(b).

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made beginning in 1989, to the extent that she borrows against the family buyer's installment obligations, and pledges the installment obligations as security for the borrowing.289 The provision applies to senior family members who sell family business or financial assets for more than $150,000, even if the installment portion of the price is less than $150,000, and may apply to selling senior family members who receive less than $150,000 for their assets when the total price for property sold in a single transaction exceeds $150,000.290 The theory is that since the taxpayer has the cash, she should pay the tax. This provision is triggered only if the taxpayer gives a direct security interest in the installment obligation. Accordingly, a selling senior family member who is able to borrow on an unsecured basis, albeit indirectly as a result of an improved balance sheet that includes the installment obligation, the tax is not accelerated. When the acceleration provision applies, the loan proceeds are treated as payments on the installment obligation, with the appropriate gross profit percentage of the loan proceeds treated as gain. Subsequent collections on the installment obligation are tax-free until they equal the amount of borrowing previously treated as payment. Example 6: The facts are the same as in Example 2. In 1992 after collecting two payments, S pledges B's note as security for a $200,000 loan. She is treated as having received payments of $200,000 and immediately reports gain of $200,000. She does not, however, report any additional gain when he receives the next $200,000 in principal payments on B's note.

289

453A(a)(1), (b)(1) and (d).

Prop. Reg. 1.1274A-1(d)((2) Example (3) (aggregating sales pursuant to a tender offer for purposes of the $2,800,000 limitation under 1274A(d); and Prop. Reg. 1.1274-1(b)(2)(iii), 1.12741(b)(4)(iii) and 1.483-1(c)(2)(ii), adopting it by reference for purposes of other amount limits.

290Cf.

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A.

Disposition by Gift

A gift of an installment obligations is an early disposition of the note within the meaning of 453B(a).291 On the other hand, the transfer of the note to an irrevocable grantor trust on which the seller-grantor remains taxable on trust income under the grantor trust rules,292 is not a disposition; the grantor is treated as the owner of the property in trust, and since one cannot make a gift to himself, no early disposition occurs.293 The fair market value of the obligation, not its face amount, determines the amount of gain to be accelerated upon the gift. As long as the donee is not the obligor on the note, so that the note continues in existence, it is irrelevant whether the donee is related (in the tax sense) to the selling senior family member. Example 7(a): The facts are the same as in Example 2. In 1996, when $300,000 of principal remains outstanding, S gives it to his son, as a gift. The donee-son is not B, the obligor on the note. Thereafter, the son collects all remaining

payments on the note. At the time of the gift the note was worth $300,000. Since S's basis in the note is zero, S must report the remaining $300,000 capital gain at the time of the gift. Accordingly, the son's basis in the note is $300,000.

Therefore, the son only reports the stated interest upon collection of the payments under the note. Example 7(b): The fact are the same as in Example 7(a) except that at the time of the gift the note is worth only $280,000. S must report a $280,000 capital gain at the time of the gift. His son's basis in the note is only $280,000. Therefore, the

e.g. Rev. Rul. 67-167, 1967-1 C.B. 107 (gratuitous transfer of an installment note to an irrevocable reversionary trust distributing all income for the trust term to the grantor's sister is a taxable early disposition)
292

291See,

677(a). Rul. 81-98, 1981-1 C.B. 40.

293Rev.

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son reports not only the interest income, but also treats the additional $20,000 of principal on the note as income. The note is a market discount debt obligation in the hands of the son because he has, in effect, acquired it at a "tax cost" less than its face amount.294 Therefore, the $20,000 represents market discount.295 All $20,000 is ordinary income,296 and the son reports $20,000 in income ratably as the annual payments on the note are received. In effect, $20,000 of capital gain is converted into ordinary income. If there is a gift of a note to the obligor, the obligation becomes unenforceable because of the state law doctrine of merger. A gift of the note to the obligor is the functional equivalent of a cancellation.297 If an installment obligation is cancelled, it is treated as an early disposition by gift, with one difference.298 If the buyer and the seller are related parties,299 the fair market value of the cancelled obligation is treated as at least equal to the face amount for purposes of determining the accelerated gain recognized on the disposition.300 If the buyer and seller are not related parties, such as a son-in-law, then the actual value of the note is used in computing the amount of gain accelerated under the early disposition rule. Example 8: The facts are the same as in Example 2 except that B, the buyer and obligor on the note, is S's son. In 1996, when $300,000 of principal remains outstanding on the note, S gives it to B as a gift, thereby effectuating a
294 295 296

1278(a)(1)(A). 1278(a)(2)(A). 1276(a)(1).

Rev. Rul. 55-157, 1955-1 C.B. 293, a taxable disposition occurred each time by foregoing the annual principal payments as they become due.
298

297In

453B(f)(1). defined in 453(f)(1), 318(a) and 267(b),

299As 300

453B(f)(2).

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cancellation on the note. At the time of the gift, the value of the note is only $280,000. B is a related party within the definition contained in 267(c)(4). Since S's basis in the note is zero (all basis was, in effect, absorbed by the outstanding mortgage), and its value is deemed to be the $300,000 face amount, S must report a $300,000 capital gain in 1996. The amount of the gift for purposes of the gift tax is based on the actual value of the note, not its face amount. B's basis in the property he purchased from S remains $2,500,000. In either case, the actual fair market value of the note, not its principal amount, should determine the amount of the gift for gift tax purposes. The value used to determine the gift tax should be the fair market value of the younger generation buyer's debt obligation using market interest rates, and not the AFR at the time of the sale or the time of death. Although 483 states that it applies for all purposes of the Internal Revenue Code and 1272 contains similar language that implicitly applies to 1274, these provisions apply to the initial sale transaction and not to subsequent transfers. Accordingly, the logic of the Ballard case,301 discussed in 207.4 G should not apply.302 G.C.M. 39503 recognizes that the income and estate results are not required to be consistent when it concludes that no amount is included in the gross estate for a SCIN, but that the deferred gain is reported as income in respect of a decedent.303 A corollary of using the lower market value in determining the amount of the gift and the amount realized by when the seller and buyer are not related parties should be that the buyer's basis is adjusted for the difference. The message of the Tufts case304 and
301Ballard 302But

v. Commissioner, 854 F.2d 185 (7th Cir. 1988), rev'g 53 T.C.M. (CCH) 325 (1987).

see Henderson, Using the Imputed Interest Safe Harbor for Intrafamily Installment Sales, 74 J. TAX'N 100, 103 (1991) (suggesting that the logic of finding no gift for the a sale of farm land using the 6% safe harbor rate might imply that principal should be used for estate tax value but recognizing that including the entire principal in the gross estate taxes value that is not real).
303G.C.M.

39503, Issues (2)(a) and (3), supra note 4.

v. Tufts, supra note 26; Reg. 1.1001-2(c) Example (8); Rev. Rul. 990-16, 1990-1 C.B. 12; Rev. Rul. 91-31, 1991-20 I.R.B. 4..

304Commissioner

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Reg. 1.1001-2 is that the amount of a liability that has been taken into account for tax purposes must be accounted for when the liability is discharged. If the amount of the gift is the fair market value of the note, only that amount is entitled to exclusion under 102. The balance is discharge of indebtedness that must be income or purchase price adjustment for a solvent taxpayer.305 Example 9: The facts are the same as in Example 8 except that B, the obligor is S's son-in-law and the gift is made to B. The $280,000 market value of the note determines the income reported by S upon the early disposition. Therefore, S must recognize a $280,000 capital gain in 1996. B's original $2,500,000 basis in the property he purchased is reduced by $20,000 under 108(e)(5). By treating the gift as only $280,000 for income tax purposes, the remaining $20,000 on the note is discharge of indebtedness income under 61(a)(12).306 Since the obligor on the note is also the buyer of the property, 108(e)(5) treats the $20,000 cancellation on the debt as a purchase price adjustment. This

treatment is necessary in order to maintain tax symmetry between B and S. If S does not have to report $20,000 of his gain, B certainly should not get a basis with respect to that portion of the liability that initially gave rise to that unreported gain. The only time a gift of an installment obligation does not trigger the early disposition rule is if it is a gift to a spouse while married or incident to a divorce.307 Instead,

may be seen more clearly by considering a situation in which a note is issued for cash. The original receipt of cash is not income because of the obligation to repay, nor is it a gift because of the note. If the note is discharged for a cash payment less than its face, there is discharge of indebtedness income even if the payment is the full fair market value of the obligation at the time of payment. See United States v. Kirby Lumber Co., 284 U.S. 1 (1931); see also Commissioner v. Jacobson, 336 U.S. 28 (1949). The same result follows if the note is cancelled as a gift and the amount of the gift is limited to the fair market value of the note; the obligor still has the cash.
306Cf. 307

305This

Rev. Rul. 90-16, 1990-1 C.B. 12; G.C.M. 39503, Issue (3), supra note 4. 453B(g) and 1041(a).

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the seller's spouse, or ex-spouse, steps into his shoes, and reports the remaining capital gain under the installment method. Even if the seller sells his installment note to his spouse for adequate consideration, the early disposition rule does not apply because under 1041 even a sale to a spouse in entitled to nonrecognition.308 B. Disposition by Bequest

Unpaid amounts due on an installment note arising from a fixed payment installment sale are included in the gross estate of the selling senior family member. 1. Transfer of the note. A bequest of an installment obligation to a bene-

ficiary who continues to hold and collect on the deceased selling senior family member's note is not an early disposition.309 Instead, the beneficiary steps into the shoes of the deceased seller, and continues to report the gain and interest in the same manner that the seller would have had he survived.310 Although the value of the note is included in the selling senior family member's gross estate under 2033 as property owned at the time of his death, there is no tax-free step-up in basis under 1014(a) for the deferred capital gain. The gain deferred under the installment method is income in respect of a

decedent.311 Similarly, on a transfer of the installment obligation by the estate to a specific or residuary beneficiary, the estate does not recognize income, but the beneficiary does when the obligation is collected or disposed of.312 When the beneficiary or other successor reports the capital gain upon the receipt of each installment payment, he is eligible for an income tax deduction under 691(c), for the estate tax attributable to the unrealized gain in the selling senior family member's gross estate. The 691(c)
1041(a) applies to "all" transfers between spouses; Reg. 1.1041-1T, Q&A-2 and Q&A-12 (dealing with sales between spouses).
309 308

453B(c). 1.453-9(e) and 1.691(a)-5, and 691(a)(3).

310Reg. 311 312

691(a)(4)(A) and 1014(c); Reg. 1.691(a)-5(a).

691(a)(2); Reg. 1.691(a)-4(b)(3) and -5(a) and (b); Priv. Ltr. Rul. 90-07-016 (Nov. 16, 1989).

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deduction may not be as favorable as deduction of the tax on the unrealized gain as a debt of the senior family member's estate that would apply if the gain is reported on the decedent's final return.313 As for a gift of the installment obligation, the value of the note should be determined under normal valuation principles and not fixed by the AFR either at the time of sale or the time of death.314 The amount of the deduction for the estate tax attributable to the gain under 691(c) should similarly be based on the amount actually included in the gross estate, not the principal amount.315 Any difference between the amount included in the gross estate and the principal of the younger generation buyer's debt obligation should not be market discount. The difference between the principal amount and the selling senior family member's basis of the obligation is excluded from the definition of market discount because it arose at original issue as part of the installment sale and the estate or other successor acquires the obligation with a transferred basis.316 Example 10: The facts are the same as in Example 2. S dies in 1996 when the unpaid principal balance of the obligation is $300,000. At the date of S's death the AFR is 12%, which would give the notes a present value of $284,262, but a realistic interest rate for B's debt obligation is 15%, which gives the note a present value of $263,074. The amount that should be included in S's gross estate for B's debt obligation is $263,074, the realistic value. Nevertheless, the entire $300,000 gain is reported by his estate or other successor as the payments are made. The
313Reg. 314See

20.2053-1(f).

207.4 A.

39503 does not discuss the deduction under 691(c), possibly because of its conclusion that nothing is included in the gross estate for a SCIN taxed under the installment method. But cf. Reg. 1.753-1(b) (the entire partnership distributive share for the period in which death occurs even though only part is unwithdrawn at the date of death and identified on the estate tax return); this provision is distinguishable because the income withdrawn by the decedent is indirectly reflected by assets owned at death.
316

315G.C.M.

1278(a)(1)(C).

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deduction under 691(c) should be computed using the amount actually included in the gross estate. A transfer of the installment obligation by either the selling senior family member's estate or the devisee can trigger the early disposition rule.317 For example, an early disposition can occur if the estate sells the note to raise funds to pay estate expenses or to fund pecuniary bequests.318 disposition by the estate.319 2. Cancellation of the obligation. If the selling senior family member A distribution to the residuary devisee is not an early

cancels the note by a clause in his will or indirectly effects a cancellation because he bequeaths the note to the obligor, the fair market value of the note is still property included in the selling senior family member's gross estate.320 A cancellation of a note on the death of the seller is, however, a disposition that results in the immediate reporting of gain previously deferred under the installment method.321 In Rev. Rul. 86-72,322 the IRS reached the questionable result that the accelerated gain upon the cancellation of a SCIN is reported by the estate.323 A better view is that the accelerated gain should be reported on the selling senior family member's final income tax return.324 Under the IRS view, the "transfer" treated as an early disposition within the
317Reg. 318Reg. 319

1.691(a)-5(b). 1.691(a)-5(c) example.

691(a)(2), last sentence, and Reg. 1.691(a)-5(b).

20.2033-1(b) specifically provides that "[n]otes . . . held by the decedent are likewise included [in the decedent's estate] even though they are cancelled by the decedent's will." The rule is different for a SCIN, which expires upon the selling family member's death by its own terms. See 203.3 A3 and 210.3 A3.
321

320Reg.

691(a)(5)(A)(ii). C.B. 253.

3221986-1 323

691(5)(A)(iii). discussion at 206.1 C.

324See

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context of 691(a)(2) does not automatically occur at the moment of death. The IRS has ruled that the triggering transfer, and related recognition of gain, does not occur until the earlier of (i) the executor's assent to the distribution of the notes under state law, (ii) the cancellation of the notes by the executor under state law, (iii) the note becoming unenforceable, or (iv) termination of the estate administration for Federal income tax purposes.325 In other words, state law controls when the obligations are transferred for purposes of determining when the taxable early disposition has occurred. Example 11: S's residuary estate passes to her child, B, including installment notes owed her by B. Gain to the estate under 691(a)(2) is reported in the year in which the notes are actually distributed to B or otherwise cancelled.326 If the obligor under the cancelled note is related to the decedent-seller and the value of the note is less than its face amount, then the amount (fair market value) included in the gross estate for estate tax purposes is irrelevant for income tax purposes. Instead, for purposes of determining the gain reported by the estate, the face amount of the note is determinative.327 Thus, although the theory is different, the amount of gain recognized is the same as for a gift. Example 12(a): The facts are the same as in Example 2. S dies in 1996 when $300,000 remains unpaid on the note. S leaves this note as a specific bequest to B, the obligor on the note, who is also his son. At the date of death the value of the note in S's gross estate is $280,000. S's basis in the note is zero. While alive S already reported $500,000 of the $800,000 gain realized upon the sale.328 S's estate is treated as having transferred the note for $300,000 under 691(a)(2).

325Priv. 326Priv. 327

Ltr. Rul. 85-52-007 (Sep. 18, 1985). Ltr. Rul. 88-06-048 (Nov. 17, 1987).

691(a)(5)(B). Example 2 for 1989 through 1996.

328See

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The estate must report the remaining $300,000 of capital gain on its fiduciary income tax return. B's basis in the land purchased from his father should remain at $2,500,000, on the ground the termination of the notes is a bequest, even though S only pays $2,200,000. Example 12(b): The facts are the same as in Example 12(a) except that B, the obligor-buyer is S's son-in-law. S's estate must report $280,000 of capital gain upon the effective cancellation of the note. B's $2,500,000 basis in the property he purchased by issuing his own note is reduced by $20,000 under 108(e)(5).329 When the fair market value of the installment obligation is more than its face amount, the selling senior family member's estate recognizes gain measured by the value of the note.330 The younger generation buyer should be able to increase his basis in the property purchased by the excess of value over face amount.331 If the buyer whose note cancelled by the selling senior family member's will is not a related party within the statutory definition, for example, a son-in-law, the fair market value of the note is used to determine the gain reported by the estate.332 The rule that the value of the note is not less than its face amount only applies when the buyer is related to the selling senior family member.333 The amount reported as income in respect of a decedent by the successor is the excess of value over the decedent's basis in the note.334

329See

207.4 A. 691(a)(5)(B) carefully.

330Read 331See 332

LANE AND ZARITSKY, FEDERAL INCOME TAXATION OF ESTATES AND TRUSTS, 15.07[3][c] (1988).

691(a)(4)(A). 691(a)(5)(B) and 453B(f)(2).

333 334

691(a)(4)(B).

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 207.5

Interest Charged by the Government

If the sale price for the family business or other assets exceeds $5,000,000, or the aggregate of different sales for the year exceed this $5,000,000 threshold, the selling senior family member incurs an interest charge on the deferred portion of the taxes that would have been incurred had the gain on the sale not been deferred.335 Interest is required to be paid only if the aggregate sales price received by the senior family member for the property exceeds $150,000 and the senior family member has total installment obligations in excess of $5,000,000.336 Thus, whether interest is required depends on both the amount realized by the selling senior family member (which only needs to exceed $150,000), and whether the taxpayer has deferred gain on other installment sales that brings his total outstanding installment obligations to more than $5,000,000. Interest is charged only on tax allocable to the portion of the gain attributable to the excess of the installment obligation over $5,000,000, but once an installment obligation becomes subject to the interest charge, it remains subject, even after the taxpayer's balance of installment receivables drops below $5,000,000.337 The interest on the tax, computed at the top rate applicable to the year of computation,338 is nondeductible personal interest.339 207.6 Interest Deduction

Interest paid by individual family buyers for shares of a family C corporation is investment interest deductible within the applicable limits.340 The character of interest

335 336 337 338 339

453A(a)(1) and (b)(2). 453A(a)(1), (b)(2) and (c). 453A(c)(4). 453A(c)(2).

163(h); Reg. 1.163-9T(b)(2)(i) (interest on underpayments of income tax is nondeductible personal interest regardless of the source of income generating the underpayment).

340

163(d)(5); Reg. 1.163-8T(b)(3); see Abbin, Interest Expense in Intrafamily Installment Sales, 74 J. TAX'N 389 (1991).

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paid by a noncorporate family buyer for shares in an S corporation or for an interest in a partnership is determined by an allocation based on the nature of the entity's assets as business assets, investment assets, etc.341 If a family C corporation is conducting a trade or business, this rule may make it advisable to convert it to an S corporation prior to the sale to avoid the investment interest limits.342 Interest paid by a family buyer that is a C corporation under an sale or redemption agreement should be fully-deductible as business interest.343 207.7 Original Issue Discount and Unstated Interest

The OID provisions relating to the time value of money were initially concerned primarily with the potential for converting ordinary income into capital gain when the principal amount was too high.344 The current concern has focused more sharply on the distortions in the time of reporting income.345

341See

Notice 89-35, Sec. IV.A, 1989-1 C.B. 675, 676.

