Installment Sales: Estate Freeze Technique For Ernst & Young Employees

According to a study published by the Employee Benefit Research Institute in 2020, nearly half of Americans die with less than $10,000 in assets. This statistic highlights the importance of estate planning and utilizing techniques such as an estate freeze to preserve wealth and ensure that it is transferred to future generations. By implementing an estate freeze, retirees can effectively lock in the current value of their assets and transfer any future appreciation to their heirs, potentially reducing their estate tax liability and providing a financial legacy for their loved ones.

What Is It?

A transaction in which one party sells an asset to another party in installments. Instead of obtaining the full purchase price at the time of the transaction, the seller receives a series of payments over time. For our Ernst & Young clients who want to know how to qualify for installment sales, the vendor must receive at least one payment in the year following the taxable year of the sale. In some ways, an installment sale transaction is comparable to a private annuity.

However, we would like our Ernst & Young clients to be aware that an installment sale is more flexible than a private annuity because payments from buyer to seller can begin and end whenever the parties desire. In contrast to a private annuity, payments under an installment sale are not required to continue until the seller's demise. Self-cancelling installment note (also known as the SCIN) is a variation on the installment transaction. Using a SCIN, the vendor takes back a note, and the buyer is required to make a series of payments to the seller in accordance with the note. There is a provision in the note stating that the remaining payments will be canceled upon the demise of the vendor. A premium should be charged for this self-cancelling feature.

With a SCIN, there are intricate income and gift tax considerations, so our Ernst & Young clients who are affected by this should consider seeking legal counsel. When the transaction is between family members and involves rapidly appreciating assets, like a family business or real estate, an installment sale can be an excellent estate-freezing strategy. The installment sale will freeze the asset's value for the seller (the elder generation) for estate tax purposes, allowing the younger generation to inherit any future appreciation.

When Can It Be Used?

One Payment Must Be Made In a Taxable Year After Year of Sale

For our Ernst & Young clients who wish to qualify for installment sale treatment, at least one installment payment must be made in a taxable year subsequent to the year of the sale. There is no requirement for a payment to be made in the year of sale. The vendor of the asset has considerable control over the structure and timing of payments.

Payments May Be Deferred As Much or As Little As the Seller Desires

The vendor of the asset is permitted to defer as much or as little of the payments as desired. The vendor has a great deal of discretion in determining how much of the total sale price will be collected in each year. So long as one of the payments is made in a taxable year following the year of sale, the vendor is free to structure the payments in virtually any manner.

Example(s):  You are 65 years old and own a successful business. You would like to retire and sell the business to your son, who has been working with you for the past ten years. You sell the business to your son for $1,000,000 in an installment sale. In the year of the sale, you have substantial other income, putting you in the highest marginal tax bracket. You expect to be in a lower tax bracket once you retire. You can structure the installment sale so that you receive either nothing or a nominal amount in the year of the sale and then spread the remaining sale price over any number of years that you desire. The payments could continue for 5 or 10 or 15 years. You have the flexibility to design the payment plan to fit your tax and other needs.

No Minimum Sale Price Required

There is no required minimal selling price for installment sales. You could arrange an installment sale for even the most inexpensive asset. For instance, if you sold your daughter a piece of land for $10,000, you could structure the transaction so that the price is paid over ten years.

Installment Sale May Take Place Even If the Selling Price Is Contingent

You may arrange an installment sale for an asset even if the selling price at the time of the sale is contingent on another event. For instance, you may sell your business to your two children, with the ultimate sale price contingent on the company's performance over the subsequent five years. Such a transaction still qualifies for installment treatment.

Installment Sale Treatment Is Automatic Unless You Elect Not to Have It Apply

Once an installment sale has been established, the Internal Revenue Service automatically considers it as such. For instance, the gain on the sale will be automatically recognized over the term of the installment sale rather than upon the sale itself. For our Ernst & Young clients who do not want the transaction to be regarded as an installment sale, you must opt out of receiving such treatment.

You Cannot Have Installment Sale Treatment for the Sale of Marketable Securities

You cannot claim installment sale treatment for the sale of stocks or securities that are transacted on established markets (such as the New York Stock Exchange, the American Stock Exchange, or over-the-counter markets). If you sell marketable securities through an installment sale, any future installment payments are deemed to have been received in the year of the sale and are taxed accordingly. In other words, you will be taxed on the entire gain from the sale of marketable securities in the year of the sale, regardless of whether the payments are made over a number of years.

