When you sell an asset, you have two basic options for dealing with any tax obligation: ‘Pay the tax’ or ‘Defer the tax’.
You must then determine which of the options best fits your needs?
- Cash Sale – The seller pays the tax in the year that the sale was completed.
- IRC 1031 Exchange; IRC 1033 Exchange – The seller defers tax obligation through the exchange of property. The exchange uses a Qualified Intermediary (QI). ALTERNATIVE; Delaware Statutory Trust (DST)
- IRC 453 Installment Sale <$5mm; IRC 453(A) Installment Sale >$5mm – Taxes are due in the tax year money is received. ALTERNATIVE; Deferred Sales Trust (DST)
- IRC 453/453(A) Installment Sale Followed by a Cash Option – Seller receives tax free limited recourse loan, invests tax dollars and defers tax for up to 30 years.
- IRC 1400Z 1&2: Economic Opportunity Zones (OZ) (Utilizes some Exchange rules) – Investors receive deferral opportunities by investing into government designates areas needing revitalization. There are varying time frames for the deferral opportunities.
The most important thing you can do for yourself and your estate is to be aware of your options and understand how each will affect your financial situation long term. Your specific situation will determine which choice best suits your needs.
For the remainder of this article, we are going to focus on the concept of ‘Tax Deferral’ and specifically the ‘Installment Sale followed by a Cash Option’. Even though this option was created almost forty years ago by Congress in the early 1980’s, most individuals and practitioners are unaware of its existence and the potential value it provides the seller of an asset.
To appreciate the value and purpose of an ‘Installment Sale followed by a Cash Option’ or in fact any “deferral” program you need to start with a fundamental question. “WHY”? Why does the Federal Government allow the deferral of tax obligations in the first place? The answers are relatively simple.
Assets such as business’s or investment property like people have a practical life cycle. Think of it in stages.
The entrepreneur’s idea starts to develop a business or property. It grows, expands, matures, and finally, its growth trajectory begins to flatten. Age, technological advancement, and consumer behavior all help to sponsor a slow decline.
Over time Congress began to realize that refurbishing and replacing of old assets with the new and modern assets had a positive benefit. Old businesses and property could make way for new more prosperous opportunities. This advancement could result in more jobs, stronger tax bases, and overall economic expansion.
While this created a positive effect on the economy, asset owners were often hesitant to sell because of the potential associated tax liability. As a solution, Congress began to create opportunities to defer the tax obligation. It has never been Congresses intent to void the tax obligation rather they provide techniques to defer. This approach allows new development and advancement to take place while collecting the tax obligation in a manner more favorable to the seller.
Congress’s decision to create the “Installment Sale followed by a Cash Option” was a combination of desired economic expansion along with the need to temper a state of economic chaos. It was the early 1980’s when interest rates were topping out of their thirty-year climb. Certificates of Deposit (CD’s) were yielding 15%. ‘AAA’ to ‘A’ rated bonds held coupon rates of 18% to 21%. This coupled with high unemployment, and high inflation produced the economic phenomena known as ‘stagflation’. The economic turmoil became so significant that an economist by the name of Arthur Okun created the ‘misery index’.
The structure of the ‘Installment Sale followed by the Cash Option’ was born out of this chaos. Its structure is elegantly simple. It consists of two basic parts. The first is the ‘Installment Sale”. The idea of an ‘Installment Sale’ is some of the oldest Internal Revenue Code (453), dating back to 1913.
The basic principle of the ‘installment sale’ is that the seller owes tax on the proceeds of the sale as they receive the money. As an example, if the seller receives the proceeds of the sale divided equally over the next five years, then they will owe tax on just 20% of the proceeds each year. If they choose to receive a lump sum distribution at some date in the future, then that will be the year the taxes are due. There is no limit to how long the installment may last, and there is no limit to the configuration of the time frame. The one constant is that the tax is due on the money that the seller receives, in the year they receive it.
In the case of the ‘Installment Sale followed by a Cash Option’ a ‘Qualified Intermediary’ (QI), is used in the same fashion as a QI is used in an IRC 1031 Exchange. The QI acts as a legal barrier between the seller and the proceeds of the sale. This allows the seller to determine when and in what configuration the sale proceeds will be received and the year the resulting tax will be owed.
Once the ‘Installment Sale’ is completed then the seller can choose how they wish to receive the money from the sale. Rather than directly receiving the sales proceeds which would trigger the tax obligation, the seller can take the money in the form of an uncollateralized, tax-free loan. Interest and principal on the loan will come from the sales proceeds held by the QI, not from the seller.
This structure provides the seller the opportunity to receive money, invest the proceeds, and ultimately have all interest and principal payments made from the sales money held by the QI. The ability to institute these two steps, the ‘Installment Sale’ and the ‘Cash Option’ produces the quintessential ‘Time Value of Money’ equation.
It is important to understand that the ‘Installment Sale’ and the ‘Cash Option’ are NOT interdependent. They are totally separate and independent functions. A seller can choose to do one or the other, both or neither.
If the seller of an asset chooses to institute a ‘Cash Option’ the ‘Time Value of Money’ leverage can provide a significant financial benefit. As a simple example, let’s assume the potential tax obligation for an asset sale was $1,000,000.
The seller could either pay the $1,000,000. in the year of the sale or defer and invest the $1,000,000. for an extended number of years by receiving their assets in the form of a tax-free loan.
If the seller invested the $1,000,000. at a 6% net return for say 30 years, the tax dollars would grow by approximately 5.74 times. At the end of 30 years, take the resulting $5,740,000. pay the $1,000,000. tax bill and increase the value of the seller’s estate by approximately $4,740,000. Just by deferring the tax obligation.
As the seller of an asset, the most important lesson to be learned is that there are options. No option, be it a 1031 exchange or a 453(A) Installment Sale coupled with a Cash Option fits every situation. If you understand your options, you are better equipped with the information necessary to make an informed intelligent decision.
Contributed by Jack Gruber