1.163-8T uses a tracing method to determine when interest is business interest, investment interest or personal interest. 163(d)(1) and (h) (investment interest and personal interest limits for taxpayers other than corporations). The 1986 Act added a provision to confirm that payments in connection with redemptions, including expenses, "greenmail" payments and the cost of standstill agreements, are not deductible. 162(k) This provision does not deny deduction of interest on obligations issued in a redemption. The deduction may be subject to limits on interest on acquisition indebtedness and high-yield discount obligations. See 163(e) and 279. H.R. Rep. No. 1337, 83d Cong., 2d Sess. 83-84, A275-77 (1954) (original enactment of 1232) (limiting capital gain on sale or retirement of debt obligation); H.R. Rep. No. 749, 88th Cong., 2d Sess. 7274, A84-87 (1964) (original enactment of 483 relating to prescribed interest on debt obligations issued for property limited capital gain and basis for the property). H.R. Rep. No. 413, 91st Cong., 1st Sess. (Pt. 1) 109-10, (Pt. 2) 83-86 (1969) (amendment of 1232 to provide ratable monthly inclusion of original issue discount); S. Rep. No. 494, 97th Cong., 2d Sess. 20914 (1982) (amendment of 1232 to provide for inclusion of original issue discount on a daily compoundinterest basis); H.R. Rep. No. 432, 98th Cong., 2d Sess. (Pt. 2) 1241-51 (1984) (extension of the daily compound-interest inclusion to transactions in property and related changes; see 163(e), 483, 1274 and 1974); S. Rep. No. 83, 99th Cong., 1st Sess. 1, 13-19, and 24 (1985) (on simplification of imputed interest rules, modifying interest inclusion on transfers of property).
345See 344See 343See

342Reg.

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A.

Issue Price of Obligations Issued for Family Corporation Shares

(or Other Property) The first of the key concepts in measuring OID is the issue price of the family buyer's debt obligations. In deferred payment sales of nonpublicly-traded family business shares or other financial assets for debt obligations that are also not publicly traded, the issue price is determined by the AFR. The AFR for obligations of $2,800,000 or less issued in a sale of family business shares (and other property) have a maximum prescribed rate of 9 per cent.346 Beginning in 1990, the $2,800,000 threshold is adjusted for inflation.347 The $2,800,000 is based on the total sale price in a transaction, not the price received by each selling senior family member.348 In the highly unusual case when either the family business shares or the family buyer's debt obligations are publicly traded (generally meaning that there is no installment sale),349 the market prices determine the sale price of the shares and the related issue price of the family buyer's debt obligation.350 B. Redemption Price

All payments, whether labelled principal or interest, become stated redemption price. Similarly, because contingent payments cannot provide for steady interest, any

1274A(a) and (b); Prop. Reg. 1.1274A-1(a) and (b). There is no longer any penalty for failing to provide explicit interest at the prescribed rate. All debt instruments that are part of the same transaction are aggregated in determining the $2,800,000 maximum amount. 1274A(d)(1)(B); and Prop. Reg. 1.1274A-1(d). 1274A(e); Prop. Reg. 1.1274A-1(e). The limit for 1992 is $3,234,900. Rev. Rul. 92-6, 1992-6 I.R.B. 4. Reg. 1.1274A-1(d)((2) Example (3) (aggregating sales pursuant to a tender offer for purposes of the $2,800,000 limitation).
349See 350 348Prop. 347

346

201.9.

1273(b)(3); Prop. Reg. 1.1273-2(c)(1).

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contingent payments of purchase price more than one year after closing also inevitably involve OID, whether or not there is public trading.351 Example 13: The facts are the same as in Example 2 except that the first installment payment is not due until 1992. The amount of the payment will

$226,000, which includes compound interest at 10% for two years as well as two years' principal payments. Although the required interest exceeds the AFR, the interest holiday means that none of the interest payments are qualified interest. The total amount of the payments in the years 1992 through 2002 are redemption price. Because interest is above the AFR, the stated principal of $600,000

determines the sale price. Interest at 10% accrues for both S and B during 1991 and 1992. If the 1992 payment is only $215,000 including only simple interest for the two years, the stated principal amount still determines the sale price, but the presence of OID means that the true yield on the obligation must be computed and interest at that rate accrued for 1991 and 1992 as well as all subsequent years. The true yield is about 9.675%. C. Effect of AFR

When the family acquisition agreement provides for interest at less than the AFR, the amount of the family buyer's debt obligation, discounted at the AFR, and not the principal amount of the obligation, determines both the selling price of the family financial assets and the basis of property to the family buyer. If the family buyer's deferred payment obligations (that are not traded) are issued for family business shares or other financial assets (that are also not traded), and provide interest at a rate at least equal to the AFR (whether or not annually), the amount of the debt and the basis of the

351See

Prop. Reg. 1.1275-4 (c) to (f); see 203.4 A and 203.4 B.

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property is face;352 if interest is payable at less than the AFR, the amount of the debt and the basis of the property is determined by discounting, using the AFR.353 Example 14(a): The facts are the same as in Example 2 except the note

provides for interest at a compound annual rate of 8.5% on the unpaid balance of principal. The interest is to be paid at the time of each principal payment. If the annual AFR is 8.5 per cent or less, there is adequate stated interest because the discounted present value of the payments, including the deferred payment of interest at 8.5%, is at least $600,000. The nominal purchase price of $2,500,000 is the sale price. All parties treat the stated interest as interest for all tax purposes. Example 14(b): If the AFR is more than 8.5 per cent, for example, 9 per

cent, the selling price is determined by discounting all payments of principal and interest at 9 per cent. The $586,133 discounted value of the installment

obligation determines the selling price. See Example 15 infra, for a description of the interplay of OID and the installment method on these facts. D. Effect of OID When the stated interest is at a rate below the AFR or there is any interest or principal holiday, the OID rules may require reporting more interest than the amounts paid. Thus, if there is OID the selling senior family member may have significant interest income to report even though he does not receive cash to use to make payment. This is, of course, a major advantage to the family buyer who receives a deduction without payment of cash. Example 15: The facts are the same as in Example 14(b). There is OID because the stated interest rate is less than the AFR. The reallocation of the payments and the reporting of OID and interest and of the adjusted principal is as follows:
see Prop. Reg. 1.1274-1(d) (providing for possible adjustment for excessive interest); see 201.7 C and 207.7 C.
353See 352But

1984 BLUE BOOK at 118-19.

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Year 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Totals

Total Payment -0$206,335 92,500 88,250 84,000 79,750 75,500 71,250 67,000 62,750 58,500 54,500 $940,085

Stated Interest -0$106,250 42,500 38,250 34,000 29,750 25,500 21,250 17,000 12,750 8,500 4,250 $340,085

Stated Principal -0$100,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 $600,000

Interest and OID $ 52,752 57,500 44,104 39,749 35,384 31,008 26,621 22,222 17,810 13,383 8,940 4,479 $353,392

Adjusted Principal -0$ 96,083 48,396 48,501 48,616 48,742 48,879 49,028 49,190 49,367 49,560 49,771 $586,133

The selling price is $2,486,133 determined by valuing the deferred payments at the AFR. Accordingly, the gross profit is $786,133. If the mortgage did not absorb all of S's basis, the gross profit ratio would be computed using the $2,486,133 selling price determined using the AFR not the nominal price of $2,500,000. The gross profit ratio would then be applied to the adjusted principal payments determined above. In the calculation in Example 14(b), the issue price of the younger generation buyer's debt obligation is determined derivatively by discounting the payments provided in the sale agreement at the AFR. When the issue price is determined directly because the property transferred is publicly traded, either shares in a family-controlled business that is also publicly traded,354 or other financial assets that include publicly-traded securities, the issue price is determined directly and the AFR does not apply to determine the amount of OID.355 Under the proposed OID regulations, when a series of obligations with OID is purchased for a single consideration, it is necessary to determine the yield to maturity of the series of obligations, that is the interest rate that matches the issue price

of a family corporation are not publicly traded if the control premiums or blockage discounts are properly involved. Prop. Reg. 1.1273-2(c)(1).
355

354Shares

1273(b) and 1274(c)(3)(D); Prop. Reg. 1.1273-2(c)(c)(1) and 1.1274(b)(5).

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with the series of payments.356 When the terms of payment for the family business provide for equal payments, standard compound-interest tables or formulas provide the yield. The difficulty arises when there are irregular payments, as a result of an interest holiday, a balloon payment or otherwise. For such cases, we have found that the IRR (internal rate of return) function of Lotus 1-2-3 and, presumably, similar functions in other spread sheet or financial programs, can provide the required yield. Example 16: S sells family financial assets consisting of publicly-traded securities to B. The securities have a quoted market price of $750,000. The terms of the sale provide for payments of $100,000 a year for 9 years and a final payment of 500,000 for the tenth year. S cannot use the installment method because the securities are publicly traded. Using the IRR function, the interest rate is

10.47062%. The components of the payments are as follows: Year 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Totals Total Received $ 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 500,000 $1,400,000 Principal $ 21,470 23,718 26,202 28,945 31,976 35,324 39,023 43,109 47,623 452,609 $750,000 Interest $ 78,530 76,282 73,798 71,055 68,024 64,676 60,977 56,891 52,377 47,391 $650,000

Gain or loss on the sale or exchange of a family buyer's debt obligation is capital gain or loss.357 If an individual younger family member's debt obligation is retired for an amount greater or less than its adjusted issue price, the gain or loss is ordinary income or

356Prop. 357Prop.

Reg. 1.1272-1(f). Reg. 1.1271-1(b)(2).

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loss,358 but gain or loss on a corporate family buyer's debt obligations, to extent not treated as ordinary income under the OID rules, is generally capital gain or loss.359 Thus, if there is a change in interest rates, the selling senior family member realizes the change in value of the family buyer's debt obligations as a investment gain or loss, not as an adjustment in interest. A purchaser of a debt obligation, or the successor to deceased holder who acquires the obligation with a date of death basis, on the other hand, has market discount or premium for the difference between the price paid for the obligation and its redemption price. Market discount is amortized over the life of the obligation on a straight-line basis unless the holder elects to amortize it on a compound-interest basis.360 It produces ordinary income on sale, exchange or retirement of the debt

obligation (including an exchange under 351361) unless the holder elects to amortize it while the bond is being held.362 This election may be useful because interest to carry market discount bonds is deferred until the discount is taken into income.363 Market premium is amortizable to reduce the interest income but only if an election is made.364 Example 17: The facts are the same as in Example 2 except that in 1993 when the principal balance is $450,000, S sells the debt obligation for $420,000, reflecting an increase in interest rates to approximately 12%. S recognizes the remaining gain on the installment sale of $450,000. As a result, S's basis for B's note increases to $450,000, and S realizes an $30,000 capital loss on the sale.
1271(b)(1); Fairbanks v. United States, 306 U.S. 436 (1939) (no sale or exchange on retirement of debt obligations prior to enactment of predecessor of 1271).
359 360 361 362 363 364 358

1271(a)(1). 1276(b). 1276(d)(1)(C). 1278(b). 1277. 171; see 201.7 H and 207.7 H.

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The purchaser's basis in the note is $420,000. The $30,000 difference between the basis and the principal of the note is market discount. The market discount can be amortized ratably at the rate of $3,333 for each $50,000 principal payment, or it can be amortized on a compound-interest basis, in which case, the character of each payment is as follows: Year 1994 1995 1996 1997 1998 1999 2000 2001 2002 Totals Total Payments $ 95,000 90,000 85,000 80,000 75,000 70,000 65,000 60,000 55,000 $675,000 E. Small Transactions The $250,000 and $2,000,000 small transaction amounts are determined by aggregating debt instruments in the same transaction, and is adjusted for inflation beginning in 1990.365 Example 18: S sells shares of a family corporation to B for $1,000,000. The purchase price is payable in a lump sum at the end of five years with simple interest at 8% payable annually. If the AFR is 9%, the discounted selling price at is $961,103. Under the cash basis election, both parties report only the $80,000 interest paid in cash each year during the first four years and report the $38,898 of OID in the year of final payment. If the election is not made, S reports OID income and B deducts OID as follows: Stated Interest $ 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 $225,000 Market Discount $ 5,226 4,872 4,475 4,031 3,534 2,977 2,354 1,656 875 $30,000 Basis Recovery $ 44,774 45,128 45,525 45.969 46,466 47,023 47,646 48,344 49,125 $420,000

1274A(d) and (e); Prop. Reg. 1.1274A-1(d) and (e). The 1992 amount is $2,310,600. Rev. Rul. 926, supra note 347.

365

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Year 1 2 3 4 5 Total F.

Stated Interest $ 80,000 80,000 80,000 80,000 80,000 $400,000 Liability Transfers

OID $ 6,500 7,085 7,722 8,417 9,174 $38,898

Total $ 86,500 87,085 87,722 88,417 89,174 $438,898

The OID rules generally do not apply to liability transfers.366 This can create exactly the type of distortion the OID rules are designed to prevent. If the transferred liability was originally issued with OID, the amount of the transferred liability is the original issue price as modified for any amortized discount.367 The same principle should apply if the obligation was originally issued at a premium.368 Example 19: The facts are the same as in Example 1. The $1,750,000 mortgage was taken out several years ago when interest rates were only 8%. At present interest rates of 10% the mortgage has a present value of approximately $1,525,0000. Accordingly, the true economic purchase price is only $2,375,000. Nevertheless, under the OID and unstated interest rules, the mortgage is valued at $1,750,000 so that there is no OID. The sale price used in determining S's gain and B's basis is $2,500,000. The basic justifications for tolerating this distortion appear to be administrative convenience, the lack of an offsetting deduction for any OID for the mortgage lender or other creditor, and the absence of the potential for the extreme distortions because the changes in value are limited by changes in market rates of interest.369 If the terms of the

366

1274(c)(4); Prop. Reg. 1.1274-7; see 201.7 F. Reg. 1.1274-7(d).

367Prop. 368See 369See

Commissioner v. Tufts, supra note 26. Lokken, supra note 47, at 155-58.

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mortgage or other liability are changed as part of the sale transaction, perhaps as a result of a negotiation required to obtain creditor consent, OID can result.370 G. Unintended Gift for Gift Tax Purposes

A family seller (and buyer) avoids the OID and unstated interest rules, as long as the terms of the sale provide stated interest at least equal to the AFR.371 A stated interest rate of, for example, 10% avoids imputed interest whenever the AFR is 10% or less. Indeed, for small transactions, a stated interest rate of 9% avoids imputed interest even when the AFR is higher.372 This may not, however, guarantee that there has not been a transfer for inadequate consideration for gift tax purposes, because 7520(a)(2) requires that a discount rate equal to 120% of the midterm AFR (apparently without the 9% maximum) be used in valuing annuities and term interests. Thus, if the mid-term rate is 10%, a discount rate of 12% is used in valuing the family buyer's obligation if it is determined to be an "annuity" or "term interest." Although these terms are not defined in the Code, it is possible that even a fixed installment obligation is a term interest. As discussed in 201.7 G, the better argument is that it is not. If the note is a term interest, there probably is no gift when the transaction satisfies the bona fide business transaction exception, an intent test.373 If neither argument is accepted, and it well may not be in family situation, the adequacy of the consideration may be measured under 7520. Example 20: The facts are the same as in Example 3 in which S financed a $600,000 balance for 12 years at 10% interest, providing level annual payments of $88,058. Under the AFR of 10%, the discounted value of the payments is the

370

1274(c)(4); Prop. Reg. 1.1274-7. 201.7 C and 207.7 C 201.7 E and 207.7 E. 25.2511-1(g)(1) and 25.2512-8.

371See 372See

373Reg.

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same as the $600,000 stated principal. If gift tax valuation requires use of a 12% rate (120% of the AFR (ignoring any differences between the mid-term and longterm AFR)), the factor is 6.1944,374 and the gift tax value of the obligation is only $545,466 (6.1944 x 88,058). This in turn means that there is a taxable transfer of $54,534 ($600,000, value of the property, - $545,466, discounted value of the payments). If the S wishes to avoid the gift tax risk, he must use a 12% stated interest rate. As applied to a level payment arrangement, this increases the annual payment to $96,862 ($600,000/6.1944). The additional annual payment of $8,804 is taxed as additional interest. On the other hand, discounting the annual

payments of $96,862 at 10% gives a present value of $659,896 ($96,862 x 6.8132, the discount factor used in Example 3). Thus, in one sense, B has been forced to pay $59,896 more than the property is worth, if 10% is an appropriate borrowing rate. This potential distortion is inevitable as long as 7520 uses 120% of the AFR to value future payments. An issue not adequately addressed is when it is appropriate to use the AFR (income tax discount rates) to determine whether a gift has been made for purposes of the gift tax. In other words, under what circumstances can the valuation rules under 1274 and 483 override the valuation rules mandated by 7520?375 When the ordinary business transaction approach applies, as G.C.M. 39503 indicates is appropriate for transactions taxed as installment sales, the AFR governs.376 On the other hand, the G.C.M. insists the transfer tax tables apply when the transaction is taxed as an annuity. Even so, the IRS indicated in G.C.M. 39503 that factors other than the actuarial tables may be considered in appropriate cases.
374See

ALPHA VOLUME, supra note 162, Table B, 12.0%, page 3-25.

v. Commissioner, 92 T.C. 1039 (1989); Ballard v. Commissioner, supra note 301. See discussion of the Ballard and Cohen cases, infra at notes 378 and 379, indicating that for installment sales the interest rate applied in 483 is used to value the installment note for gift tax purposes.)
376G.C.M.

375Cohen

39503, Issue (2)(B), supra note 4.

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Two recent cases involving intrafamily sales that occurred in 1981, when the then version of 483 provided that there was no imputed interest if stated interest was at least 6%. Actual market interest rates in 1981 were significantly higher, a factor that is partly responsible for the present versions of 483 and 1274. The IRS argued that it was not bound by the 483 rate for gift tax purposes, and used an 11% rate in the Krabbenhoft case,377 and an 18% rate in the Ballard case.378 Although it is possible that the parties used the lower 483 rate to convert ordinary income into capital gain, it is apparent that they also intended to use obligations with a value less than their face amount. The court of appeals in Ballard held that the 483 rate applied for all purposes of the Code and refused to find a gift, but the appellate court in Krabbenhoft upheld the IRS. More significantly, in the Cohen case,379 the court upheld use of realistic interest rates and disregarded the transfer tax tables in valuing an interest-free loan. At one level, the IRS position, upheld in Krabbenhoft and Cohen, although rejected in Ballard, is that it is not bound by use of unrealistic specified rates, particularly income tax rates, in determining gift tax values. In a broader sense, however, the cases may stand for the proposition that economic reality, not prescribed rates, should determine the gift tax consequences. The question is whether the AFR rates or the 7520 rates more closely reflects that reality. A substantial argument can be made that to the extent that a transaction is taxed as a sale, the AFR, which is now based on current interest rates, albeit ones that are consciously less than most taxpayers could obtain, should nevertheless control. Interestingly, the IRS has recently argued, in a case arising before the enactment of 2702, that it could

377Krabbenhoft 378Ballard 379Cohen

v. Commissioner, 939 F.2d 529 (8th Cir. 1991), aff'g 94 T.C. 887, cert. den. Jan. 27, 1992..

v. Commissioner, 53 T.C.M. (CCH) 325 (1987), rev'd, 854 F.2d 185 (7th Cir. 1988).

v. Commissioner, 910 F.2d 422, aff'g 94 T.C. 887 (1990); see also Estate of Arbury v. Commissioner, 93 T.C. 136 (1989) (interest rate on noninterest bearing loans not limited by state's usury rate); Tech. Adv. Mem. 87-01-002 (Sep. 19, 1986).