Strengths

Shifts Income from High Tax Years Into Low Tax Years

A sale by installment permits you to distribute the taxable gain from the sale of an asset over a number of payments. This allows you to defer the taxable gain from high tax bracket years to reduced tax bracket years. You must report a portion of the gain from the sale only when you receive each payment. You have the flexibility to transfer income from high tax years to low tax years with an installment sale.

Example(s):  You own a piece of undeveloped land with a basis of $20,000 that is currently worth $100,000. You are presently in a high tax bracket. You expect to retire from Ernst & Young in two years and anticipate that you will be in a lower tax bracket at that time. You would like to sell the land to your daughter this year, but you do not want to report the entire gain before your Ernst & Young retirement. One solution for these Ernst & Young clients is to structure an installment sale. You can sell the land this year to your daughter, structuring the sale so that you will not start receiving payments until three years after the sale when you will be retired from Ernst & Young and in a lower tax bracket.

May Help Reduce Estate Taxes

Many of our Ernst & Young clients have found an installment sale transaction to be an effective estate-freezing technique; it is particularly effective when the sale is between family members and involves appreciating assets such as real estate or a closely held company. Only the present value of any unpaid installment payments is included in the seller's estate at the time of mortality when the asset is sold for full and adequate consideration. The value of the underlying asset is excluded from the seller's taxable estate.

Consequently, any appreciation of the asset subsequent to the sale has been removed from the seller's estate without gift or estate tax consequences. A further method of reducing the seller's estate is for the vendor to return a portion or all of the payments received from the buyer.

May Create a Market for a Business

The owner of a business or other form of property may be able to sell the asset more quickly through an installment sale. A buyer who cannot afford to purchase the asset outright may be able to extend the purchase price over a number of years through an installment sale.

Example(s):  You own a closely held company and would like to retire. Your son works in the business and would like to buy the company. The company has a fair market value of $3,000,000. Your son does not have enough capital to buy the company outright. One solution is to structure an installment sale of the business so that the purchase price can be spread out over a number of years. Your son can then use the cash flow from the company to fund the payments.

Seller May Retain Security Interest In Property Without Jeopardizing Income Tax Consequences

In an installment sale transaction, unlike a private annuity, the vendor may retain a security interest in the property sold without jeopardizing the favorable income tax treatment. If the vendor retains any security interest in a private annuity, all gains will be taxed at the time of sale.

However, in an installment sale, the vendor may retain a security interest in the sold property and still allocate the taxable gain over the installment payment term. In a transaction involving an installment sale, the vendor may also require a third party (such as a bank issuing a standby letter of credit) to guarantee payment in the event of buyer default.

Caution:  The IRS and some courts have held that funds placed in an escrow account to secure the interest of the seller are considered to be constructively received and are currently taxable to the seller.

Allows Flexibility and Certainty About Repayment Plan

A sale on installments offers greater flexibility and certainty regarding the repayment schedule than a private annuity. In contrast to a private annuity, an installment sale transaction can begin and end whenever the parties desire (so long as one of the payments occurs in a taxable year following the year of sale). At the time of the transaction, the buyer will also be aware of the exact duration and amount of the payments (assuming the installment payments are not contingent).

The buyer of a private annuity cannot predict how long the vendor will live and, consequently, how many payments must be made. Additionally, with a private annuity, the quantity of each payment must be actuarially determined and fixed. With an installment transaction, you have some leeway in determining the payment schedule.

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Example(s):  You would like to sell a piece of artwork to your daughter this year. You expect to be in a very high tax bracket for the next two years. For tax reasons, you would like to defer receiving any payments until at least year three. You can accomplish this goal with an installment sale. You can sell the painting this year and, in the installment sale agreement, specify that payments will not begin until the third year. Furthermore, your daughter will know at the time of the sale exactly how many payments she will have to make.

Buyer May Be Able to Deduct Interest Payments on Installment Sale Purchase

In contrast to a private annuity, where the buyer cannot deduct any portion of the payment, the buyer of an installment sale may be able to deduct interest payments made in connection with the sale. A deduction is authorized under Section 163(h) of the Internal Revenue Code for interest on the purchase of a qualified residence, investment interest to the extent of investment income, and interest on business-related purchases. If the interest is deemed personal interest, no interest deduction will be allowed.