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disregard the transfer tax valuation tables in valuing a retained income interest.380 Although it lost, it has appealed to the same circuit that decided Krabbenhoft. H. Premium

Although there is apparently no authority relating to whether premium can arise in the sale of a family business. Before the current express provisions relating to OID were adopted, there was a split of authority whether OID could arise when debt obligations were issued for property.381 To add to the confusion, the IRS has ruled that an accrual method senior family member must take the face amount of the family buyer's obligation into income, implying that a cash basis taxpayer can use the fair market value of the obligation.382 Although taxpayers have frequently claimed that obligations have a fair market value below the face amount, no case has been found in which the taxpayer or the IRS has claimed a value above face. Finally, the OID proposed regulations contain a provision permitting the IRS to recharacterize as purchase price, a portion of the interest if the IRS determines that the interest rate is excessive.383 These regulations indicate that
v. Commissioner, 95 T.C. 646 (1990), appeal filed, Mar. 2, 1991, 8th Cir. see also Tech. Adv. Mem. 91-33-001, (Jan. 31, 1990) (since death was imminent and would most likely occur within one year, the IRS ignored the transfer tax actuarial tables in valuing the younger generation buyer's private annuity obligation and used the facts and circumstances to value it). was permitted in American Smelting and Refining Co. v. United States, 130 F.2d 883 (3d Cir. 1942) (debt obligations issued for issuer's own stock; before Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 139 (1974) (finding no OID in exchange of the issuers $50 debt obligations for the issuer's outstanding preferred shares initially issued for $50); and Nassau Lens Co. v. Commissioner, 308 F.2d 39 (2d Cir. 1962) (debt obligations issued in transaction under 351; remanded for determination of values; transferred basis), but rejected in Montana Power Co. v. United States, 332 F.2d 541 (3d Cir. 1956) and 159 F. Supp 593 (Ct. Cl. 1958) (debt obligations issued in tax-free reorganization; discount claimed using transferred basis; no evidence that value of assets less than face of debt) and Southern Natural Gas Co. v. United States, 412 F.2d 1222 (Ct. Cl 1969) (debt obligations issued for property; IRS conceded that face of debt governed basis of property until Code amended to require transferred basis); cf. 171(b)(4) (limiting amortizable premium on debt obligations received in exchanges where there is a substituted basis in whole or part to the fair market value of the debt obligation; this prevents conversion of an unrecognized, possibly capital loss, into a currently deductible item). Rul. 79-292, 1979-2 C.B. 287. See Mieves, Revenue Ruling 79-292 and Deferred Reporting, 36 U. MIAMI L. REV. 175 (1981); Goldberg, Open Transaction Treatment for Deferred Payment After the Installment Act of 1980, 34 TAX LAWYER 605 (1981). The ruling does not address the buyer's basis.
383Prop. 382Rev. 381Discount 380O'Reilly

Reg. 1.1274-1(d).

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the excess may be determined on the basis of the fair market value of the property or an arm's-length interest rate, and, further, indicates that the relative tax effect to the parties from the overstatement is a major factor. If the regulation provision applies, the effect is to treat the recharacterized portion as premium, but the regulations do not state this, or refer to the possible amortization. The regulation is an anti-tax-avoidance provision, and does not provide general authority on premium in sales of shares under family sale agreements (or otherwise). The 1986 Act placed premium amortization on a compoundinterest basis, by express cross reference to the accrual methods under 1272.384 When the premium provisions apply, they make no distinction between original issue and market premium.385 Example 21: S sells family financial assets consisting of publicly-traded securities to B. The securities have a quoted market price of $650,000. The terms of the sale provide for principal payments of $50,000 a year for ten years plus interest at 12%. Because market interest rates are only 10%, B's obligation is worth $650,000 even though the stated principal amount is only $600,000. It is not clear if the excess of the value of the financial assets over the principal amount of the debt obligation gives rise to amortizable premium. If it does not, S's amount realized and B's basis for the property is probably determined by the $600,000 face of the notes. Even if S is a cash basis taxpayer generally required to use the fair market value of debt obligations, valuing the B note at $650,000 is inconsistent with a determination that there is no amortizable premium. S must report gain in the year of sale and not under the installment method, because the family financial assets are publicly-traded securities.

171(b)(3). The legislative history, which treats this as a technical correction, gives no indication why the other concepts relating to issue price and redemption price are not adopted.
385

384

171; Reg. 1.61-2(c). Compare 207.7 D.

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If the legal conclusion is that there can be amortizable premium, the amount realized by S for the assets is $650,000. If B is an accrual basis taxpayer, he routinely amortizes the discount as a reduction of his interest deduction. S has an election to amortize the premium. If she does not, she has a capital losses aggregating $50,000 when the debt obligations are paid. If she does, the principal, interest and amortized premium are as follows: Year 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Total Total Received $ 122,000 116,000 110,000 104,000 98,000 92,000 86,000 80,000 74,000 68,000 62,000 56,000 $1,068,000 Payments Principal $ 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 $600,000 Stated Interest $ 72,000 66,000 60,000 54,000 48,000 42,000 36,000 30,000 24,000 18,000 12,000 6,000 $468,000 Amortized Premium $ 6,563 6,257 5,921 5.551 5,143 4,694 4,201 3,657 3,059 2,400 1,676 878 $50,000

The amortized premium is a reduction in the interest taxable to S, and deductible, within applicable limits, by B. If neither the family financial assets, nor the B debt obligations, are publicly traded, but the parties can establish the fair market value, the results relating to premium should be the same. The premium provisions make no distinction based on the presence or absence of public trading. If there is no public trading, the sale should qualify for reporting under the installment method. If there is premium, the selling price should be $$650,000. S's higher gain is offset by the

amortization of the premium that reduces her interest income on the B debt obligations.

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 207.8

Convertible Obligations

Debt obligations convertible into shares of a family corporate buyer can qualify for installment sale treatment in the same manner as straight debt obligations. Convertible obligations convertible into shares that are readily tradeable on an established securities market can qualify under the installment method as long as the obligations are not themselves so traded. The regulations provide a safe harbor for obligations that are not convertible for one year from date of issue.386 They also provide a more general exception for obligations convertible at a substantial discount.387 Although conversion of a convertible security is normally not a recognition event,388 the IRS has ruled that the entire value of shares received on conversion is a taxable disposition of an installment obligation.389 Unlike the OID rules, when a corporate family buyer's debt obligation is convertible, the value of the conversion privilege is excluded from any amortizable premium.390 Example 22: S sells to B, a family corporation, shares worth $1,000,000 that have a basis of $100,000 and receives a B convertible debenture with a principal amount and value of $1,000,000. S subsequently converts the debenture into B shares with a value of $2,500,000. Under the IRS view, the entire $2,500,000 value of the B shares, not the $1,000,000 principal amount and selling price is the amount S receives on disposition of the installment obligation so that he reports gain of $2,400,000, not $900,000 (or zero) at the time of the conversion. S's gain
386Temp. 387Id.

Reg. 15A.453-1(e)(5)(ii).

A substantial discount exists if the value of the shares is less that 80% of the value (not the principal amount) of the obligation. Apparently the value of the obligation does include the value of the conversion privilege. Rul. 72-265, 1972-1 C.B. 222; see Fleischer and Cary, The Taxation of Convertible Bonds and Stock, 74 HARV. L. REV. 473, 476-88 (1961).
389Rev. 390 388Rev.

Rul. 72-264, 1972-1 C.B. 131; G.C.M. 34595 (Aug. 25, 1971).

171(b)(1); Reg. 1.171-2(c). See 201.8 and 207.8.

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does not affect B's basis in the family corporation shares (if the sale is not a redemption by B of its own shares). S's basis in the shares received on conversion is $2,500,000. The full market price or AFR issue price of convertible debt obligations of a family corporate buyer is the issue price for OID purposes; the conversion privilege is not separately valued to give rise to OID.391 If, on the other hand, the family buyer's debt obligation is part of bond and warrant or bond and stock package, value is separately assigned to the stock or warrants issued as part of a package, even if the debt obligation may be used to pay the exercise price for the warrant.392 This may cause OID or unstated interest if the remaining consideration allocated to the family buyer's debt obligation is less than the stated redemption price. 207.9 Exclusions

There is no installment recognition of loss.393 Inventory assets, depreciation recapture and marketable securities do not qualify for installment sale treatment,394 as are dispositions by dealers in personal property or real property (with an exception for dispositions of farm property, unimproved residential lots and time shares).395 Although not expressly excluded, it is likely that tax benefit items are also not eligible because the sale is "fundamentally inconsistent" with the prior deduction that gives rise to the tax benefit problem.396

391Prop. 392Prop. 393See 394 395

Reg. 1.1273-2(e); Lokken, supra note 47 at 30. Reg. 1.1273-2(d); Lokken, supra note 47 at 29-30.

Rev. Rul. 68-13, supra note 87.

453(b)(2), (i) and (k)(2). Similarly, unamortized market discount is recognized. 1276(a)(2). 453(l). Hillsboro National Bank v. Commissioner, supra note 274; Manning, supra note 274.

396See

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Reporting the recapture income increases the selling senior family member's basis in the younger generation buyer's debt obligation for purposes of determining the gross profit ratio under the installment method for the remainder of the gain. When the younger generation buyer takes over the selling senior family member's liabilities in a deferred payment sale of an asset with potential depreciation recapture income, the increase in the seller's basis resulting from the immediate reporting of the recapture income may reduce or even eliminating the "deemed" payment of cash that occurs when the liability transferred exceeds the seller's basis in the property sold. Example 23: The facts are the same as in Example 2 except that the asset sold is improved real estate depreciated using an accelerated method. (The building was acquired by S prior to 1987.) The real estate has $125,000 of depreciation recapture. S must report as gain on the sale $125,000 of ordinary income in 1989, the year of the sale. For purposes of determining the gross profit ratio applied to "all" payments received under the sales contract, S's basis in the asset is increased by the $125,000 of recapture income that was not eligible to be deferred under the installment method. With a redetermined basis of $1,825,000, the gross profit is now $675,000. The entire $1,750,000 mortgage reduces the $2,500,000 sales price to arrive at a $750,000 contract price. Since the mortgage does not exceed S's basis, as redetermined, no fictional payment of cash occurs. The resulting 90% gross profit ratio ($675,000/$750,000) is applied to the $150,000 down payment and $600,000 of principal payments on the note so that the $675,000 of the 1231 or capital gain realized on the sale is reported under the installment method. The total gain on the sale remains at $800,000. The timing of this gain has changed because $125,000 of the gain is not eligible for the installment method.

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 207.10 Part-Sale, Part Gift When a transaction is part-sale, part gift, the senior family member can apply her entire basis against the sale price,397 but usually cannot recognize a loss if the basis exceeds the consideration received.398 The younger generation buyer can, however, reduce any subsequent gain by the loss denied the senior family member.399 Similarly, the younger generation buyer's basis in the property generally is the greater of the price paid or the transferor's basis limited by the fair market value of the property.400 When the selling senior family member has a basis greater than the value of the property and the purchase price, the younger generation buyer's basis in the property is split, with the selling senior family member's basis for purposes of determining gain but the fair market value for purposes of determining loss.401 When there is a split basis, the gain basis is used to determine depreciation,402 although this appears inconsistent with using the split basis to determine loss for the younger generation buyer. Any gift tax paid can increase the buyer's basis up to, but not beyond, the fair market value of the property.403 The senior family member's gift tax should not increase the buyer's basis if it is determined by the purchase price even when the purchase price is less than the fair market value of the property, because the adjustment is treated as an increase in the transferor's basis.404

397 398 399 400

1011(a); Reg. 1.1001-1(e). 267(a)(1); Reg. 1.100-1(e) Examples (2) and (4). 267(d); Reg. 1.267-1(a). 1015(a); Reg. 1.1015-4 1.1015-4(b) Example (4).

401Reg. 402 403

167(g); Reg. 1.167(g)-1. 1015(d); Reg. 1.1015-5 1015(d) and 1016(b); Reg. 1.1015-5(c).

404

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Example 24(a): The facts are the same as in Example 2 except that B's notes are only for $350,000. S has made a gift of $250,000. Her gain is only $550,000, (amount realized of $2,250,000 ($1,750,000 mortgage, $150,000 cash and $350,000 notes) $1,700,000 basis. S does not allocate any of her basis to the gift. B's basis in the property is $2,250,000. Example 24(b): The facts are the same as in Example 24(a) except that S's basis in the property is $2,400,000 and the fair market value of the property is $2,300,000. S does not realize a loss on the sale and has made a gift of $50,000. B's basis in the property is $2,400,000 for purposes of determining gain and depreciation. It is only $2,300,000 for purposes of determining loss on a subsequent sale so that if B sells the property for $2,350,000 he realizes neither gain nor loss. Example 24(c): The facts are the same as in Example 24(b) except that the fair market value of the property is $2,250,000. S cannot deduct any loss. There is no gift and B's basis in the property is the purchase price of $2,250,000 for purposes of determining gain, loss and depreciation. If B subsequently sells the property for $2,350,000, he can offset S's nondeductible loss and report no gain. If the property is depreciable, B is worse off having paid full value for the property than if he had received a part gift. When a transaction is a part-sale, part-gift, it is difficult to find that it satisfies the bona fide business transaction rule for gift tax purposes. Nevertheless, the note given in

the sale portion of the transaction should be valued under the OID and unstated interest principles, not under 7520.405

405See

201.7 G.

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 208 208.1

Private Annuity Sale Obligations Tax Treatment of Annuities in General

An individual who saves by depositing money in a bank savings account must report the interest earned each year under the doctrine of constructive receipt even if no withdrawals are made. Even an individual who buys a long-term certificate of deposit where early withdrawal incurs a penalty must report interest as earned under the OID rules.406 Example 25: A deposits $2,460.80 in a bank savings account on January 1, 1990. The bank pays 10.6% annual interest. A intends to withdraw $1,000 annually for the next three years beginning on December 31, 1990. The following illustrates the interest income earned each year: Deposit on January 1, 1990 Interest at 10.6% for 1990 Withdrawal on December 31, 1990 Balance on January 1, 1991 Interest at 10.6% for 1991 Withdrawal on December 31, 1991 Balance on January 1, 1992 Interest at 10.6% for 1992 Withdrawal on December 31, 1992 Balance $2,461 + 261 -1,000 $1,722 + 182 - 1,000 $ 904 + 96 -1,000 -0-

When the individual saves by purchasing an annuity, the implicit interest in the internal buildup in the policy is not taxed currently.407 The doctrine of constructive receipt does not apply because the annuitant does not have a right to withdraw as the interest is earned.

406Prop. 407See

Reg. 1.1275-1(b).

202.1. Cf. 56(g)(4)(B)(ii) including such internal buildup in determining the adjusted current earnings adjustment for purposes of the corporate alternative minimum tax.

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The basic mechanism for taxing annuities is to allocate each payment between basis recovery and income on a straight line basis by use of the "exclusion ratio,"408 the fraction determined by dividing the annuitant's "investment in the contract"409 by the "expected return,"410 that is, the total of the undiscounted payments to be made.411 If all payments to be made are not subject to any contingencies, then the guaranteed number of payments is used to determine the expected return.412 If there is a contingency, such as payments to be made for the rest of the annuitant's life, then the life expectancy of the annuitant at the "annuity starting date" is the multiple used to determine the expected return.413 The annuity starting date is the date in the future the annuity payments are to commence.414 The life expectancy multiples to be used in determining the expected return are prescribed in the Regulations under 72.415 Example 26: B purchases an annuity on January 1, 1990, for $2,461, the present value of $1,000 a year for three years at 10.6%, the 7520 rate. This annuity contract provides that B will receive $1,000 annually for three years, the first payment to be made on December 31, 1990. The "investment in the contract" is $2,461. The "expected return" is $3,000. The "exclusion ratio" is 82.03%. Therefore, B must report $179 as income every time he receives a $1,000 annuity payment.

408 409 410

72(b)(1). 72(c)(1). 72(c)(3). 202.1.

411See 412 413 414

72(c)(3)(B). 72(c)(3)(A). 72(c)(4). 1.72-9, Table V.

415Reg.

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As Example 26 indicates, the annuity reporting rules do not change the aggregate amount of interest income reported. But, the timing rules for annuities have a deferral advantage. Table A Year 1990 1991 1992 Total 208.2 Annuity Income $180 180 180 $540 Private Annuity Sales Interest Income $261 183 96 $540

The traditional tax treatment of private annuity sales developed before the Installment Sales Revision Act of 1980 extended installment sale treatment to contingent payment sales,416 presumably including those with payments in the form of an annuity.417 The following facts will be used to illustrate the tax consequences of the private annuity sale and SCIN examples in the balance of Part II. Example 27: S is 70 years old. On April 1, 1990, S sells the stock in a family business corporation to B for $1,000,000. S's basis for the stock is $200,000 and it is worth $1,000,000. Under Reg. 1.72-9, Table V, a 70-year old has a life expectancy of 16.0 years. However, the estate and gift tax valuation tables in Reg. 20.2031-7(f) and the tables in the Alpha Volume use 10.8 years as the life expectancy of a 70-year old. As announced in Rev. Rul. 90-28,418 the AFR annual interest rates for April, 1990 are:

H.R. Rep. No. 1042, 96th Cong., 2d Sess. 10, note 12; S. Rep. No. 1000, 96th Cong., 2d Sess. 12, note 22; Manning and Hesch, supra note 2, at 20-21, 23-27; see also 203.
417See

416See

G.C.M. 39503, supra note 4; see also 205. I.R.B. 10.

4181990-14

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Mid-term AFR Long-term AFR 120% AFR, the 7520 rate The present value of $1 annually is: For life for a 70-year old under income tax tables (16 years) at 8.8%, the AFR, (rounding 8.75%) For life for a 70-year old under income tax tables (16 years) at 10.6%, the 7520 rate For life for a 70-year old under transfer tax tables (10.8 years) at 8.8%, the AFR For life for a 70-year old under transfer tax tables (10.8 years) at 10.6%, the 7520 rate

8.75% 8.75% 10.60%

$8.4161 $7.5520 $6.8745 $6.1972

Accordingly, the annual level payment needed to pay the price of $1,000,000 is: For life for a 70-year old under income tax tables (16 years) at 8.8%, the AFR, (rounding 8.75%) For life for a 70-year old under income tax tables (16 years) at 10.6%, the 7520 rate For life for a 70-year old under transfer tax tables (10.8 years) at 8.8%, the AFR For life for a 70-year old under transfer tax tables (10.8 years) at 10.6%, the 7520 rate A. Installment Sale $118,820 $132,415 $145,465 $161,363

For comparison purposes, we will first illustrate an installment sale in which the younger generation buyer makes a level annual payment over a fixed term. When all payments are fixed, the deferred payment arrangement is an installment sale governed by the installment reporting rules under 453. The 16-year term for the payments corresponds to the selling senior family member's 16-year life expectancy used in the income tax tables.419 As discussed in 202.7 G, the higher interest rate required under 7520 (120% x AFR), if applicable, can result in a deferred payment obligation having a lower value for

419Reg.

1.72-9, Table V.

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gift tax purposes than the principal amount of the debt obligation determined under the OID and unstated interest rules under 1274(d)(1) (the AFR) . Example 28: The facts are the same as in Example 27. On April 1, 1990, S sells his family business shares, with a basis of $200,000, to B for $1,000,000. S agrees to finance the entire $1,000,000 purchase price over 16 years. In order to avoid any imputed interest issues, B will pay interest at 8.8%. A gross profit ratio of 80% is applied to each principal payment to determine the amount of capital gain reported under the installment method. (a) Decreasing Payment Obligation. One form of installment sale requires B

to pay $62,500 annually for 16 years, plus 8.8% interest on the unpaid balance. The first annual payment (principal and interest) is $150,000 ($62,500 principal and $87,500 interest). The annual payment decreases each year, and finally is only $67,969 ($62,500 principal and $5,469 interest) at the end of the 16-year term. (b) Level Payment Obligation. An alternative is a level annual payment over

the entire 16-year term of the loan. Using the actuarial tables for 8.8% interest, the present value of $1.00 annually for 16 years is 8.4161. Therefore, the annual payment is $118,820 ($1,000,000 divided by 8.4161). For gift tax purposes, the present value of an obligation to pay $118,820 annually for 16 years would be discounted at 10.6% under 7520, if it is applicable. Therefore, the value of B's obligation would be only $897,327 ($118,820 x 7.5520), resulting in a potential gift of $102,673.420

420If

S uses 10.6% interest to determine the annual installment payment, it would be $132,415 ($1,000,000 divided by 7.5520), and under 7250 the value of the buyer's obligation is $1,000,000, and no gift arises because the consideration is adequate. However, for income tax purposes, using 8.8% interest, the principal amount of this obligation is $1,114,420.

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For income tax purposes, B's basis is $1,000,000 because 1274 using the AFR, treats $1,000,000 as both the imputed and the stated principal amount of B's obligation. The amount, character and timing of S's income upon receipt of each annual payment, using an 80% gross profit ratio for each principal payment, is: Year 4-1-91 4-1-92 4-1-93 4-1-94 4-1-95 4-1-96 4-1-97 4-1-98 4-1-99 4-1-00 4-1-01 4-1-02 4-1-03 4-1-04 4-1-05 4-1-06 Payment $ 118,820 118,820 118,820 118,820 118,820 118,820 118,820 118,820 118,820 118,820 118,820 118,820 118,820 118,820 118,820 118,820 $1,901,120 Basis $ 6,164 6,707 7,297 7,939 8,632 9,392 10,218 11,117 12,096 13,160 14,318 15,578 16,949 18,441 20,063 21,829 $200,000 Capital Gain $ 24,656 26,826 29,186 31,755 34,528 37,566 40,872 44,469 48,382 52,640 57,272 62,312 67,796 73,762 80,253 87,315 $800,000 Interest $ 88,000 85,287 82,337 79,126 75,660 71,862 67,730 63,234 58,342 53,020 47,230 40,930 34,075 26,617 18,504 9,676 $901,120

As the above table indicates, the 80% gross profit ratio is applied each year to an increasing principal payment. And, as the outstanding principal balance is reduced each year, the interest portion of each succeeding payment decreases. If any of the sellerprovided financing is later cancelled, the amount of the cancellation is a purchase price adjustment that reduces the buyer's basis.421 B. Traditional Treatment

When contingent payment sales did not qualify as installment sales, the IRS permitted deferred reporting of certain contingent sales under the annuity rules.422
421

108(e)(5); see 207.4 A.

Rul. 55-119, supra note 103; Rev. Rul. 69-74, supra note 103; see 202.2. At the time Rev. Rul. 69-74 was issued, the annuity rules under 72 permitted the indefinite use of the exclusion ratio, thereby permitting an annuitant to continue to exclude from taxation a portion of all annuity payments as the

422Rev.

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If a private annuity sale is governed by the annuity rules, the younger generation buyer's basis initially equals the value of the private annuity obligation, but changes depending upon the amount the buyer pays under the annuity arrangement.423 This "tentative basis" is finally determined only after the selling senior family member dies, and all payments are finally fixed. The younger generation buyer's "final" basis is equal to the aggregate of all annuity payments made to the seller. Once the total of all payments made exceeds the tentative basis amount, each additional payment is added to the buyer's basis. The basis only becomes final when the payments cease. If the selling senior family member dies before the total of the annuity payments made equals the tentative basis amount, then the final basis is an amount equal to the payments actually made. If the younger generation buyer sells the family business or other

financial assets before the selling senior family member's death, there is a split basis, with gain determined using the tentative basis, but loss allowed only to the extent the sale price is less than payments made.424 All subsequent payments are loss, whether gain or loss was realized on the interim sale of the family business or other financial assets. No interest is imputed for any annuity payment made by the younger generation buyer.425 The effect is that the entire amount of each annuity payment made by the buyer is treated as a principal payment. The inability of the buyer to treat any portion of an

investment in the contract even though he had previously recovered his entire investment in the contract. Effective for annuities starting after December 31, 1986, 72(b)(2) eliminated this so-called mortality gain. The discrepancy between Rev. Rul. 69-74, treating the seller's basis in the property sold as his investment in the contract, and Reg. 1.1011-1(b) Example (8), treating the value of the property sold as the investment in the contract, no longer has any tax significance because of 72(b)(2) which precludes the use of the exclusion ratio once the entire basis is recovered.
423Rev. 424Id.

Rul. 55-119, supra note 103.

v. Commissioner, supra note 115; Bell v. Commissioner, 76 T.C. 232 (1981). Under 1275(a)(1)(B)(i), the OID and unstated interest rules do not apply. For the seller, the annuity rules under 72 accomplish the same objective as the imputed interest rules under 1274. Under 72 the seller treats a portion of each payment as "annuity income." This is in effect the interest component.

425Dix

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annuity payment as interest expense requires the buyer to capitalize, as part of his basis, what is realistically an interest expense. Because the younger generation buyer cannot treat any portion of the annuity payment as interest expense, the total of the actual payments will exceed the tentative basis amount well before the selling senior family member reaches his actuarial life expectancy. Therefore, a younger generation buyer using a private annuity sale arrangement can expect to have a basis for an asset far greater than the amount he paid for it (i.e., greater than its value). Another distortion is caused when the higher interest rates (120% of the AFR as mandated by 7520) and shorter mortality assumptions found in the gift tax valuation tables under Reg. 20.2031-7(f) and the Alpha Volume are used to calculate the annuity payments. The amount of each annuity payment will be larger than if the lower income tax interest rate and longer income tax mortality assumptions were used. Since Rev. Rul. 55-119 requires the use of the gift tax valuation tables,426 the younger generation buyer can end up undertaking an obligation that has a value greater than the value of the property purchased as determined under the OID and unstated interest rules. Consequently, if the buyer lives to the longer actuarial life expectancy used in Reg. 1.72-9, Table V, the buyer will end up paying far more for the property than it may be worth, with a resultant basis greater than its value. Example 29: The facts are the same as in Example 27. B, the buyer, agrees to pay S an annual annuity payment for the rest of the S's life. If the annual annuity payment is computed using the transfer tax tables in the Alpha Volume at 10.6%, the 7520 rate, it is $161,363 ($1,000,000 divided by 6.1972).

Estate of Bell v. Commissioner, supra note 425, the court sanctioned the use of the estate and gift tax tables in valuing an annuity obligation under Rev. Rul. 55-119 for determining the buyer's tentative basis.

426In

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The investment in the contract is $200,000. The expected return is $2,581,811 ($161,363 x 16.0 year life expectancy of the income tax annuity tables). Therefore, the exclusion ratio is 7.75%.427 Assume that S dies in the year 2009. Under the 72 annuity rules the amount, character and timing of S's income is: Date 4-1-91 4-1-92 4-1-93 4-1-94 4-1-95 4-1-96 4-1-97 4-1-98 4-1-99 4-1-00 4-1-01 4-1-02 4-1-03 4-1-04 4-1-05 4-1-06.428 4-1-07 4-1-08 4-1-09 Total Payment $ 161,363 161,363 161,363 161,363 161,364 161,363 161,363 161,363 161,363 161,364 161,363 161,363 161,363 161,363 161,364 161,363 161,363 161,363 161,363 $3,065,900 Basis $ 12,500 12,500 12,500 12,500 12,500 12,500 12,500 12,500 12,500 12,500 12,500 12,500 12,500 12,500 12,500 12,500 -0-0-0$200,000 Capital Gain $ 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 50,000 -0-0-0$800,000 Annuity Income $ 98,863 98,863 98,863 98,863 98,864 98,863 98,863 98,863 98,863 98,864 98,863 98,863 98,863 98,863 98,864 98,863 161,363 161,363 161,363 $2,065,900

As illustrated in Example 30, the younger generation buyer's basis in a private annuity sale reported under the annuity rules exceeds the value of the property purchased far before the selling senior family member reaches the end of his actuarial life expectancy. This is because the buyer cannot deduct any portion of his annuity payments as interest expense and because the transfer tax tables used in determining the annual

using a 16.0 year life expectancy under 72, the seller will end up recovering his basis over a longer term than the 10.8 year life expectancy used to compute the amount of the annual annuity payment. In other words, the recovery of basis is over a 16-year period instead of over 10.8 years.
428Once

427By

basis fully recovered; all subsequent payments are annuity income. 72(b)(2).

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annuity payments use shorter life expectancies and higher interest rates, thereby increasing the amount of the annual annuity payment that is required to avoid gift tax. Example 30: B's tentative basis for the private annuity sale in Example 29 is $1,000,000, the present value of the annuity obligation using the transfer tax tables at 10.6%, the 7520 rate. As the annuity payments are made B's tentative and final basis is as follows: Annual Payment $161,363 161,363 161,363 161,363 161,364 161,363 161,363 161,363 161,363 161,364 161,363 161,363 161,363 161,363 161,364 161,363 161,363 161,363 161,363 Payments to Date $ 161,363 322,726 484,089 645,452 806,816 968,179 1,129,542 1,290,905 1,452,268 1,613,632 1,774,995 1,936,358 2,097,731 2,259,084 2,420,448 2,581,821 2,743,174 2,904,537 3,065,900 Tentative Basis429 $1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,129,542 1,290,905 1,452,268 1,613,632 1,774,995 1,936,358 2,097,731 2,259,082 2,420,448 2,581,821 2,743,174 2,904,537 3,065,907

Date 4-1-91 4-1-92 4-1-93 4-1-94 4-1-95 4-1-96 4-1-97430 4-1-98 4-1-99 4-1-00 4-1-01 4-1-02 4-1-03 4-1-04 4-1-05 4-1-06 4-1-07 4-1-08 4-1-09

Example 31: The facts are the same as in Example 30. The annual private annuity payment, using an 8.8% interest rate and a 16.0 year life expectancy, is $118,820. This is the same annual amount as when B's obligation is a fixed 16year installment obligation.431
an interest deduction been allowed consistent with the interest income reported by the seller, then only $62,500 of each annual annuity payment would have been applied towards basis so that the $1,000,000 tentative basis would not have been adjusted upward until the end of the 16th year. buyer's basis in the shares purchased begins to exceed the $1,000,000 value of the shares by the seventh annual payment.
431See 430The 429Had

Example 28 in 208.2 A.

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If the selling senior family member in a private annuity sale reported under the 72 annuity rules dies before reaching his actuarial life expectancy, there is an unrecovered "investment in the contract." Presumably, the seller may deduct any unrecovered basis on his final income tax return under 72(b)(3)(A). The character of the loss for unrecovered basis should be determined by reference to the character of the property sold rather than being viewed as a loss in an independent annuity transaction.432 Where the asset sold is a capital asset, the loss is a capital loss. Nevertheless, when the buyer in a private annuity sale is related to the seller, the loss provided an annuitant for unrecovered basis on premature death should not be disallowed under the related party rule of 267(a)(1) because it is not part of the sale, but of the annuity transaction.433 Example 32: The facts are the same as in Example 30. If S dies at the end of the year 2000 at age 80, having received only 10 of the expected 16 annual payments. The remaining, unrecovered basis is $75,000. S is permitted to deduct $75,000 on his final income tax return. B's basis is finally determined to be $1,613,630, the aggregate of all payments made. C. Part-Sale, Part-Gift

When a private annuity sale is a portion of a part-sale, part-gift transaction, the only significant difference from a part-sale, part-gift in a fixed payment installment sale is that, under the IRS view, the gift portion is determined using the transfer tax tables including the higher discount rates under 7520. Example 33: The facts are the same as in Example 29 except that B's annual payments are only $50,000. S's gift is $ under the transfer tax tables of Reg.

2031-7(f). S's basis in the property should be applied first to the mortgage and then to B's payments. B's initial basis for the property is $ , the sum of the

432See 433

Arrowsmith v. Commissioner, supra note 221; see also 209.

72(b)(3)(A).

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mortgage and the actuarial value of the payments as further increased for any gift tax paid by S. If S's basis is more than $ , B's initial basis for the property

is the same as S's basis (adjusted for gift tax paid) in determining gain and depreciation, but is limited by the fair market value in determining loss. 208.3 Impact of Chapter 14

When a deferred payment obligation is a bona fide debt, even if a private annuity, it should not be subject to the special valuation rules of 2701.434 Such a bona fide arrangement should also avoid 2702 because there is no "retained" interest.435 The deferred payment obligation is not an interest in the business purchased even though the payment terms resemble those of a guaranteed retained annuity trust ("GRAT"). As long as the younger generation buyer's obligation is an independent one, that is, not a nonrecourse obligation secured solely by the business purchased,436 it is not a retained interest.437 If this is so, the selling senior family member does not have to survive the term of the retained interest to remove the transferred property from the gross estate as is required for a GRAT.438 For similar reasons a private annuity obligation or SCIN should not be considered a lapsing right under 2704.439 It is not a voting or liquidation right. Although cancellation of the obligation to make payments may save the younger generation buyer of the family business money, that possibility of early termination is

434See

202.3.

435Covey,

Recent Developments Concerning Estate, Gift and Income Taxation--1990, 25th ANN. PHILIP E. HECKERLING INST. ON EST. PLAN., Ch. 1, 101.4 F (1991). e.g., LaFargue v. Commissioner, 689 F.2d 846 (9th Cir. 1982) (private annuity transaction with a trust is sale, not retention of income interest where annuity amount not related to income of trust, had a value substantially less than value of trust and taxpayer lacked control of trust); Stern v. Commissioner, 747 F.2d 555 (9th Cir. 1984) same even though value of annuity close to value of transferred property).
437See 438See 436See,

Estate of Moss v. Commissioner, supra note 158. Covey, supra note 435. supra note 16, at 708.061 (1991).

439See Manning,

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properly taken into account in fixing the value of the payments.440 Nevertheless, since the IRS has always had, at best, an ambivalent approach to private annuity sales and SCINs, there remains a possibility that future proposed regulations under 2701 or 2702 will seek to apply Chapter 14 to private annuity sales.441 The regulations should not do so for the reasons stated above. A private annuity obligation or SCIN should not be used in determining price in a buy-sell agreement effective at death. Because such arrangements are rarely used in arm's-length agreements among unrelated parties, their use will probably prevent the agreement's satisfying the requirements of 2703(b)(4).442 209 Contingent Payment Installment Sales When contingent payments are part of an installment sale, providing for the recovery of basis, and application of the OID and unstated interest rules, adds significant additional complexity to a transaction that is not simple to begin with. 209.1 Recovery of Basis

The temporary installment method regulations approach to the complex problem of basis recovery, by classifying contingent price sales as those providing a maximum price, a maximum payment period or neither, and establishing different basis recovery approaches depending on the classification, leaves a significant risk that there will be unrecovered basis after the last payment is made.443 Based on the Arrowsmith case, the loss should be characterized by the initial sale transaction.444 The loss is presumably a

440See 441It

200, 208.2 and 210.2.

took a similar position in Notice 89-99, Part V(C), 1989-2 C.B. 422, 430 under former 2036(c). Cf. Priv. Ltr. Rul. 91-13-009 (Dec. 21, 1990) (senior family member's guarantee of loan to junior family member is taxable transfer of the entire amount of the loan).
442See

Manning, supra note 16, at 708.061. Reg. 15A.453-1(c); see 203.1.

443Temp.

v. Commissioner, supra note 221 (loss to shareholders on payment of corporate liabilities after liquidation is capital because gain on liquidation was capital gain); see Rev. Rul. 78-25, supra note

444Arrowsmith

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capital loss, with limited deducibility, unless for the family financial assets sold were not capital assets.445 The selling senior family member may be able to take advantage of 1341(a)(5), but this is far from clear.446 Section 1341(a)(5) allows a taxpayer who restores a significant amount which he was required to include in income in an earlier year to avoid the disadvantage of lower tax rates or limited deducibility by computing the tax effect of the deduction in the current year by reference to what the results would have been in the earlier year if the amount had not been received. A. Stated Maximum Selling Price

When less than the maximum price is received, there may be unrecovered basis deducted in the year in which the claim becomes worthless.447 Example 34: The facts are the same as in Example 2 except that S's basis for the property is $1,925,000 and all payments after the initial $150,000 payment in 1990 are to be equal to 25% of the income from the property for the first 20 years after the sale, with maximum additional payments of $900,000. Each payment is to be accompanied by an interest payment at an annual rate of 10% from the date of sale to the date of payment. The gross profit is $875,000 determined by assuming that the maximum of $900,000 contingent payments will be made ($2,800,000 amount realized ($900,000 maximum contingent payments + $150,000 down payment + $1,750,000 mortgage) - $1,925,000 basis). The gross profit percentage is 83-1/3% ($875,000 gross proft/$1,050,000 contract price).

444 (loss in case like Arrowsmith case eligible for 1341); Rev. Rul. 67-331, 1976-2 C.B. 290 (similar result for repayment of part of 1231 conversion gain). 453B(a). It is possible that the loss is eligible for the special treatment provided by 1341. See Arrowsmith v. Commissioner, supra note 221. Rev. Rul. 78-25, supra note 444; Rev. Rul. 67-331, supra note 444; see also Reg. 1.483-1(e)(3) Example (4), (under the former provisions of 483), which provides a "loss in accordance with the other applicable provisions of the Code" without stating what they are or the time or character of the loss.
447Temp. 446See 445

Reg. 15A.453-1(c) Example (5).