Buyer In Installment Sale Gets Stepped-Up (or Stepped-Down) Basis In Property

In contrast to a gift, in which the done takes the donor's basis (typically the property's cost), the buyer's basis in an installment sale is the property's purchase price. This may be particularly advantageous if the seller's basis in the property is very minimal and the property has appreciated substantially. The buyer may use the new stepped-up basis for depreciation (if the property is depreciable) or for income-tax purposes on a subsequent sale (if the property is held for at least two years after the sale).

Example(s):  You own a piece of land with a basis of $50,000. You sell the land for $150,000 to your daughter in an installment sale. Your daughter's basis in the land is now $150,000. She holds the land for two years and then sells it for $160,000. Her taxable gain is only $10,000. She does not have to pay the tax on the $100,000 gain to which you would have been subject had you sold the land outright. The gain is further amplified if your daughter is in a lower tax bracket than you are.

Seller May Purchase and Be the Beneficiary of a Life Insurance Policy on the Buyer of The Property

A vendor in an installment sale may own, pay the premiums for, and be the beneficiary of the buyer's life insurance policy. Therefore, the vendor can safeguard against the potential cessation of payments upon the buyer's untimely demise. In many installment sale transactions, the payment amount is increased so that the vendor can purchase a life insurance policy on the purchaser.

Tradeoffs

Present Value of Unpaid Installments Included In Gross Estate of Seller

In contrast to a private annuity, the present value of outstanding installments must be included in the seller's gross estate. When the vendor dies shortly after an installment sale, the gift and estate tax consequences can be particularly severe. With a private annuity, the value of the sold property is not included in the seller's total estate because payments cease upon the seller's death.

This holds true even if the vendor passes away shortly after the sale. With an installment sale, however, if there are unpaid installments due at the time of the seller's demise, the present value of those unpaid installments must be included in the seller's gross estate.

Example(s):  You sell your business to your son-in-law in an installment sale. Under the terms of the transaction, you will receive  10 payments of $200,000 each. You die two years later after receiving 2 payments. The present value (using IRS valuation tables) of the remaining 8 payments must be included in your taxable estate. If, however, the transaction was structured as a private annuity, then the present value of the remaining annuity payments is not included in your gross estate.

May Cause a Sizable Portion of Each Payment to Be Considered Interest Income to Seller If a Note Is Used

In many installment sale transactions, the vendor will typically accept the buyer's installment note. When a promissory note is used, a significant portion of each payment will be deemed interest. This interest income will be entirely taxable to the seller as ordinary income.

Gift and Estate Tax May Be Due If Property Is Sold for Less Than Fair Market Value

If the fair market value (FMV) of the property sold exceeds the present value of the installment payments, the vendor is deemed to have gifted the difference to the buyer. If the difference exceeds the annual exclusion for gift and estate taxes, federal gift and estate taxes may be due. To the extent that it is available, any tax may be mitigated by your applicable exclusion amount (which is $11,580,000 in 2020, $11,400,000 in 2019, plus any deceased spouse's unused exclusion amount). Additionally, a tax may be due if the interest rate on the installment note is lower than the pertinent federal interest rate. The IRS deems the obligation to be less valuable than its nominal value. Your state might also impose a tax on gifts.

Is Not Allowed for Sale of Listed Securities

There is no application of the installment sale method to the sale of marketable securities. Under the Internal Revenue Code, a marketable security is any stock or security that is transacted on an established securities market on the date of disposition. All proceeds from the sale of listed securities are treated as income and subject to tax in the year of sale.

Payments Under Installment Sale May End Before the Death of the Seller

Unlike a private annuity, an installment sale does not guarantee that payments will continue until the seller's demise. You should structure the transaction as a private annuity for our Ernst & Young clients who are concerned about outliving the payment term.

May Have Adverse Tax Consequences for the Seller When Property Sold Is Subject to a Mortgage

In an installment sale, when the buyer takes the property subject to a mortgage, the amount of the debt in excess of the seller's basis is treated as a payment to the seller and is completely taxable to the seller in the year of the sale.

Example(s):  You sell a piece of property to your son. The property has an FMV of $100,000, and your basis in the property is $20,000. The property also has a mortgage of $40,000. Your son buys the property subject to the mortgage (meaning he is responsible for the mortgage payments in the future). You are considered to have received a payment of $20,000 in the year of the sale (in addition to any payments under the installment sale contract). This $20,000 payment is fully taxable in the year of the sale.