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Thus, only $25,000 basis is recovered from the initial $150,000 payment. Similarly, only 16-2/3% of each additional principal payment is basis recovery. If less than $900,000 is received so that basis remains at the end of the 20-year payment period, the unrecoverd basis may be deducted as a loss. It is not clear whether the loss is a capital loss or worthlessness of the debt obligation or whether its character is determined by the nature of the property sold. B Maximum Payment Period

The maximum payment period approach allocates the basis over time somewhat like straight-line depreciation, without regard to the actual pattern of contingent payments, with adjustment for any component of the term, for example, a changing percentage of profits, that is not uniform throughout the term.448 When basis is allocated ratably over the maximum payment period, and the principal payments received for any year are less than the basis recovery allocable to the year, the excess of the basis normally allocated for that year is not allowed as a loss.449 The excess is carried to the next year in which there is an excess of a principal payment over the basis otherwise allocated to that subsequent year.450 Example 35: S sells family financial assets worth $1,000,000, in which her basis is $500,000, to B for payments over a 10-year period equal to 10% of the value of the assets at the beginning of the year. Although the assets are pledged to secure payment of the obligation, B is personally liable for the payments without regard to income from the assets. Each payment is to be accompanied by an interest payment equal to 10% from the date of sale to the date of payment. S treats $50,000 of each payment as a return of basis, whether the payment is $75,000 or

448Temp. 449Temp. 450Temp.

Reg. 15A.453-1(c)(3). Reg. 15A.453-1(c)(3)(i). Reg. 15A.453-1(c)(3)(i) Example (2).

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$200,000. If the payment for the third year is only $45,000 because of a sharp decline in the value of the assets, S does not deduct any loss. Instead, she carries the $5,000 excess forward to the fourth year and recovers basis of $55,000 then if the fourth year payment is at least $55,000 The formula does not work well if there is a substantial fixed payment as well as a contingent component. Example 36: The facts are the same as in Example 35 except that B makes a lump sum payment of $400,000 at the time of sale and the subsequent payments are only 6% of the value of the property. The family can demonstrate that the 6% payments are expected to provide payments of $60,000 a year for the ten-year period, but that amount is neither guaranteed nor is it a limit on the payments. Nevertheless, only $50,000 of the initial payment is recovery of basis with a similar $50,000 basis recovery for each subsequent payment. There is a complex special basis recovery procedure to deal with this problem.451 C. Period When there is neither a maximum price nor term, the regulations first query whether a sale has occurred.452 If, not, the transaction is not a sale, it is taxed, presumably, as a lease or license or some similar transaction that may not properly be called a disposition of a family business and is therefore beyond the scope of this paper.453
451See

Neither Stated Maximum Selling Price Nor Maximum Payment

209.1 D. 1.453-1(c)(4).

452Reg. 453See,

e.g., Commissioner v. Brown, 380 U.S. 563 (1965) (sale of business to tax-exempt charity for contingent price and lease back is a sale); Rev. Rul. 66-153, 1966-1 C.B. 187 (Brown not applicable when amount payable by charity is in excess fair market value of stock); Restland Memorial Park v. United States, 509 F.2d 187 (5th Cir. 1975) (transaction was contribution to equity and not a sale to a new corporation; not at arm's length and no fixed price nor payment period); Portermain v. Commissioner, 58 T.C.M. (CCH) 293 (1989) (purported contingent price sale was a sham where price for sale to nonresident alien employee based on management agreement between acquired corporation and selling shareholder's controlled corporation).

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Although the regulations do not so state, there should be no significant issue whether a sale of family business has occurred when there is a substantial fixed payment as well as a contingent payment.454 Other indicia of sale, such a transfer of control and of other benefits and burdens of ownership should also be relevant.455 When a sale has occurred, basis is recovered on a straight line basis over a 15 year (or other) period,456 and the rules are a basically the same as for a maximum payment period. If the payment for any year is less than the basis recovery allocable to that year, the unused basis is carried forward to the next year.457 If payments cease before the end of the 15-year term, any unrecovered basis can be deducted at the time it is determined that no further payments will be made.458 Example 37: S sell shares of the family corporation worth $1,000,000, in which her basis is $150,000, to B for a fixed payment of $300,000 plus contingent payments equal to 5% of the pre-tax net profits of the corporation without limit as to time or amount. Any annual loss offset against future net profits in

determining the amount of the payment. The earnings prospects of the corporation are such that the fair market value of B's obligation is $1,000,000. Despite the unlimited nature of the payment, the transaction should still be a sale because of the significant fixed payment, because the contingent payment is not measured by the amounts B receives from the corporation but by the income of the corporation itself, and because the transfer passes control and other benefits and

Rev. Proc. 77-37, Secs. 3.03 and 3.06, 1977-2 C.B. 568, (providing as a guideline for rulings in reorganizations that 50% of maximum amount of purchaser shares are to be delivered at closing). e.g., Commissioner v. Brown, supra note 453; Frank Lyon Co. v. United States, 435 U.S. 561 (1978) (sale and lease-back is sale when purchaser-lessor undertook substantial liability).
456See 455See,

454Cf.

203.1 C. Reg. 15A.453-1(c)(4).

457Temp. 458Id.

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burdens of share ownership to B. S treats $10,000 of each payment for fifteen years as recovery of basis. D. Special Basis Recovery

When the rules above result in a substantial and inappropriate deferral or acceleration of basis recovery, a more reasonable, alternative allocation of basis may be used.459 The IRS has been relatively liberal in allowing adjustments, freely accepting reasonable taxpayer representations as a basis for such rulings.460 However, an advance private letter ruling is required to accelerate basis recovery and the ruling request must show that under the alternative method the selling senior family member will appropriately recover basis at twice the rate under the prescribed 15-year approach.461 This would be almost impossible to demonstrate in most annuity sales.462 Example 38: The facts are the same as in Example 36. The family can

demonstrate that the expectation that the 6% payments are expected to provide payments of $60,000 a year for the ten-year period is reasonable. Under these facts, basis recovery should be 50% of each payment or $200,000 for the first payment and $30,000 for each subsequent payment. After five years $350,000 of basis is recovered under this approach as compared with only $250,000 under the regulations' approach. Despite the distortion, it is not clear that the alternate method will be approved.

459See

203.1 D

Ltr. Rul. 90-13-014 (Dec. 21, 1989) (allows use of estimated contingent payments in computing basis recovery when there are both fixed and contingent payments); Priv. Ltr. Rul. 89-46-028 (Aug. 21, 1989) (same where estimate that two-thirds of price received in year of sale). Temp. Reg. 15A.453-1(c)(2)(i), (c)(3)(i), (c)(4) and (c)(7) (allow use of other methods to prevent substantial acceleration or deferral of basis recovery).
462For 461See

460Priv.

example, a 70-year old has a 16-year life expectancy. In a private annuity sale, the seller would need to have more than a 30-year life expectancy. A 53-year old has a life expectancy of 30.4 years. See Reg. 1.72-9 Table V. Therefore, the seller would need to be younger than age 54 to satisfy Temp. Reg. 15A.453-1(c)(7)(ii).

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Another unfortunate aspect of the regulations is that in every case that can qualify, the family must undertake the trouble and expense of obtaining a private letter ruling. It would be much better if the regulations made provision for using reasonable estimates of contingent payments when there are significant fixed payments.463 There is also a limited provision for use of an income forecast method without the necessity for obtaining a private letter ruling.464 Under the maximum selling price approach, the same gross profit ratio is applied to each principal payment. Under the maximum term and 15-year basis recovery

approach, the basis recovery is a level amount that does not bear any specified ratio to the principal payment so that the gain portion of each principal payment is not a constant percentage of each principal payment. 209.2 Determining the Buyer's Basis

The contingent payment provisions of the proposed OID and unstated interest regulations take the approach that the younger generation buyer's initial basis is determined on the assumption that only fixed or minimum payments will be made, thus minimizing the younger generation buyer's basis.465 In other words, a buyer cannot obtain basis for undertaking a contingent payment obligation.466 The younger generation buyer's basis for the family assets is adjusted if fixed or minimum payments are paid earlier than assumed,467 and when contingent payments are made.468 As a corollary,

463Cf.

Rev. Proc. 77-37, secs. 3.03 and 3.06, supra note 454. Reg. 15A.453-1(c)(6).

464Temp. 465Prop.

Reg. 1.1275-4(d)(1)(i)(B) and (c)(3)(i) and (4) Examples (1) and (2). For payments the buyer is obligated to make, but with the timing not known, Prop. Reg. 1.1275-4(d)(2) takes the position that the amount he is obligated to pay will be paid at the last possible date. This has the effect of allocating a greater portion of each obligated payment to interest, thereby minimizing the buyer's initial basis.
466Prop.

Reg. 1.483-5(b)(3)(iv) and (d) Example (3)(i) and 1.1275-4(d)(2). See Albany Car Wheel v. Commissioner, supra note 279. Reg. 1.1275-4(d)(2)((ii)(B).

467Prop.

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under the contingent payment provisions of the OID and unstated interest regulations, the selling senior family member seller treats the receipt of a contingent payment as an additional amount realized in reporting gain on the sale under the installment method.469 This approach may be appropriate for contingent payments that occur as a result of payment of contingent liabilities,470 but it is not consistent with the approach of the maximum price provisions of the contingent payment installment sale regulations that take the maximum price into account in allocating basis.471 The inconsistency between the approach of the contingent installment sale regulations and the contingent OID regulations is difficult to justify and may be unworkable.472 This is discussed further in 209.4 B. Example 39: The facts are the same as in Example 34. Although S determines gain on each payment except the last by assuming that all contingent payments will be made, B's basis for the property does not include any of the contingent payments until they are made. If the property is disposed of before the payments are completed and the obligation to make the payments is not transferred, the principal portion of subsequent payments is a loss.473 Although there is no express authority, the taxpayer may be able to

Reg. 1.483-5(b)(3)(iv) and 1.1275-4(c)(4) Example (1)(iii). This position is supported by the case law. See David R. Webb Co. v. Commissioner, supra note 178; Commercial Security Bank v. Commissioner, supra note 179; Crane, supra note 181. Reg. 1.1274-4(c)(4) Example (1)(iii), last sentence. See also David R. Webb Co. v. Commissioner, supra note 178. Albany Car Wheel v. Commissioner, supra note 143; David R. Webb Co. v. Commissioner, supra note 280.
471See 472The 470See 469Prop.

468Prop.

203.1 A and 209.1 A.

proposed regulations recognize the inconsistency, but do not explain or justify it. Prop. Reg. 1.1275-4(d)(2). Rev. Rul. 55-119, supra note 103 (private annuity sale); Rev. Proc. 77-37, secs. 3.03 and 3.06, supra note 454 (contingent shares in a reorganization).
473Cf.

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elect to compute the tax effect of the loss as if realized in the year of sale under 1341(a)(5).474 209.3 Electing Out of Installment Method

A selling family member who elects not to report a contingent payment sale on the installment basis is allowed to use the basis-first method of reporting payments only in rare and extraordinary circumstances.475 The regulations indicate that the contingent amount realized is at least equal to the fair market value of the family business or the fair market value of the contingent payment obligation itself.476 These regulatory provisions ignore the practical reality that bona fide contingent payment obligations reflect uncertainty about those values, but may be justified as creating a strong incentive to stay with the installment method and, in particular, a disincentive to attempt to use the basis-first method. The regulations indicate further that in those rare circumstances in which neither the property, nor the contingent payment obligation, has a measurable fair market value, the transaction will be examined to determine whether a sale has occurred.477 When the contingent payment obligation is valued in the year of sale, subsequent collections in excess of the value assigned are apparently ordinary income, either as OID478 or as receipts that are not part of a sale or exchange.479 It may be possible to
Rev. Rul. 78-25, supra note 444; Rev. Rul. 67-331, supra note 444. The payment of additional purchase price does not fit the traditional picture of repayment of a receipt, but should be so characterized because gross income only includes "gains derived from dealings in property" 61(a)(3) [emphasis added]. Cf. 280E (disallowing expenses but not costs of drug dealers). Reg. 15A.453-1(d)(2)(iii); S. Rep. No. 1000, 96th Cong., 2d Sess. at 23 (disapproving use of cost-recovery method of Burnet v. Logan, 283 U.S. 404 (1931)). The validity of this regulation for cash basis taxpayers has been questioned. See Goldberg, supra note 382 at 648-49 (1981). Some aspects of the application to accrual basis taxpayers have also been questioned. See Mieves, supra note 382. Reg. 15A.453-1(d)(2)(iii). Cf. Temp. Reg. 15A.453-1(c)(4) (similar issue when there is neither a maximum price nor maximum term); 209.1 C.
478See 477Temp. 476Id. 475Temp. 474See

201.7 G.

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argue, based on the Arrowsmith case, that the tax consequences of the subsequent collections should be considered part of the original sale transaction.480 If basis is not fully recovered, the selling senior family member is entitled to deduct any unrecovered basis when the final payment is made.481 209.4 OID and Unstated Interest

The proposed OID and unstated interest regulations take radically different approaches to interest determinations depending on whether the family financial assets (or the buyer's obligations) are publicly traded or not. If there is public trading, interest is front-loaded. If there is no public trading, interest is back-loaded. A. Publicly-Traded Property

When there is public trading, the amount of the younger generation buyer's contingent payment obligation is treated as equal to the value of the publicly-traded family financial assets or family corporation securities.482 The proposed regulations bifurcate the instrument.483 If fixed payments (whether labelled principal or interest) equal or exceed the issue price, the fixed payments are a separate instrument with issue price determined under the general principles including those relating to qualified interest.484 Under the proposed regulations, fixed payments up to the issue price are principal, remaining fixed payments are OID, and all contingent payments are interest.485
Bittker, Capital Gains and Losses--The "Sale or Exchange" Requirement, 32 Hastings L.J. 743, 762-63 (1981).
480Arrowsmith 481 482 479See

v. Commissioner, supra note 221; Rev. Rul. 67-331, supra note 444; see 209.1.

453(b)(f); Temp. Reg. 15A.453-1(c)(2) Example (5) and (c)(3)(i); see 209.1.

1273(b)(3). Since the value of a publicly-traded security is known, it is logical to conclude that it was sold for its value. Therefore, it is presumed that the value of the obligation (issue price of the debt instrument) equals the value of the property received in an arm's length exchange.
483Prop. 484Prop. 485Prop.

Reg. 1.1275-4(e)(1) and (f)(1). Reg. 1.1275-4(e)(4) Examples (1) to (4). Reg. 1.1275-4(e)(2) and (3).

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If the fixed payments are not sufficient to cover the issue price, all fixed payments are principal and contingent payments are split between interest and principal, applied first to interest accrued at the AFR to the date of payment on the issue price as adjusted for prior payments of principal from fixed or contingent payments.486 When fixed

payments do not cover the issue price, and the final contingent payment does not cover the remaining principal, the selling senior family member has a loss for the remaining principal.487 The buyer presumably adjusts the basis of the family corporation shares for the deficiency.488 If the contingent principal payments would otherwise exceed the issue price, the excess is all interest.489 The effect of this is a front-loading of interest in the contingent payments.490 In determining the interest portion of each contingent payment, an interest rate at least equal to the AFR is applied to the outstanding principal balance at the time the payment is received.491 The amount of any contingent payment in excess of the amount treated as a payment of the interest accrued on the outstanding principal is treated as a principal payment,492 which in turn reduces the outstanding principal balance used to accrue interest for the next contingent payment.493 Once the aggregate of the amounts treated as principal payments exceed the value of the publicly-traded securities, any additional contingent payment is treated as entirely interest.494 The assumption supporting this
486Prop. 487Prop. 488See

Reg. 1.1275-4(f). Reg. 1.1275-4(f)(3) and (4) Example (1)(iii).

108(e)(5); 207.4 A. Reg. 1.1275-4(f)(3) and (4) Example (1)(ii). Reg. 1.1275-4(f); see 209.4 B for the back-loading of interest when there is no public trading. Reg. 1.1275-4(f)(2)(iii). Reg. 1.1275-4(f)(2)(ii)(B). Reg. 1.1275-4(f)(2)(iv). Reg. 1.1275-4(f)(2)(ii), last sentence.

489Prop. 490Prop. 491Prop. 492Prop. 493Prop. 494Prop.

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front-loading approach is that the issue price of the obligation issued by the buyer for publicly-traded family financial assets or family corporation shares is equal to the value of the publicly-traded family corporation securities.495 In other words, the contingent nature of the payment is not a factor in determining the principal amount of the younger generation buyer's obligation, but only in determining the timing of the payment of interest and, possibly, whether the obligation is in fact paid in full. The proposed regulations do not directly address the buyer's basis for the publicly-traded securities. When fixed payments equal or exceed the issue price, the younger generation buyer's basis should equal the issue price. When fixed payments are not equal to the issue price, the choices are: i. The younger generation buyer's initial basis is equal to the issue price of

his obligation, with an adjustment in basis if payments differ from this amount, or ii. The younger generation buyer's initial basis does not include contingent

payments and is adjusted as contingent principal payments become fixed. Since the publicly-traded regulations view the buyer as undertaking an obligation having an ascertainable principal amount at the time of the sale, the better view is to recognize an initial basis equal to the issue price. However, given that the publicly-traded

regulation is an exception to the contingent payment regulation for purposes of determining the interest component inherent in each payment, the rules denying the buyer a basis until a contingent payment is fixed may prevail. Example 40(a): S sells shares of a family-controlled corporation that is publicly traded, which have a basis of $100,000, to B for fixed principal payments of $800,000 and contingent payments over the next five years based on 20% of the pre-tax profits of family corporation, up to additional payments of $400,000. The

Philadelphia Park Amusement Corp. v. Commissioner, supra note 53; United States v. Davis, 370 U.S. 65 (1962) (value of property rights surrendered by wife in divorce in exchange for marketable securities presumed to be equal to value of securities).

495Cf.

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fixed principal payments are to be made $400,000 at closing and $400,000 five years later. In addition, B is to make annual interest payments of $40,000 at 10% on the deferred principal payment of $400,000. On the date of the sale, the family corporation shares have a quoted market price of $900,000. Because the fixed payments are $1,000,000 ($800,000 principal + $200,000 (5 x $40,000) interest), the fixed deferred payments constitute a separate debt instrument with an issue price of $500,000 ($900,000 - $400,000 initial payment). Disregarding the

qualified interest provisions, the yield of the fixed obligation is only 3.5%. The determination of principal and interest for the fixed payments is made as described in 207.7 D and Example 16. Any contingent payments are interest. B's basis in the shares should be $900,000, the issue price, with no adjustment when contingent payments become fixed. Because of the public trading, there is no installment sale. Accordingly, S must report gain in the year of sale, presumably measured by the issue price. Example 40(b): The facts are the same as in Example 40(a) except that the quoted market price of the family corporation shares on the date of sale is $1,100,000. All fixed payments are principal. Thus, each $40,000 payment, labelled interest by the parties, is principal for tax purposes. Although the quoted market price should allow B to claim an initial basis for the property of $1,100,000, his initial basis may be limited to the fixed payments of $1,000,000. If a contingent payment of $70,000 is made at the end of the first year and the AFR is 9%, the payment is interest to the extent of $63,000 (9% of $700,000 ($1,100,000 - $400,000 initial payment) and the remaining $10,000 is principal. An additional $80,000 payment at the end of the second year is interest to the extent of $58,770 (9% of $653,000 ($700,000 - $47,000 ($40,000 fixed payment + $7,000 principal component of first contingent payment).

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If B's initial basis is limited to $1,000,000, the principal portion of both payments increases the basis. If the initial basis is $1,100,000, there should be no

subsequent adjustments. Even if contingent payments would otherwise increase principal, under the proposed regulations, all excess is interest. Because of the public trading, there is no installment sale. Accordingly, S must report gain in the year of sale, presumably measured by the quoted market price. B. Property That Is Not Publicly Traded

When there is no public trading to fix an issue price, there is no fixed principal that can be used to compute OID. The amount of interest inherent in each contingent payment can only be calculated as payments are actually received.496 In other words, it must first be determined how much of each periodic payment is principal and how much is interest. Both the temporary installment sale and the proposed contingent payment OID and unstated interest regulations adopt a back-loading of interest approach.497 Recognizing the impracticality of determining in advance how many principal payments will be made, each payment is a separate original issue discount debt instrument that includes all of the interest accrued on the outstanding principal inherent in each payment.498 Therefore, the principal inherent in each payment is equal to the present

temporary installment sale regulations indicate that qualified interest can be provided, at least for maximum price sales, by providing for payment of interest at the prescribed rate in addition to all payments of the price under the contract. Temp. Reg. 15A.453-1(c)(2)(ii). This regulation provision, however, was promulgated before the extension of the OID rules to sales of property and applies only for purposes of determining the maximum selling price. It does not determine what portion of subsequent payments is, in fact, treated as interest under the OID rules. Reg. 15A.453-1(c)(2)(ii) and Prop. Reg. 1.483- 5(b)(3) and 1.1275-4(c)(3)(ii). The backloading of interest approach used by the temporary installment sale regulation dealing with a contingent payment sale having a maximum selling price, Temp. Reg. 15A.453-1(c)(2)(ii), is used only to determine the maximum selling price so that a gross profit ratio can be calculated. Since this temporary regulation was promulgated before the extension of the OID rules to sales of property, it appears that this temporary regulation can only apply for purposes of determining the gross profit ratio. Once the gross profit ratio is calculated, this temporary regulation should defer to the proposed regulations under 483 and 1275 for purposes of determining what portion of each payment received is, in fact, treated as interest.
498Prop. 497Temp.

496The

Reg. 1.483-5(b)(3) and 1.1275-4(c)(3)(ii).

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value of the payment, determined by discounting the payment from the date the payment is received to the date of the sale.499 Example 41: The facts are the same as in Example 34 and 39 except that there is no additional interest paid with each contingent payment. The transaction is a contingent payment installment sale. If payments are made as shown below, the discount factor at the 8.8% AFR, the principal and the interest are as follows: Date 4-1-91 4-1-92 4-1-93 4-1-94 4-1-95 4-1-96 4-1-97 4-1-98 4-1-99 4-1-00 Total Payment $ 70,000 80,000 90,000 80,000 60,000 50,000 90,000 120,000 160,000 100,000 $900,000 Discount Factor.500 .919118 .844777 .776450 .713649 .655927 .602874 .554112 .509294 .468101 .430240 Principal $64,338 67,582 69,880 57,092 39,356 30,144 49,870 61,115 74,896 43,024 $557,297 Interest $ 5,662 12,418 20,120 22,908 20,644 19,856 40,130 58,885 85,104 56,976 $342,703

The back-loading of interest approach used in the contingent payment regulations results in treating an increasing portion of each payment as interest and a decreasing portion as principal. This back-loading approach should be contrasted with the constant level of principal and interest reported under traditional annuity treatment,501 and with the front-loading of interest in a guaranteed deferred payment sale502 and when there is public trading.503

499Prop. 500See 501See 502See 503See

Reg. 1.483-5(b)(3)(i)(A) and 1.1275-4(c)(3)(ii)(A). See Prop. Reg. 1.483-5(d) Example (3).

ALPHA VOLUME, supra note 162, at p. 3-17. 208.2. 207.1. 209.4 A.

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Under the equivalent provisions in the maximum price installment sale regulations, the calculation is adjusted annually on the basis of facts as they appear at the end of the year (and which are subject to prompt verification, presumably in time for filing of the return). This has the effect of minimizing the anticipated interest, maximizing the anticipated principal and therefore deferring the recovery of basis. Example 42: The facts are the same as in Example 40 except that the shares of the family corporation are not publicly traded. Under the temporary installment sale regulations, the initial maximum price is $1,166,972 ($800,000 fixed payments + $366,972 discounted value of the contingent payment on the assumption that earnings could be sufficient to pay that amount at the end of the first year). This amount is used to compute the initial gross profit ratio of 91.4% ($1,066,972/$1,166,972) so that $365,600 of the $400,000 initial payment is gain under the installment method. A contingent payment of $70,000 is made at the end of the first year. The temporary installment sale regulations assume that this payment is interest of $5,780 and principal of $64,220. The maximum price is reduced to $1,141,974

($800,000 fixed payments + $64,220 principal portion of the contingent payment + $277,754 discounted value of the remaining $330,000 maximum contingent payment on the assumption that it will be made at the end of the second year). The new gross profit ratio is 94.1% ($698,036 remaining gain ($1,141,974 $100,000 basis - $365,6000 gain reported)/$741,974 remaining payments ($400,000 fixed payment + $64,220 + $277,754)). Thus, $60,417 of the $64,220 principal portion of the $70,000 contingent payment is gain. On the other hand, as set forth in Example 40(b), the principal portion of the first year payments is $47,000 ($40,000 fixed payment labelled interest + $7,000 of the contingent payment). These results seem impossible to reconcile.

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 210 210.1

Self-Cancelling Installment Notes When Used?

The major nontax difference between an installment sale, a private annuity sale and a SCIN is the payment period. In an installment sale, the payment period is fixed. The specified payments continue even if the selling senior family member dies before the end of the payment term. The payments cease at the end of the specified period, even if the seller is still alive. Thus the payment period may be more or less than needed to fund the selling senior family member's retirement. A private annuity sale shifts this actuarial risk to the younger family member buyer, but at the cost of an obligation to make payments that may exceed the value of the property. A SCIN seeks to split the difference in part, but leaves the selling senior family member at risk if the capital value accumulated during the maximum period does not provide adequate funds for the rest of his or her life. The higher payments needed for a SCIN to have an initial value equal to the value of the property may help make up for this.504 210.2 Valuation of a SCIN

The difference in payment terms between a SCIN and a fixed period installment sale on the one hand, and a private annuity sale on the other, requires use of different discount factors that take into account not only the maximum term and the life expectancy but the actuarial relation between them. The determination is complicated by the different life expectancy and discount rates used for income tax purposes under 72 and the AFR than those used for transfer tax purposes and 7520. The IRS has published a simplified method for determining the relevant divisor to be used in determining the annual payment for a SCIN.505

504See 505See

210.2.

ALPHA VOLUME, supra note 162, at page 5, Example (9), illustrating the determination of factors involving one life and a term of years and Factors at 10 Percent Involving One and Two Lives (Actuarial Values II), IRS Publication 723E (12-83).

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Example 43: The facts are the same as in Example 27. Several additional factors must be added to take into account the mixed nature of a SCIN. The present value of a payment of $1 annually for the life of a 70-year old or 16 years, whichever is less is: Under the income tax annuity tables and at 8.8%, the AFR Under the income tax annuity tables and at 10.6%, the 7520 rate$6.3981 Under the transfer tax tables and at 8.8%, the AFR Under the transfer tax tables and at 10.6%, the 7520 rate $6.5083 $5.9331 $7.4899

Accordingly, the annual level payment needed to pay the price of $1,000,000 is: Under the income tax annuity tables and at 8.8%, the AFR $133,512

Under the income tax annuity tables and at 10.6%, the 7520 rate$156,297 Under the transfer tax tables and at 8.8%, the AFR $153,649 $168,546

Under the transfer tax tables and at 10.6%, the 7520 rate

If a SCIN, computed using the transfer tax tables, is taxed under the annuity rules, the expected return is $2,140,533.62 ($168,545.95 x 12.7 years).506 210.3 Income Tax Treatment of a SCIN

The income tax treatment of a SCIN depends on whether it is classified as an installment sale or as a private annuity sale. Under G.C.M. 39503, this in turn depends on whether the maximum term exceeds the selling senior family member's life expectancy under the income tax annuity tables of 72. If it does not, it is an installment sale; but if it does, it is a private annuity sale. Thus, major consequences can depend on relatively minor differences in payment periods. Example 44: A selling senior family member who is 70 years old has an actuarial life expectancy of 16 years under the 72 annuity tables. Accordingly, a
12.7 year life expectancy multiple used to determine the expected return is obtained from Reg. 1.72-9, Table VIII.
506The

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SCIN that provides a maximum period of 15 years and 11 months is an installment sale, while one that provides a term of 16 years and 1 month is a private annuity sale under the IRS view. G.C.M. 39503 indicates that gain on a secured sale that is classified as a private annuity sale under these rules is taxed in the year of sale, but this is questionable.507 If being secured means that a private annuity sale does not qualify for traditional private annuity sale treatment, with the result that the transaction is an installment sale, the anomaly becomes greater because a secured sale may be classified as an installment sale if secured or while an unsecured sale with identical payment terms may be treated as a private annuity sale. A. Under the Annuity Rules

The effect of the minor modifications of the annuity rules to deal with a SCIN classified as a private annuity sale are set forth in the examples that follow: 1. The seller. The only difference for the senior family member seller

between a straight private annuity sale and a SCIN classified as a private annuity sale is the amount of the annual payment required to achieve a value equal to the desired sale price. Example 45: The facts are the same as in Example 43. S agrees to sell the $1,000,000 worth of shares in the family corporation to B for $168,546 a year over the next 16 years or until S's death, whichever occurs first. The payment provided has a present value of $1,000,000 under the transfer tax tables using the 7520 rate. The sale occurs on 4-1-90, and the first annual payment is due on 41-91. The $1,000,000 value of the property divided by the expected return of $2,140,534 gives an exclusion ratio of 46.72%, so that $78,740 of each annual

507G.C.M.

39503, Issue (2)(C)(1)(a), supra note 4.; see 202.2.

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payment, is the principal and $89,806 is annuity income. The $78,740 principal is further broken down into $15,748 recovery of basis and $62,992 capital gain. After $1,000,000 of principal has been received (occurring after 12.7 years), the entire payment is treated as annuity income because the exclusion ratio is no longer be applied once the annuitant has recovered his entire investment in the contract.508 The expected return is $2,140,534 (12.7 years x $168,546). The amount, character and timing of the income reported by S if he receives all 16 annual payments are as follows: Date 4-1-91 4-1-92 4-1-93 4-1-94 4-1-95 4-1-96 4-1-97 4-1-98 4-1-99 4-1-00 4-1-01 4-1-02 4-1-03509 4-1-03 4-1-04 4-1-05 4-1-06 Total 2. Payment $ 168,546 168,546 168,546 168,546 168,546 168,546 168,546 168,546 168,546 168,546 168,546 168,546 117,982 50,564 168,546 168,546 168,546 $2,696,736 Basis $ 15,748 15,748 15,748 15,748 15,748 15,748 15,748 15,748 15,748 15,748 15,748 15,748 11,024 -0-0-0-0$200,000 Capital Gain $ 62,992 62,992 62,992 62,992 62,992 62,992 62,992 62,992 62,992 62,992 62,992 62,992 44,096 -0-0-0-0$800,000 Annuity Income $ 89,806 89,806 89,806 89,806 89,806 89,806 89,806 89,806 89,806 89,806 89,806 89,806 62,862 50,564 168,546 168,546 168,546 $1,696,736

The buyer. Similarly, the younger generation buyer's only significant

difference is in computing the initial tentative basis. Example 46: At the 7520 rate 10.6%, the present worth of the right to receive $168,546 annually for 16 years or until the death of the person age 70, whichever

508

72(b)(2).

payment for the 13th year must be bifurcated because the exclusion ratio cannot be applied once the annuitant has recovered his entire investment in the contract. 72(b)(2).

509The

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is earlier, is $1,000,000 ($168,546 x 5.9331) under the transfer tax tables.510 Therefore, B's tentative basis in the shares purchased from S is $1,000,000. Since the younger generation buyer under a private annuity purchase is not permitted to deduct the interest component inherent in each annuity payment, the aggregate of the payments made will exceed the tentative basis amount well before the senior family member seller achieves the actuarial life expectancy used to determine the annual SCIN payment. Moreover, if the seller does survive to that age, the payments will exceed the value of the property by more than would be the case for a straight private annuity sale. Example 47: The facts are the same as in Example 46. The annual and cumulative payments and B's tentative basis are as follows: Date 4-1-91 4-1-92 4-1-93 4-1-94 4-1-95 4-1-96 4-1-97 4-1-98 4-1-99 4-1-00 4-1-01 4-1-02 4-1-03 4-1-04 4-1-05 4-1-06 Annual Payment $168,546 168,546 168,546 168,546 168,546 168,546 168,546 168,546 168,546 168,546 168,546 168,546 168,546 168,546 168,546 168,546 Cumulative Payments $ 168,546 337,092 505,638 674,184 842,730 1,011,276 1,179,822 1,348,368 1,516,914 1,685,460 1,854,006 2,022,552 2,191,098 2,359,644 2,528,190 2,696,736 Tentative Basis $1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,011,276 1,179,822 1,348,368 1,516,914 1,685,460 1,854,006 2,022,552 2,191,098 2,359,644 2,528,190 2,696,736

If S collects all 16 payments, B's final basis will be the total of all payments made, or $2,696,7356, an amount far in excess of the value of the property purchased and, because of the larger annual payment, more than the $2,581,821 tentative basis at the end of 16 years in a standard private annuity sale. See Ex-

510See

ALPHA VOLUME, supra note 162, Example (9) at page 6.

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ample 30 in 208.2 B. There is, of course, the possibility that payments in a standard private annuity sale may continue for more than 16 years. 3. When SCIN is cancelled. Under the annuity rules the final younger

generation buyer's final basis is fixed when payments cease. Example 48: The facts are the same as in Example 45, but S dies on June 1, 2000, at age 80, having received only 10 payments under the SCIN. B's final basis is $1,685,460. This is more than the $1,613,632 tentative basis if S had died on the same date in a standard private annuity sale. See Example 30 in 208.2 B. The cancellation rules that apply upon the cancellation of a installment obligation at the death of the seller do not apply to a private annuity sale. Therefore, neither the selling senior family member nor the estate is required to report any of the capital gain that would have been reported upon receipt of the remaining payments. There no longer is a "right" to a payment because the obligation is cancelled by its own terms.511 The selling senior family member should be able to deduct any unrecovered basis on the final income tax return.512 Example 49: The facts are the same as in Example 48. The $42,520 of unrecovered basis can be deducted on S's final income tax return. Although six payments were cancelled, only three contained unrecovered basis. B. Under the Installment Method When a SCIN is taxed under the installment method, the gross profit ratio determines the allocation of each principal payment between return of basis and capital gain. Even though the installment method regulations classify it as a maximum price sale, the contingent payment OID regulations may back-load the interest.

511See 512

691(a)(2), (4) and (5).

72(b)(3)(A).

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The following examples will illustrate the income tax consequences of a SCIN treated as an installment sale by taking into account the two variables: (i) whether the risk premium is to be treated as additional principal ("SCIN-

PRIN") or as additional interest ("SCIN-INT"), and (ii) whether the income tax mortality assumptions of the annuity tables and

the AFR or the transfer tax mortality assumptions and 7520 rates apply . The intermediate cases involving use of income tax mortality assumptions and the 7520 rate or using the transfer tax mortality assumptions and the AFR are not illustrated. The mortality assumptions create the major portion of the difference so that the results of the former case are closer to those also using the AFR and the latter case closer to those using the 7520 rate. If the premium required because of the risk that the selling senior family member will die before the end of the maximum term of the obligation is characterized as an additional principal amount, then the maximum sales price of the property is greater than for a fixed payment sale. This may result in additional capital gain and a larger basis for the younger generation buyer. If the risk premium is characterized as a higher interest rate, the principal, gain and basis are the same as for a fixed payment sale, but the interest is significantly more. The discounted value of the series of payments is the same no matter how the payments are split between principal and interest is characterized as long as the same discount rate and actuarial assumptions apply. 1. The seller

The literature on SCINs written during the last decade assumes that the gift and estate tax tables are used to determine the periodic SCIN payments. As previously discussed, this assumption is not appropriate in all situations. Therefore, the examples that follow will illustrate the tax treatment for (i) a SCIN using the higher interest rates and shorter life expectancy multi-

ples found in the Alpha Volume, and

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(ii)

a SCIN using the lower AFR interest rates and the longer life expectancy

multiples found in Reg. 1.72-9. Examples 50 through 54 assume that the interest portion of each payment is based on the outstanding principal during each payment period. Therefore, the amount of principal inherent in each payment is arrived at by reducing the payment by the interest that has accrued on the outstanding principal balance. This approach front-loads the interest to the earlier years as occurs in the amortization of principal for a fixed payment obligation such as a mortgage loan. However, as illustrated in Example 55, the

contingent payment installment sale regulations back-load the interest by assuming that each payment is a separate debt obligation with its own interest.513 . Example 50: SCIN-PRIN at 8.8%. Using the AFR of 8.8% and the 12.7-year actuarial period for a temporary life annuity, based on the lesser of 16 years of the life of a 70-year old, found in the income tax annuity tables, the annual payment for the purchase of $1,000,000 worth of shares is $133,512. See Example 43. At 8.8%, the present value of $133,512 annually for 16 years is $1,127,150. Therefore, the risk premium of $127,160 is additional principal, increasing the seller's gain and the buyer's basis by an equal amount. With a sales price of $1,127,150 and a basis of $200,000.00, the gross profit ratio under the installment method is 82.26%.

513See

Temp. Reg. 15A.453-1(c)(2)(ii)

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The amount, character and timing of the income reported by S is: Date 4-1-91 4-1-92 4-1-93 4-1-94 4-1-95 4-1-96 4-1-97 4-1-98 4-1-99 4-1-00 4-1-01 4-1-02 4-1-03 4-1-04 4-1-05 4-1-06 Total Payment $ 133,512 133,512 133,512 133,512 133,512 133,512 133,512 133,512 133,512 133,512 133,512 133,512 133,512 133,512 133,512 133,512 Interest $ 98,627 95,575 92,254 88,645 84,714 80,448 75,805 70,756 65,265 59,293 52,799 45,736 38,056 29,704 20,620 10,742 Basis $ 6,190 6,732 7,321 7,961 8,658 9,416 10,239 11,135 12,110 13,169 14,322 15,575 16,937 18,420 20,031 21,784 $200,000 Capital Gain $ 28,695 31,205 33,937 36,906 40,140 43,648 47,468 51,621 56,137 61,050 66,391 72,201 78,519 85,388 92,861 100,986 $927,153

$2,136,192 $1,009,039

Example 51: SCIN-INT at 8.8%. Payments of $133,512 annually for the 16 year maximum term have a present value of $1,000,000 if the discount rate is 10.7% instead of the 8.8% AFR. With a $1,000,000 sales price and a $200,000 basis, the gross profit ratio under the installment method is 80%

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The amount, character and timing of the income reported by S is: Date 4-1-91 4-1-92 4-1-93 4-1-94 4-1-95 4-1-96 4-1-97 4-1-98 4-1-99 4-1-00 4-1-01 4-1-02 4-1-03 4-1-04 4-1-05 4-1-06 Totals Payment $ 133,512 133,512 133,512 133,512 133,512 133,512 133,512 133,512 133,512 133,512 133,512 133,512 133,512 133,512 133,512 133,512 $2,136,192 Interest $ 107,418 104,615 101,511 98,074 94,267 90,051 85,383 80,213 74,488 68,148 61,126 53,351 44,740 35,205 24,645 12,950 $1,136,192 Basis $ 5,218 5,779 6,400 7,088 7,849 8,692 9,626 10,660 11,805 13,073 14,477 16,032 17,754 19,662 21,773 24,112 $200,000 Capital Gain $ 20,875 23,117 25,600 28,350 31,396 34,768 38,503 42,639 47,219 52,291 57,908 64,128 71,017 78,646 87,094 96,449 $800,000

If all payments are made, the total gain is $127,153 less and the total interest is $127,153 more than in Example 50. Example 52: SCIN-PRIN at 10.6%. Using the transfer tax tables in the Alpha Volume at the 7520 rate of 10.6%, the annual payment for a 16-year maximum term is $168,548. See Example 43. This is $35,036 more than when the income tax annuity tables and the AFR are used. At 10.6%, the present value of $168,546 annually for 16 years is $1,272,865. With a basis of $200,000 and a sales price of $1,272,865, S's gross profit ratio under the installment method is 84.29%. The entire $272,865 premium is additional principal that increases S's potential capital gain and B's potential basis by an equal amount. If all payments are made, this is $145,712 more than in Example 50.