Special Rules for Disposition of Property Between Related Parties May Cause Adverse Tax Consequences to Seller

In an installment sale, the disposition of property between related parties is governed by special regulations. Included among related parties are siblings and sisters, spouses, ancestors and direct descendants, as well as other related entities. The rules are extremely complicated and may result in unanticipated income tax liabilities for the original seller. If an asset is sold to a related party in an installment sale transaction and the related party disposes of the property before the original seller receives all of the installment payments, the original seller is treated as if he or she received the entire amount from the second sale.

The original seller is then subject to capital gains tax on the amount by which the second disposition exceeds the original seller's basis. The benefit is however limited to the amount by which the second disposition exceeds the selling price between related parties. This rule is applicable only if the second disposition occurs within two years of the first.

Example(s):  You sell property to your daughter for $100,000. Your basis in the property is $50,000. Your daughter sells the property one year later for $115,000. Under the second disposition rule, you are considered to have received the $115,000. However, your reportable gain (for tax purposes) is limited to $15,000 ($115,000 minus $100,000). Furthermore, under this rule, any payments that you receive from your daughter in the future will be tax-free until they equal the $15,000 gain that you have to recognize.

How to Do It

Hire a Competent and Experienced Attorney

Employing a competent, seasoned attorney to compose all the necessary legal documents to establish the installment sale for these Ernst & Young clients is essential. Additionally, you may wish to have an experienced tax attorney or tax accountant examine the transaction to ensure that you have complied with all applicable Internal Revenue Code sections. The sections of the Code governing installment sale transactions are extremely complex, and you must comply with all applicable provisions. Otherwise, income, gift, and estate tax consequences could be calamitous.

For Certain Types of Property, an Appraiser Should Be Hired

If the fair market value of the property chosen for the installment sale cannot be readily determined, a third-party, independent appraiser should be engaged to conduct an appraisal. The amount of the installment installments should be determined by the property's fair market value. If the fair market value is not used, gift and estate tax issues may arise.

Buyer And Seller Need to Select Appropriate Property for Installment Sale

Before engaging in an installment transaction, the buyer and seller must agree on which property to acquire. If the transaction is between family members, assets with the potential for rapid future appreciation are typically chosen. These assets may consist of closely held stock, undeveloped real estate, and commercial real estate, among other similar assets.

From an estate planning perspective, it makes sense to choose assets that you believe will appreciate in the future, as any future appreciation in the asset will be withdrawn from the seller's gross estate following the installment sale. A sale by installments is a highly effective method for freezing the value of the seller's estate.

Tax Considerations

Income Tax

Seller's Income Tax Liability on Gain May Be Spread Over Term of Installment Payments

One of the primary tax advantages of an installment transaction is the seller's ability to spread the taxable gain over the duration of the installment payments. Each payment will be divided into three parts for income tax purposes: (1) a tax-free return of the seller's investment, (2) taxable profit, and (3) taxable interest income. To determine the portion of each payment that constitutes taxable income, you must calculate the gross profit ratio. This is the ratio between the gross profit (selling price minus seller's adjusted basis) and the entire contract price (amount the seller will receive). Interest income is categorized separately and taxed as ordinary income.

Example(s):  You sell a piece of land to your daughter for $200,000. Your adjusted basis in the land is $100,000. You arrange an installment sale where you will receive $20,000 per year for ten years. The gross profit is $100,000 ($200,000 selling price minus $100,000 adjusted basis). The gross profit ratio is 50 percent ($100,000 gross profit divided by the $200,000 to be received over the life of the installment payments). Therefore, 50 percent of each payment will be a tax-free return of investment, and 50 percent will either be capital gains or ordinary income, depending on whether the property sold was a capital asset or not. (For the sake of simplicity, interest has been ignored in this example.)

The interest Portion of Each Payment, Whether Stated or Imputed, Will Be Taxed As Ordinary Income

Interest is separated from the principal portion of each payment and taxed as conventional income. If the interest rate stated in the contract is not below market, the actual interest charged will be taxed as ordinary income to the vendor and may be deductible by the buyer. Frequently, the installment sale agreement does not specify an interest rate or has an interest rate below the market rate. In this instance, the tax code imputes interest on each payment based on a statutory rate of interest and compounded semi-annually.

Both the seller and the buyer will then be charged interest on a component of the payment. The seller is taxed on the interest portion of each payment as ordinary income, and the buyer may be able to deduct the interest payments (subject to the same restrictions and limitations that apply to all interest payments). The remainder of the payment is deemed principal, and the gross profit ratio is applied to this portion of the payment to determine what percentage of the payment is a tax-free return on investment and what portion is either a capital gain or ordinary income.

Example(s):  You sell land to your neighbor for $100,000. Your adjusted basis in the land is $25,000. You set up an installment sale agreement where you will receive ten annual payments of $10,000. There is no mention in the agreement about interest on the unpaid balance. The IRS will impute a statutory rate of interest to the balance and compound it twice a year. Let's assume that $1,000 of the $10,000 annual payment is determined by the IRS to be interest. The seller must then report this $1,000 each year as ordinary income. The gross profit ratio (75 percent in this instance — $75,000 divided by $100,000) is next applied to the remaining $9,000 principal payment. This 75 percent of $9,000 (or $6,750) is considered either a capital gain or ordinary income, and 25 percent (or $2,250) is considered a tax-free return of investment.

Buyer May Be Able to Deduct Interest Portion of Installment Payments

In general, the buyer cannot deduct the interest component of an installment payment if the interest is considered personal. The buyer may deduct interest if the debt is properly allocated to (1) investment activities, but only to the extent of investment income, (2) the operation of a trade or business, and (3) the purchase of a qualified residence.

Caution:  Your tax advisor should be consulted before you deduct the interest payments on an installment sale. The rules allowing interest deductions are very complex.

Example(s):  You buy your parents' house from them on an installment sale basis. You intend to use the house as your principal residence. The installment sale agreement sets an interest rate on the unpaid balance that is equal to the going market rate for fixed-rate mortgages. You will be able to deduct the interest portion of each installment payment from your income (as long as the acquisition indebtedness does not exceed $750,000) because the debt is allocable to the purchase of a qualified residence.

If the Sale Results In Loss, Installment Sale Treatment Does Not Apply

If the sale results in a loss for the vendor, he or she cannot use the installment sale method to spread the loss over the duration of the installment payments. In the year of the sale, the complete loss deduction must be claimed.

Example(s):  You own a piece of land with a basis of $100,000. Land prices in the area have been falling in recent years. You sell the land for $60,000 in an installment sale for ten annual payments of $6,000. You are not allowed to spread the $40,000 loss over the ten-year term of the installment sale. Rather, the entire $40,000 loss must be deducted in the year of the sale.

Installment Sale Treatment Does Not Apply To Sale of Listed Securities

Installment sale treatment is not available for the sale of securities traded on established markets (such as the New York Stock Exchange, the American Stock Exchange, and over-the-counter markets). In the year of the sale, the entire gain from the sale of the securities must be recognized.

Example(s):  You sell $100,000 worth of IBM stock to your grandson in an installment sale. Your basis is $30,000, and the $100,000 will be paid in ten installments of $10,000 each. Your entire gain of $70,000 must be reported in the year of the sale. You are not allowed to spread the gain over the term of the installment payments.

Installment Sale Treatment Not Allowed for Depreciation Recapture of Real or Personal Property

If you sell any depreciated personal or real property, you must recognize the recapture of that depreciation up to the amount of your gain in the year of the sale, even if other gain on the sale is recognized over the term of the installment payments. The amount recaptured and included in taxable income in the year of sale may be added to the property's basis. Thus, the annual gain that must be reported will be diminished.

Example(s):  You sell a building to another person for $100,000, to be paid in four annual installments. Your original basis for the building was $120,000, but you have taken $40,000 in depreciation deductions over the years, bringing your adjusted basis down to $80,000. You have a gain of $20,000 ($100,000 selling price minus your adjusted basis of $80,000). You could normally spread this gain out over the four years of the installment payments. However, you must recapture your depreciation up to the amount of your gain. Therefore, the entire gain of $20,000 must be reported in the year of the sale. This reported gain of $20,000 may then be added to your adjusted basis of $80,000, bringing your basis up to $100,000. Because your new basis now equals the sale price, there is no gain, and you do not have to report any taxable gain from the four installment payments. If you had sold the property for $150,000, the entire depreciation recapture amount of $40,000 would have to be reported in the year of the sale. The remaining gain of the $30,000 could then be spread out over the four installment payments.

Installment Sale Treatment Not Allowed for Sale of Depreciable Property to Certain Controlled Entities

For the sale of depreciable property to a controlled entity, installment sale treatment is disallowed. A controlled entity consists of any partnership or corporation in which you own more than 50 percent. A controlled entity may also consist of a trust in which you or your spouse are beneficiaries. For tax purposes, all payments to be received (even if structured as an installment plan) are deemed to be received in the year of the sale. This tax result holds true even if the asset has not been depreciated. As long as the asset qualifies for depreciation, the entire gain must be reported in the year of sale.