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Date 4-1-91 4-1-92 4-1-93 4-1-94 4-1-95 4-1-96 4-1-97 4-1-98 4-1-99 4-1-00 4-1-01 4-1-02 4-1-03 4-1-04 4-1-05 4-1-06 Totals

Payment $ 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 $2,696,752

Interest $ 134,924 131,360 127,418 123,058 118,237 112,904 107,005 100,482 93,267 85,288 76,462 66,701 55,905 43,965 30,758 16,153 $1,423,887

Capital Basis $ 5,283 5,843 6,463 7,148 7,905 8,743 9,670 10,695 11,828 13,082 14,469 16,002 17,699 19,575 21,650 23,945 $200,000

Gain $ 28,340 31,344 34,666 38,341 42,405 46,900 51,872 57,370 63,452 70,177 77,616 85,844 94,943 105,007 116,139 128,449 $1,072,865

Example 53: SCIN-INT at 10.6%. Payments of $168,547.20 for the 16 year maximum term have a present value of $1,000,000 if the discount rate is 15.1% instead of the 10.6% 7520 rate.. Assuming that 15.1% is not an excessive interest rate, with a $1,000,000 sales price and a $200,000 basis, S's gross profit ratio under the installment method is 80%.

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Date 4-1-91 4-1-92 4-1-93 4-1-94 4-1-95 4-1-96 4-1-97 4-1-98 4-1-99 4-1-00 4-1-01 4-1-02 4-1-04 4-1-05 4-1-06 Totals

Payment $ 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 $2,696,752

Interest $ 150,713 147,025 144,933 141,373 137,278 132,565 127,142 120,902 113,721 105,458 95,950 72,418 57,931 41,259 22,075 $1,696,752

Basis $ 3,567 4,104 4,723 5,435 6,254 7,196 8,281 9,529 10,965 12,618 14,519 19,226 22,123 25,458 29,294 $200,000

Gain $ 14,267 16,417 18,892 21,739 25,015 28,785 33,124 38,116 43,861 50,470 58,078 76,903 88,493 101,830 117,178 $800,000

If all payments are made, the total gain is $145,712 less and the total interest is $145,712 more than in Example 52. 2. The buyer. As previously discussed, under the contingent payment reg-

ulations, a younger generation buyer does not obtain any initial basis for undertaking a contingent payment obligation.514 Basis is obtained only as payments become fixed or are made. The buyer is permitted to deduct the interest component inherent in each payment. The interest and basis increase of each payment vary depending upon the treatment of the risk premium. Example 54: B's basis. Using the transfer tax tables and the 7520 rate: . (a) If the risk premium is characterized as an additional principal payment, then the amount of B's obligation and B's potential basis is $1,272,865. B's initial basis in the property purchased is zero. $1,423,887 if all 16 payments are made. (b) If the risk premium is characterized as additional interest, then the amount of B's obligation and B's potential basis is $1,000,000. B's initial basis in the shares
514

B's interest deductions will total

1.275-4(d)(2); see 203.2 and 209.2.

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is zero. B's interest deductions will total $1,696,755.20 if all 16 annual payments are made. Using the income tax annuity tables and the AFR: . (a) If the risk premium is characterized as an additional principal payment, then the amount of B's obligation and B's potential basis is $1,1,127,153. B's initial basis in the property purchased is zero. $1,009,039 if all 16 payments are made. (b) If the risk premium is characterized as additional interest, then the amount of B's obligation and B's potential basis is $1,000,000. B's initial basis in the shares is zero. B's interest deductions will total $1,696,755.20 if all 16 annual payments are made. 3. When SCIN is cancelled. Under the contingent payment OID and unB's interest deductions will total

stated interest regulations, the younger generation buyer's basis may be limited to payments made. This is an anomalous result when the senior family member seller dies before the end of the maximum SCIN term in a related party sale in that the younger generation buyer's basis can be less than the aggregate of the capital gain and return of basis reported by the seller or the estate. Whatever the merits of the position of G.C.M. 39503 in giving the buyer an initial basis measured by the contingent payment obligation, the logic of Rev. Rul. 86-74, requiring the decedent's estate to report the entire inherent gain, supports the view that the cancellation is a bequest to the younger generation buyer that should support a basis at least equal to fair market value at death.515 A counter argument is that although the gain is reported by the selling senior family member, the value of the remaining payments is not included in the gross estate.516 Nevertheless, the income tax result should prevail.
Rev. Rul. 67-96, 1967-1 C.B. 195 (basis of stock acquired through exercise of option provided in will is date of death value plus any consideration paid for option).
516See 515See

204.1.

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By similar logic, if the cancellation is during the selling senior family member's lifetime and thus, a gift, the younger generation buyer's basis should be the fair market value, although there is some chance that the gift rule of the higher of the donor's basis or purchase price applies.517 The effect of differences in the amount of principal depending on whether the risk premium is treated as interest or principal carries through to the consequences of termination of the SCIN upon the premature death of the selling senior family member. When the buyer and the seller are related parties, the value of the cancelled installment obligation is deemed to be equal to its face amount.518 Since a SCIN-PRIN treats the risk premium as additional loan principal, there is more capital gain potential than in a SCININT and a greater basis for the younger generation buyer. Again, when the gain is reported by the senior family member seller's estate, the full basis should be allowed the younger generation buyer. Example 55: The facts are the same as in Example 54 except that S dies on June 1, 2000, having received only 10 annual payments. B's obligation to make the remaining six annual payments is cancelled. B and S are related parties.

Therefore, the value of the cancelled payments is treated as equal to its face amount. (a) SCIN-PRIN. The outstanding principal amount for the remaining payments is $721,340, and the unrecovered basis is $113,340. The estate reports $608,000 of capital gain upon cancellation of the obligation. B's basis in the shares should be $1,272,865, but, under the contingent price OID and unstated interest regulations, may be limited to $551,528, the principal payments actually made.

517See 518

Reg. 1.1015-4.

691(a)(2), (a)(4)(B) and (5)(B).

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(b) SCIN-INT. The outstanding principal amount is $636,641, and the unrecovered basis is $127,328. The estate reports $509,313 of capital gain. B's basis in the shares should be $1,000,000, but, under the contingent price OID and unstated interest regulations, may be limited to $ 363,359, the principal payments actually made. As illustrated in Example 55, all of the capital gain inherent in the annual payments is eventually reported by the seller and the seller's estate. The only difference is that for a SCIN-PRIN there is an additional $272,865 of capital gain. Therefore, an advantage of a SCIN-INT is the potential for less aggregate income being reported in the event of the selling senior family member's premature death. The irrebutable presumption that the value of the cancelled payments equals the principal amount does not apply if the buyer is not a related party, such as a son-in-law. The built-in termination reduces the amount received upon the disposition to zero, permitting the unreported realized gain on a sale to an unrelated party to escape income taxation. And, the tax savings are further increased because the selling senior family member should receive a deduction for any unrecovered basis.519 Since the unrelated buyer's initial basis cannot include his initial obligation, the cancellation of the unrelated buyer's remaining obligation has a symmetrical effect with the capital gain reported by the seller. Example 56: The facts are the same as in Example 55, except that B is S's sonin-law. (a) SCIN-PRIN. B's initial basis in the shares is zero, even though B undertakes a contingent $1,272,865 obligation to make 16 annual payments of $168,547 each. Upon the death of S, the remaining $721,340 of principal payments becomes

Reg. 15A.453-1(3)(i) and (4). There is some argument for denying a deduction on the ground that the loss is not part of a transaction entered into for profit, see Rev. Rul. 72-193, 1972-1 C.B. 58, or that the loss did not occur until death so that it is essentially a reduction in value of the property at death.

519Temp.

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worthless. Therefore, none of the remaining capital gain is reported as income, and S can deduct the $113,340 of unrecovered basis on the final income tax return. B's basis in the shares is $551,528, the principal payments B made. (b) SCIN-INT. B's initial basis in the shares is zero even though B undertakes a contingent $1,000,000 obligation to make 16 annual payments. Upon S's death, the remaining $636,641 principal obligation becomes worthless. None of the remaining capital gain is reported as income, and S can deduct the $127,328 of unrecovered basis on his final income tax return. B's basis in the shares is $363,359, the principal payments B made. 4. Treatment as contingent payment sale with a maximum selling price.

The treatment illustrated in Examples 50 through 56 does not reflect the back-loading of interest approach apparently required in the contingent payment regulations. In the examples, the interest was front-loaded to the early years because it was assumed that the principal portion of each annual payment reduced the outstanding principal for the subsequent year. In effect, Examples 50 through 56 illustrate the results when a SCIN is treated as a maximum selling price installment sale, the result we consider proper.520 The contingent payment OID and unstated interest regulations back-load the interest to the later years on the assumption that there is no principal amount so that each payment contains its own interest on the principal inherent in that payment from the date of sale to the date of payment.521 In other words, each payment is treated as a separate OID obligation. Example 57: The facts are the same as in Example 52. SCIN-PRIN at 10.6%. Treating the first annual payment of $168,547 as a separate OID obligation means that the amount of the interest inherent in it is $16,154. The present value of $1

520

206.1 F. Reg. 15A.453-1(c)(2)(ii).

521Temp.

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to be received in one year at a 10.6% discount rate is .904159. Therefore, the principal amount in the first payment is $152,393 ($168,547 x .904159). The present value at 10.6% of $1 received in two years is .817504. Therefore, the principal amount in the second payment received on 4-1-92 is $137,788 ($168,547 x .817504), and the interest portion is $30,759. By treating each annual payment as a separate debt obligation, the amount of the discount (the interest element) increases with each subsequent payment. By the time the last payment is received on 4-1-06, the present value of $1 in 16 years is .199489 so that the principal portion of the payment is $33,623 ($168,5470 x .199489) and the interest portion is $134,924. The amount, character and timing of each payment, using an 84.29% gross profit ratio for each principal payment, is: Date 4-1-91 4-1-92 4-1-93 4-1-94 4-1-95 4-1-96 4-1-97 4-1-98 4-1-99 4-1-00 4-1-01 4-1-02 4-1-03 4-1-04 4-1-05 4-1-06 Totals Payment $ 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 168,547 $2,696,752 Interest $ 16,153 30,759 43,965 55,905 66,700 76,462 85,288 93,267 100,481 107,006 112,903 118,234 123,059 127,418 131,360 134,924 $1,423,884 Gain $ 128,449 116,138 105,007 94,943 85,844 77,616 70,178 63,452 47,371 51,871 46,901 42,407 38,340 34,667 31,344 28,340 $1,072,868 Basis $ 23,945 21,650 19,575 17,699 16,003 14,469 13,081 11,828 10,695 9,670 8,743 7,906 7,148 6,462 5,843 5,283 $200,000

A comparison of Examples 52 through 57 shows that the aggregate amount of capital gain, return of basis and interest income reported does not change if the maximum payments are made. The approach of in the contingent payment OID and unstated interest regulations accelerates capital gain and defers interest income and deduction, an

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advantageous result for the seller when there is a significant rate preference for capital gains, although not advantageous for the younger generation buyer. More importantly, the OID approach permits deferral of the aggregate annual income reported. In Example 51 the total income reported upon the receipt of the first payment is $163,264. In Example 57, first year income totals only $144,602, the difference attributable to the greater portion treated as principal and a resultant return of basis. Another consequence of back-loading the interest is that when the younger generation buyer's obligation is cancelled upon the selling senior family member's premature death, less capital gain is reported upon a cancellation because more capital gain and less interest income was reported in the earlier years. Back-loading of interest means that the younger generation buyer's basis greater, but at the cost of reduced interest deductions. Example 58: The facts are the same as in Example 52 except that interest is computed under the approach of the contingent payment OID and unstated interest regulations as illustrated in Example 56. S dies after receiving only 10 annual payments. SCIN-PRIN at 10.6%. For a SCIN-PRIN, the potential capital gain inherent in all 16 annual payments is $1,072,865 and the potential interest is $1,423,885. In Example 52, the interest is front-loaded to the earlier years. The remaining capital gain inherent in the cancelled payments is $608,000, and that amount must be reported by S's estate on its first fiduciary income tax return. Example 55(a). In Example 57, the interest is back-loaded to the later years. The remaining capital gain inherent in the cancelled payments is $221,999, and that amount must be reported by S's estate. See also

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Front-loading Capital Gain First 10 Payments At death Totals B's final basis B's interest deductions Totals Interest Capital Gain $ 850,870 221,998 $1,072,868

Back-loading Interest $675,986 -0$675,986 $1,272,865.523 675,986 $1,948,851

$ 464,865 $1,133,939 608,000 -0$1,072,865 $1,133,939 $1,272,865.522 1,113,939 $2,386,804

In Example 51, where interest is front-loaded, the unreported interest inherent in the six cancelled payments is $289,947. In Example 57 where interest is backloaded, the unreported interest inherent in the six cancelled payments is $747,900. 210.4. Comparing SCINS as Installment Sales and Private Annuity Sales

The differences between taxing a SCIN under the installment method or as a private annuity sale shows that the cumulative effects of the differences in timing of the selling senior family member's gain and ordinary income and the younger generation buyer's basis and deduction creates a crazy quilt pattern that may display a certain symmetry, but no real sense. Example 59: A comparison of the results set forth in the SCIN taxed as a private annuity sale as described in Examples 45 to 49 with the result when it is taxed under the installment as shown in Examples 51 to 58 is shown below:

amount represents the total principal payments that measure the gain required to be reported by the seller of the estate on termination, but the buyer's basis may be limited to $551,558 payments made.
523May

522This

be limited to $1,009,485 payments made.

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Private Annuity S's potential amount realized Annual payments B's initial basis Final capital gain if all payments made 1,000,000 $168,546 $1,000,000 800,000

Installment Sale 1,127,153 168,546.524 -0927,153.525 1,423,887 1,127,153 1,127,153 464,865 1,133,912 1,127,153.527 551,528

Ordinary income if all payments made1,696,736 Final basis if all payments made Final gain if S dies after 10 years526: Related party sale Unrelated party sale 2,696,736 629,920. 629,920

Ordinary income if S seller dies after 10 years898,060 Final basis if S dies after 10 years Related party sale Unrelated party sale 1,686,460 1,686,460

In a private annuity sale, S may deduct the any unrecovered basis on his final income tax return. In an installment sale, the remaining basis offsets the amount of principal reported as capital gain upon cancellation.528 As Example 59 illustrates for both situations, basis cannot be obtained unless there is a corresponding income recognition on the selling senior family member's side of the transaction.

524SCIN-PRIN 525Under

at 10.6% of capital gain and it is reported on

691(a)(2), the cancellation accelerates the remaining $ the estate's first income tax return.
526$42,540 527For

of unrecovered basis can be deducted on S's final return.

illustrative purposes, if the interest portion of each annuity payment is factored out, B is treated as having made 10 principal payments of $62,500 each and the final basis would be $625,000. Under Rev. Rul. 55-119, supra note 103 , the buyer must capitalize the interest component inherent in each payment.
528

691(a)(4)(A).

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When the buyer and the seller are related parties, the installment reporting rules mandate that the entire gain initially deferred under the installment method will be reported by the seller or the seller's estate in all events.529 Therefore, the younger generation buyer should be permitted to use the entire obligation as part of his final basis.530 Since the annuity rules do not require the remaining capital gain to be reported if the selling senior family member dies prematurely, the buyer cannot obtain basis for any payment obligation that is cancelled. The seller deducts any unrecovered basis in the annuity sale so that the buyer should obtain no benefit for it.. 211 Private Annuity Sales and SCINs as Installment Sales This part of the paper illustrates how the installment method, using the approach for contingent payment sales, would be applied to a private annuity sale. 211.1 In General

The temporary regulations applying the installment method to contingent payment sales531 and the proposed regulations determining allocations between interest and principal for payments received under contingent payment sales for purposes of determining OID and unstated interest532 contain the rules that must be applied concurrently when a private annuity sale is treated as a contingent payment installment sale.

the value of the cancelled obligation is less than its face amount and the buyer and the seller are not related parties, than no gain is reported with respect to that decline in value. However, a corresponding reduction in basis is mandated by 108(e)(5). See 207.4 A. G.C.M. 39503, Issue (2)(C)(2)(b), the IRS indicated that the buyer can include the full value of the contingent payment obligation in basis because the seller reports the remaining capital gain under the installment sale early disposition rules. This is inconsistent with Prop. Reg. 1.483-5(b)(3)(iv) and 1.12754(c)(4) providing basis only as payments become fixed or are made, but the regulations do not expressly refer to the effect of the installment sale provisions.
531Temp. 532Prop. 530In

529If

Reg. 15A.453-1(c).

Reg. 1.483-5 and 1.1275-4.

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 211.2 Annuity Sales A.

Application of the Contingent Payment Regulations to Private

Treatment as an Installment Sale with Neither Maximum Price nor

Fixed Period When a private annuity sale is treated as a contingent payment sale, it may be viewed as one with neither a maximum price nor a maximum payment period.533 As such, under the temporary installment sale regulations, basis is allocated over an arbitrary 15-year period. Under the proposed contingent payment regulations, the interest

component of each payment is determined as if that payment was the only one made.534 Even after the selling senior family member survives beyond his actuarial life expectancy, each subsequent payment will continue to contain a principal component and a back-loaded interest component. Once the entire basis is recovered, however, the selling senior family member treats all of the principal portion of each subsequent payment as additional capital gain.535 The aggregate of the capital gains reported by the seller will exceed the capital gain inherent in the asset sold well before the selling senior family member reaches the end of his actuarial life expectancy. This is caused by the backloading of interest, which has the effect of front-loading the principal payments. Similarly, under the temporary contingent payment OID and unstated interest regulations, the younger generation buyer's initial basis for the property is zero,536 adjusted for the principal portion of each payment as it becomes fixed.537 In addition, the buyer continues

533Temp. 534Prop. 535See

Reg. 15A.453-1(c)(4); see 203.1 C and 208.1 C.