Example(s):  You sell personal tangible property to a corporation in which you are an 80 percent owner. The sale price is $50,000, and your basis is $10,000. The property is eligible to be depreciated. The corporation buys the property on an installment plan, paying $10,000 a year for five years. For tax purposes, you have to report the entire $40,000 gain in the year of the sale. You have sold the depreciable property to a controlled entity.

Estate Tax

Present Value of Installment Payments Still Due Must Be Included In Gross Estate of Deceased Seller

In contrast to a private annuity, the present value of any outstanding installments at the time of the seller's demise must be included in the seller's gross estate. Even if the vendor dies before the end of the installment payments, the buyer must continue making payments in a sale on installments. The estate of the deceased must include the present value of these posthumous payments. The property and any prospective appreciation are removed from the seller's estate, making the installment sale a valuable estate-freezing tool.

Example(s):  You have sold a piece of property to your daughter in an installment sale for $500,000. The original sale agreement calls for your daughter to make ten annual payments of $50,000 each. After five payments have been made, you die. The present value of the five remaining payments is included in your gross estate. Your daughter must continue to make the payments to your estate or the recipient of the installment note. However, the value of the property and any appreciation in that property are not included in your gross estate. If the property was worth $700,000 at the time of your death, you have removed this $200,000 of appreciation from your gross estate. The installment sale can therefore be a very effective estate-freezing technique. A further tip is that you can use the annual exclusion gift to return part of each payment back to your daughter, tax-free.

Upon the Death of the Seller, Remaining Payments Must Be Reported By the Beneficiary As Income In Respect of a Decedent

The beneficiary who received the installment note from the property's deceased seller must disclose the remaining payments in the same manner as the seller did during life. In other words, the recipient must separate each payment into tax-free return on investment, gain, and taxable interest. To the extent that the seller's estate was liable for estate taxes on the unpaid installments, the beneficiary will be eligible for an income tax deduction.

Gift and Estate Tax

Gift And Estate Tax Liability May Arise If Property Is Sold For Less Than Fair Market Value

When a property is sold for less than its fair market value, the difference between the FMV and the purchase price may be a gift from the vendor to the buyer. If the present value of the installment payments is less than the FMV of the property sold in an installment sale transaction, the vendor is considered to have gifted the difference to the buyer. On this difference, the seller will incur gift and estate tax, which will be due and payable immediately if the applicable exclusion amount has been entirely utilized.

Caution:  Because the FMV of the property should be the selling price, you should hire an experienced, objective appraiser to value any property for which there may be a question about the true value.

Example(s):  You sell a piece of property with a fair market value of $100,000 to your son in an installment sale. The present value of the installment payments that your son will make to you is only $70,000. You have made a gift to your son of the $30,000 difference.

Installment Payments With Low-Interest Rates May Trigger Gift and Estate Tax Liability

If the interest rate on the installment payments is extremely low, this may generate gift and estate tax liability because the present value of the payments will be less than their face value. The IRS considers the disparity to be a gift from the seller to the buyer (since the buyer is paying less than he or she would at a market-rate interest rate). Unfortunately, it is currently unclear what interest rate should be charged to circumvent tax implications.

You could use the prevailing market rate, the applicable federal rate, the rate for agricultural sales under $500,000, or the rates imputed for income-tax purposes on installment sales. There is disagreement between the IRS, the tax court, and some appellate tribunals regarding the applicable tax rates. Before setting up an installment sale, you should consult your tax advisor. However, these Ernst & Young clients should be aware that using a very low interest rate could result in tax issues.

Example(s):  You sell a commercial building to your daughter in an installment sale. The installment agreement states that the interest rate on the unpaid balance will be 2 percent. The prevailing market rate is 7 percent, and the applicable federal rate and other rates are all well above 2 percent. Under this transaction, the IRS may consider this installment sale to be a partial gift from you to your daughter because of the low-interest rate. Consequently, you may owe gift and estate tax.

Transaction Structured As Installment Sale May Be Disregarded By IRS And Treated As a Gift

If the IRS determines that an installment sale lacks substance, it may treat the transaction as a gift-in-kind. The IRS is particularly suspicious of intrafamily transfers in which the vendor accepts notes from the buyer (typically the seller's child) but has no intention of enforcing the notes. The IRS views this type of transaction as an outright gift to the child, and the vendor may be liable for a gift tax on the property's fair market value. To avoid IRS invalidation, these Ernst & Young clients must carefully structure the transaction using valid, enforceable, interest-bearing notes.