Reg. 1.483-5(b)(3)(i) and 1.1275-4(c)(3)(ii); see 203.4 B B and 208.5 B.

Prop. Reg. 1.1275-4(c)(4) Example (1)(iii).

Reg. 1.483-5(b)(3)(iv) and -5(d) Example (3)(i), and 1.1275-4(c)(4) Example (1)(iii); see also 203.2 and 209.2.
537Id.

536Prop.

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to increase the basis of the asset for each principal payment made after the selling senior family member reaches his actuarial life expectancy. Example 60: S, age 70, has a 16-year life expectancy. S owns stock with a basis of $200,000 and a value of $1,000,000. S sells the stock to B in exchange for B's promise538 to pay S $161,363 annually for life. S dies in the year 2009 having received 19 annual payments. At 10.6%, the amount, character and timing of S's income is: Date 4-1-91 4-1-92 4-1-93 4-1-94 4-1-95 4-1-96 4-1-97 4-1-98 4-1-99 4-1-00 161,364 4-1-01 4-1-02 4-1-03 4-1-04 4-1-05 4-1-06 4-1-07 4-1-08 4-1-09 Payment $ 161,363 161,363 161,363 161,363 161,364 161,363 161,363 161,363 161,363 13,333 161,363 161,363 161,363 161,363 161,364 161,363 161,363 161,363 161,363 $3,065,900 Basis $ 13,333 13,333 13,334 13,333 13,333 13,334 13,333 13,333 13,334 45,585 13,333 13,334 13,333 13,333 13,334 -0-0-0-0$200,000 Capital Gain $ 132,565 118,582 105,938 94,508 84,173 74,827 66,378 58,738 51,830 102,446 39,939 34,832 30,217 26,043 22,269 32,190 29,105 26,316 23,793 $1,097,828 Interest $ 15,465 29,448 42,091 53,522 63,858 73,202 81,652 89,292 96,199 108,091 113,197 117,813 121,987 125,761 129,173 132,258 135,047 137,570 $1,768,072

B's initial basis in the stock is zero. Upon payment of the first annuity payment on 4-1-91, B's basis is increased by the $145,898 principal payment he has made. Upon the termination of B's obligation in the year 2009, B's final basis is $1,297,828. At the end of 10 years, B's basis will have reached $966,457 and the S's gain $833,124. See Example 59.
538It

does not matter whether or not B's promise is secured because installment reporting is available for both secured and unsecured obligations.

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Under the 72 annuity reporting rules, as illustrated in Example 29, S's allocation of the $161,363 annual payment between principal and interest is constant for each year at $62,500 of principal and $98,863 of interest. Thus, S reports

$625,000 of principal and $988,630 of annuity income over a ten-year period under the annuity reporting rules. B. Treatment as an Installment Sale with a Maximum Selling Price

If the actuarial value of the annuity is treated as if it is a fixed maximum price, the interest is front-loaded. The entire principal obligation would be fully paid at by the time the selling senior family member reaches his actuarial life expectancy; any subsequent payments are entirely interest.539 If the value of the younger generation buyer's

obligation is treated as a maximum principal amount, then this value would be used to determine the seller's capital gain on the sale and the resultant gross profit ratio. Example 61: The facts are the same as in Example 60. If treated as a maximum price sale, S has sold the stock for $1,000,000, the value of B's annuity obligation, thereby realizing an $800,000 capital gain. The gross profit ratio is 80%. S dies after receiving 19 annual payments. The amount, character and timing of the S's income is:

539Prop.

Reg. 1.1275-4(c)(3)(ii) and 1.483-5(b)(3)(iii); see 203.4 B..

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Date 4-1-91 4-1-92 4-1-93 4-1-94 4-1-95 4-1-96 4-1-97 4-1-98 4-1-99 4-1-00 4-1-01.541 4-1-01 4-1-02 4-1-03 4-1-04 4-1-05 4-1-06 4-1-07 4-1-08 4-1-09 Total

Payment $ 161,363 161,363 161,363 161,363 161,364 161,363 161,363 161,363 161,363 161,364 101,602 59,761 161,363 161,363 161,363 161,364 161,363 161,363 161,363 161,363 $3,065,900

Interest.540 $ 106,000 100,132 93,641 86,462 78,523 69,742 60,030 49,288 37,409 24,270 9,737 59,761 161,363 161,363 161,363 161,364 161,363 161,363 161,363 161,363 $2,065,900

Basis $ 11,073 12,246 13,544 14,980 16,568 18,324 20,267 22,415 24,791 27,419 18,373 -0-0-0-0-0-0-0-0-0$200,000

Capital Gain $ 44,290 48,985 54,178 59,921 66,273 73,297 81,066 89,660 99,163 109,675 73,492 -0-0-0-0-0-0-0-0-0$800,000

540The

interest for each year is 10.6% of the principal outstanding for the preceding 12 months, determined as follows:
Date 4-1-90 4-1-91 4-1-92 4-1-93 4-1-94 4-1-95 4-1-96 4-1-97 4-1-98 4-1-99 4-1-00 4-1-01 Total
541The

Principal Balance $1,000,000 944,637 883,405 815,683 740,782 657,942 566,320 464,987 352,913 228,958 91,865 -0-

Principal Payment -0$ 55,363 61,232 67,722 74,901 82,840 91,621 101,333 112,074 123,954 137,094 91,865 $1,000,000

entire $1,000,000 of principal is amortized over 10.8 years instead of 16.0 years because the tables in the ALPHA VOLUME, supra note 162, used in computing the annual annuity payment incorporate this shorter life expectancy.

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B's basis is finally determined to be $1,000,000 because a maximum price limits the amount of principal and potential basis. If the private annuity sale is treated as a contingent price sale with a fixed period, the only significant difference is that the selling senior family member's basis is allocated ratably over the life expectancy on a straight-line basis instead of as a fixed portion of each principal payment. This is likely to result in larger basis recovery and lower gain in the early years when interest is front-loaded and the reverse when it is back-loaded. Another approach uses the temporary contingent payment, installment sale maximum selling price regulation only for purposes of treating the private annuity sale as having a maximum selling price, and then uses the proposed contingent payment OID regulations for purposes of determining the interest inherent in each payment. Under this approach, the interest is back-loaded, but the selling senior family member's actuarial life expectancy542 determines the maximum principal amount by totalling the principal portion of only those payments that can be received before the seller reaches the actuarial life expectancy. Again, by treating the private annuity sale as having a maximum selling price, once the total treated as principal exceeds this maximum, any additional contingent payments are interest.543 Example 62: The facts are the same as in Example 61, except that the alternate approach is applied. Under this approach, S is treated as having sold his stock for $1,218,614.02, the aggregate of the principal portion inherent in the first 16 annual payments. S realizes a $1,018,614.02 capital gain on the sale and the gross profit ratio is 83.59%. If S dies after having received 19 annual payments. The amount, character and timing of S's income is:

542The

longer life expectancy multiples used in Reg. 1.72-9 Table V are used for this purpose. Reg. 1.483-5(b)(3)(iii) and 1.1275-4(a)(3)(ii).

543Prop.

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Date 4-1-91 4-1-92 4-1-93 4-1-94 4-1-95 4-1-96 4-1-97 4-1-98 4-1-99 4-1-00 4-1-01 4-1-02 4-1-03 4-1-04 4-1-05 4-1-06 4-1-07544 4-1-08 4-1-09 Total C.

Payment $ 161,363 161,363 161,363 161,363 161,364 161,363 161,363 161,363 161,363 161,364 161,363 161,363 161,363 161,363 161,364 161,363 161,363 161,363 161,363 $3,065,900

Interest (10.6%) $ 15,465 29,448 42,091 53,522 63,858 73,203 81,652 89,292 96,199 102,444 108,091 113,197 117,813 121,987 125,761 129,173 161,363 161,363 161,363 $1,847,286

Basis (16.41%) $ 23,9459 21,650 19,575 17,699 16,003 14,469 13,082 11,828 10,695 29,670 8,743 7,905 7,147 6,462 5,844 5,283 -0-0-0$200,000

Capital Gain (83.59%) $ 121,953 110,265 99,697 90,142 81,503 73,691 66,629 60,243 54,469 49,249 44,529 40,261 36,403 32,914 29,759 26,907 -0-0-0$1,018,614

Private Annuity Sale of Publicly-Traded Property

A private annuity sale of publicly-traded property cannot qualify as an installment sale, but there is no reason that it cannot be a contingent payment sale under the contingent payment OID and unstated interest regulations.545 If so, the issue price is fixed and the interest rate should be determined using the AFR, not the 7520 rate. The proposed regulations require that the interest be front-loaded. Example 63: The facts are the same as in Example 29 except that the property sold was publicly-traded securities worth $1,000,000 on the date of the sale. The

544If

principal payments received in excess of the initial principal amount are not treated as interest, the breakdown between principal and interest for the last three annual payments is:
Date 4-1-07 4-1-08 4-1-09
545See

Interest $132,258 135,048 137,570

Principal $29,105 26,315 23,793

209.4 A.

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principal amount of B's obligation on the 4-1-90 sale date is $1,000,000. The 8.75% (unrounded) AFR is used to determine the amount of interest accrued each year. Assume that S dies after receiving 19 annual payments of $161,363 each. The amount, character and timing of S's income is: Date 4-1-91 4-1-92 4-1-93 4-1-94 4-1-95 4-1-96 4-1-97 4-1-98 4-1-99 4-1-00546 4-1-00 4-1-01 4-1-02 4-1-03 4-1-04 4-1-05 4-1-06 4-1-07 4-1-08 4-1-09 Total 211.3 Payment $ 161,363 161,363 161,363 161,363 161,364 161,363 161,363 161,363 161,363 52,467 108,897 161,363 161,363 161,363 161,363 161,364 161,363 161,363 161,363 161,363 $3,065,900 Interest $ 87,500 81,037 74,008 66,365 58,053 49,013 39,182 28,491 16,865 4,221 108,897 161,363 161,363 161,363 161,363 161,364 161,363 161,363 161,363 161,363 $2,065,900 Principal $ 73,863 80,326 87,355 94,998 103,310 112,350 122,181 132,872 144,498 48,246 -0-0-0-0-0-0-0-0-0-0$1,000,000

Comparison of Installment Method and Private Annuity Sales

As the foregoing shows, the differences between the tax treatment of standard installment sales, SCINs and private annuity sales makes the choice among them ridiculously complex. The following list details the large number of differences between them that makes the choice a true challenge to the tax professional. (i) The younger generation buyer's basis is finally determined at the initial

time of purchase using the value of the buyer's obligation for a fixed payment
payment for the year 2000 must be bifurcated once the entire $1,000,000 principal amount has been received.
546The

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installment sale, tentatively determined at the actuarial value of the annuity in a private annuity sale and may be determined only as payments become fixed for contingent installment sales.547 (ii) The younger generation buyer is permitted an interest deduction in fixed

or contingent payment installment sales, but not in private annuity sales. (iii) The selling senior family member reports interest income as it financially

accrues, back- or front-loaded for installment sales, but a uniform annual amount for private annuity sales. (iv) If the younger generation buyer's obligation for a fixed or contingent in-

stallment obligation is terminated prior to maturity, the selling senior family member or the estate must report the remaining capital gain if the buyer and seller are related parties, under the installment method,548 but not for a private annuity sale. Consequently, the seller does not have unrecovered basis in an installment sale, but may in a private annuity sale. (v) Depreciation recapture cannot be deferred under the installment

method,549 but there is no similar limitation for private annuity sales. (vi) The anti-Rushing rule of 453(e) for a subsequent sale by a related pur-

chaser applies to installment sales but not to private annuity sales. (vii) The installment method is not available for sales of depreciable property

to related parties,550 but there is no similar limitation for private annuity sales. (viii) The installment method is not available for dealer or inventory sales, but may be for private annuity sales.551
may be a purchase price adjustment under 108(e)(5) if the value of the obligation at death is less than its face amount and the buyer is unrelated to the seller. See 207.4 A.
548 549 550 547There

691(a)(5)(B). 453(i). 453(g).

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(ix)

The selling senior family member in a large installment sale may be re-

quired to pay interest under 453A on taxes deferred under the installment method, but there is no similar requirement for private annuity sales. (x) Pledging of an installment obligation as collateral for a loan results in

reporting of the gain otherwise deferred,552 with no similar provision for private annuity sales. (xi) The installment method is not available if the younger generation buyer's

obligation is readily tradeable,553 but such trading may not prevent qualification as a private annuity sale. (xii) The installment method is available even if the younger generation buyer's

obligation is secured, but not the private annuity sale approach. (xiii) The installment method is not available for deferred payment sales of publicly-traded securities,554 but the private annuity sale approach may be. (xiv) The OID and imputed interest rules apparently determine the transfer tax

value of obligations taxed under the installment method, but do not apply to private annuity sales,555 so that the value is determined by discounting under the 7520 rate. (xv) The status of a selling senior family member's health and other factors

may be considered in an installment sale, but the actuarial tables are more likely to control private annuity sales.

551 552 553 554

453(b)(2) and (l). 453A(d). 453(f)(4). 453(k)(2). 483(c)(3) and 1275(a)(1)(B).

555

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(xvi)

Specific rules control when the selling senior family member elects out of

the installment method that generally prohibit use of the basis-first method; similar, but different, rules avoid basis-first recovery for private annuity sales. (xvii) The installment method can be used by shareholders for obligations resulting from a corporate sale of property,556 but there is no similar express provision for private annuity sales. (xviii) An S corporation can distribute an installment obligation without immediate gain recognition,557 but there is no similar provision for private annuity sales. The following example provides a further comparison and shows additional complexities of a transaction that is part-sale and part gift. Example 64: S, who is 70 years old, has finally decided to enter into a buy-sell arrangement to turn the family widget manufacturing corporation over to his son, B. Since he continues to need funds to live on, he is not prepared to make a gift of the entire business, but does want to reduce his estate to a degree. S's basis in the 10,000 shares of stock is $500,000 for 9,000 shares and $200,000 for the remaining 1,000 shares (inherited from his deceased wife, Wilma, in early 1989). The business is estimated to be worth $2,000,000. S wants about $150,000 a year to live on. He is adamantly opposed to any arrangement that gives him preferred stock of the corporation, since he insists on an absolute legal right to his payments. He has heard about private annuity sales, straight installment sales and self-cancelling installment notes as possible means of accomplishing his goals and asks for your advice concerning which he should use.

556 557

453(h). 453B(h).

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Under the unisex income tax annuity tables, he has a life expectancy of 16 years. An annuity of $150,000 a year for a person of his age has a value of approximately $950,000 under the estate and gift tax tables, using the March, 1990, rate under 7520 of 10.2%. If viewed as an installment sale, contrary to the IRS position in G.C.M. 39503, it is a contingent installment sale with no maximum price or term. As a result, basis is presumably spread over 15 years and an increasing portion of each payment is treated as interest and a decreasing portion as principal. A payment of $150,000 per year for the lesser of 20 years or life has an expected return of 14.4 years, and on that basis, incorporating compound interest of 8.59% (long-term AFR for March, 1990), represents an installment sale principal of approximately $1,200,000 but has an estate and gift tax table value of about $950,000. The difference is attributable to a combination of a higher interest rate and to different actuarial assumptions. G.C.M. 39503 indicates there may be some room to argue against use of the tables. An installment sale with 20 level annual payments of $150,000, incorporating the March, 1990 long-term AFR of 8.59% interest, represents a principal of

approximately $1,400,000 but has an estate and gift tax table value of about $1,250,000, all attributable to the different interest rate assumptions.

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Self-Cancelling Installment Note Installment Sale Installment Private Sale Annuity

Private Annuity Sale Contingent InTradi- stallment tional Sale

(in thousands) Initial Sale Transaction S--Gift: Value Shares Value Payments Gift S--Gain--Own Shares: Amount Realized (90%) Basis Gain S--Gain (Loss)--Inherited Shares: Amount Realized (10%) Basis Gain (Loss560) B--Initial Basis: S's Shares561 Inherited Shares563 Total
558May

2,000 1,250 750

2,000 2,000 950.558 950 1,050 1,050

2,000 950 1,050

2,000 950.558 1,050

1,125 500 625

1,080.559 500 580

855 500 355

855 500 355

??? 500 ???

125 200 (75.)

120 200 (80.)

95 200 (105.)

95 200 (105.)

??? 200 ???

1,125 200 1,325

1,080 200 1,280

855 200 1,055

855 200 1,055

500.562 200 700

be able to argue for installment sale value $1,200,000 under G.C.M. 39503, reducing gift to about $800,000.
559Effect

of maximum price approach not clear; may be same as column 1. under 267 or basis limited under Reg. 1.1015-4.

560Nondeductible 561In

part-sale, part-gift, greater of S's basis or purchase price. Reg. 1.1015-4. Where transferred basis is greater; also includes any gift tax up to FMV.
562Presumably, 563Gain

transferred basis is a minimum.

basis; loss basis is presumably amount paid.

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Self-Cancelling Installment Note Installment Sale Installment Sale

Private Annuity Sale Contingent InTradi- stallment tional Sale

Private Annuity

(in thousands) Annual Payments S: Amount Received-Own Shares: OID or Ordinary Income: Gain Basis Recovery Amount Received-Inherited Shares: OID or Ordinary Income: Gain Basis Recovery 135 115.564 55.6% 44.4% 135 110.564 53.7% 46.3% 135 75.565 25.565 35.565 135 135

82.566 12.5567 22.566 109.2568 31.566 13.3569

15 12.564 None

15 11.564 None

15 7.5565 None

15 8.566 None

15 1.3567 None

Balance Balance Balance Balance Balance

564First 565For 566For

year; decreasing amounts each year thereafter.

14.4 years; thereafter entire payment is ordinary annuity income. 16 years; thereafter entire payment is ordinary annuity income.

year; increasing amounts thereafter to 95.8 in fifteenth year and 109.0 twentieth year. After fifteenth year, all amounts may be interest under Prop. Reg. 1.1275-4(c)(3)(ii) and 1.483-5(b)(3)(iii). year; decreasing amounts thereafter to 25.9 in fifteenth year. In sixteenth and subsequent years all amounts that are not interest are gain since basis has been recovered.
56915 568First

567First

years.

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Self-Cancelling Installment Note Installment Sale B: Investment Interest Deduction570 Basis Increase-S's Shares Yes None Yes None None Payments after Year 6 Installment Sale

Private Annuity Sale Contingent InTradi- stallment tional Sale

Private Annuity

None

Yes

Pay- Princiments pal Payafter ments Year 6 after year 3 None571

Basis Increase-Inherited Shares

None

None Payments Payments after after Year 14 Year 14 Self-Cancelling Installment Note

Private Annuity Sale Contingent InTradi- stallment tional Sale

Installment Sale

Installment Sale

Private Annuity

(in thousands) S's Death Gross Estate Inclusion Gain or Loss Recognition B's Basis Adjustment Value Remaining Payments As Payments Received None

None572 Unreported Gain None

None572

None572

None572 Unreported Gain Unreported Gain

None

None

Limited Limited to Pay- to Payments ments

570Where

available, same amount as S's income. payments never will total $200,000. no inclusion under Chapter 14.

571Principal 572Assumes

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