In Community Property States, Both Spouses Should Join In Conveyance of Real Property

If the real property being transmitted in an installment sale is community property in a state with community property, then both spouses must participate in the conveyance of the community real property. In certain community property states, if real property is held solely in the name of one spouse and that spouse attempts to transfer the property without the other spouse's assent, the other spouse has the right to void the sale. If the community property is held in the names of both spouses, then the transfer by one spouse is void only with regard to the other spouse's interest. Therefore, these Ernst & Young clients must exercise extreme caution when structuring an installment transaction in a state with community property.

One Community Property Owner May Sell Interest As an Installment Sale While Other Owner Sells Interest Outright

In a community property state, each individual may sell his or her share of the community property separately. For instance, one spouse may sell his or her interest outright and must recognize the entire gain in the year of the sale. The other spouse could sell his or her interest in an installment transaction and distribute the profit over the duration of the installment payments. There may be instances in which this strategy makes tax sense.

Unmarried Partners May Have Joint Property Rights Similar to Community Property States

Recent court decisions have found that unmarried individuals may have implicit agreements to regard their property similarly to that of community property states. Therefore, any of these Ernst & Young consumers should be cautious when purchasing property from a person with such a relationship. It is possible for the other party to nullify the entire sale, or at least the portion of the transaction involving his or her share of the joint property. You might want to convince the other party to transfer their interest as well.

Questions & Answers

How Can Life Insurance Be Used to Enhance an Installment Sale Transaction?

There are a number of methods in which life insurance can be utilized to improve an installment sale transaction. First, if the buyer dies before all installment payments have been made, the seller may be in difficulty. In an installment sale, the seller may purchase life insurance on the buyer to provide some protection in the event of the buyer's untimely demise. The seller can be both the policy's proprietor and beneficiary, as well as the premium payer. Moreover, the buyer's installment payments could be increased to cover the seller's cost of purchasing the life insurance policy.

Second, the consumer may wish to purchase his or her own life insurance. The buyer's total estate will include both the purchase price and any subsequent appreciation of the acquired property. His estate may require additional funds to pay the gift and estate taxes upon his passing. Thirdly, the buyer's family may wish to purchase life insurance on the buyer (payable to the buyer's estate) to ensure that the buyer's estate will have sufficient funds to continue making installment payments to the vendor. Even if the buyer passes away before the installment payments have been completed, the buyer's estate is usually responsible for making the remaining payments.

Are There Any Special Requirements for a Self-Canceling Installment Note?

A SCIN is merely a note with a provision stating that any outstanding payments at the time of the holder's demise are automatically canceled. All tax regulations applicable to installment sales also apply to SCINs. However, there are additional tax regulations that apply to a SCIN that our Ernst & Young clients should be aware of. According to Section 453B of the Internal Revenue Code, the cancellation of an installment note is a taxable disposition. The estate would then be required to disclose the gain as income in respect of a decedent. Because the seller may die before all of the notes are due, the buyer's prospective tax benefit is increased (he may not be required to make all of the payments).

Therefore, if the selling price is not increased, the seller is deemed to have gifted the buyer, and gift and estate tax may be due. If the selling price is increased to circumvent the tax issue, the seller will be required to report a greater gain on the initial sale than if there were no self-cancelling feature. Due to the fact that the remainder of the note is canceled upon the seller's death, the tax court has determined that there is nothing to include in the decedent's estate.

Example(s):  You sell all the stock in your closely held business to your daughter. You receive a small cash down payment from your daughter and take back a 10-year installment note for the remainder of the purchase price. The sales agreement and the installment note both provide that all sums due on the note will be automatically extinguished and canceled at your death. The terms of the sale include a risk premium to compensate you for the possible cancellation of the note. You die six years later. At the time of your death, the unrecognized installment sale income is $25,000 (your death cancels the installment obligations under the note with five years of payments still to be made). No portion of the note receivable has to be included in your gross estate.

How Can Sellers Increase Their Security In an Installment Sale?

There are numerous methods for sellers to ensure that they will receive all payments owed to them under an installment agreement without being taxed on the entire gain in the year of the sale during an installment sale. As discussed in the first question, the seller may purchase life insurance on the buyer to safeguard himself or herself against the buyer's untimely demise. Second, a third party may guarantee payment in the event that the consumer defaults. The vendor may require the purchaser to secure the installment payments with a standby letter of credit from a financial institution.

Thirdly, the seller may require the customer to deposit funds into an escrow account as payment security. If the parties establish an escrow account, they must do so with extreme care. Typically, the IRS considers escrow funds to be constructively received by the seller and therefore completely taxable in the year of sale. However, the seller may prevail if he or she can demonstrate that the escrow account serves a legitimate business purpose and that he or she will continue to rely on the buyer's contractual obligation for payment.

Can You Do an Installment Sale If the Selling Price Is Contingent on Some Future Event?

Yes, installment sale treatment is conceivable even if the selling price is not precisely known at the time of the sale. In the sale of many types of property, it is common for the final sale price to hinge on some future contingency that is unknown at the time of sale. For instance, you could sell a closely held corporation in installments to one of your employees, with the annual installment payments being a proportion of the company's annual profits. Even in this circumstance, installment sale terms are available.

The formulas for determining what portion of each payment received by a vendor should be treated as a tax-free return of basis and what portion should be treated as a taxable gain are fairly complex. Under one approach, you estimate the maximum potential gross profit from the transaction and then divide that figure by the maximum potential selling price. This ratio is then multiplied by the installment payment to determine the proportion of each installment payment that constitutes taxable gain. Adjustments can be made to the remaining payments to reimburse you for tax overpayments if it later becomes apparent that the utmost outcome will not occur. If the sale price cannot be determined but a fixed number of payments can be made, the basis is distributed proportionally across the fixed number of payments.

Caution:  The tax treatment of installment sales with contingent payments can be extremely complex. Your tax advisor and accountant should be consulted before you try to set up an installment sale transaction where the sale price is contingent on some future event.

What Are the Tax Consequences When the Seller Forgives the Buyer's Obligation to Make Payments?

The IRS views the buyer's cancellation of his obligation to continue making payments as a disposition, and the vendor must report either a gain or a loss. The gain or loss is determined by the difference between the obligation's fair market value (FMV) and its basis. The transaction may also subject the seller to gift and estate taxes. If the transaction involves related parties, the IRS considers the obligation's FMV to be at least its face value.

Example(s):  You sell a piece of property to your son for $200,000 in an installment sale. The sale price will be paid in 10 installments of $20,000 each. Your basis is $50,000. You immediately cancel your son's obligation to make payments. You must report a taxable gain of $150,000. In addition, you may have to pay gift and estate tax.

One solution in the above example to avoid the imposition of the gift and estate tax is to simply forgive enough of the annual payments each year (assuming you do not cancel your son's obligation) to fully make use of the annual gift tax exclusion each year. In this manner, you could forgive up to $15,000 (in 2019 and 2020) worth of installment payments and not pay any federal tax (you may still owe state gift tax). If you split the gift with your spouse, and you are both U.S. citizens and make the gift jointly, then you could forgive up to $30,000 (in 2019 and 2020) worth of installment payments and not be liable for any tax. However, the IRS may question whether the transaction qualifies as a sale, as opposed to a gift in the year of the original transfer, where there appears to be a plan to cancel the installments due.

When Would a Seller Want to Forego the Installment Sale Method of Reporting a Gain for Tax Purposes, Even If The Sale Was Done on an Installment Basis?

There are situations in which it may be advantageous to report the entire gain from a sale in the year of the sale, even though the proceeds will be received in installments. For instance, if you have other unrelated losses in a given year against which you can deduct the gains, it may be advantageous from a tax perspective to realize the entire gain in the year of the sale. Also, if your income is unusually low in a given year (and you expect to be in a lower tax classification), you will likely be better off taking the entire gain from the installment sale in that year. Similarly, if you have unusually large deductions in a given year, you may wish to offset the entire gain against those deductions.

Caution:  For tax purposes, installment sale treatment is automatic (for a qualifying sale). If you want to report the entire gain in one year, you have to report the gain in your gross income for that year. When you have decided to report all of the gain in one year, then you can revoke this election only under very limited circumstances.

Does the Seller Have to Receive a Payment In The Year of the Sale to Qualify for Installment Sale Treatment?

No, the vendor is not required to be paid in the year of the sale. At least one payment must be received in a taxable year other than the year of sale. In reality, the buyer and vendor have a great deal of leeway in structuring the payment schedule. For instance, they could wait five years before receiving payments. Similarly, the buyer and seller have discretion over the amount of each payment (for instance, more money could be paid in one year than another).