A Deferred Sales Trust Operation Under Investigation by IRS

The IRS Sue to Enforce Deferred Sales Trust Summons

The IRS Sue to Enforce Deferred Sales Trust Summons

There are many ways that tax promoters attempt to goad taxpayers into investing in various tax strategies that may not be altogether kosher. Two recent examples that have come on the IRS’s radar are the Malta Pension Plan and the Syndicated Conservation Easement Transaction. More recently, the Internal Revenue Service filed a lawsuit to enforce a summons on a matter involving a Deferred Sales Trust. The Deferred Sales Trust is becoming a more common type of tax promotion used by promoters aimed at taxpayers seeking to dispose of their assets and reduce their tax liability. Recently, the IRS filed a lawsuit in California District Court which seeks to enforce a summons on matters involving deferred sales trust transactions. Oftentimes these types of strategies may not pass muster and will end up as an IRS reportable/listed transaction. It may also result in fines and penalties for both the taxpayer and the promoter. Let’s take a brief look at what a deferred sales trust is and why the IRS does not like it.

What is a Deferred Sales Trust?

The idea behind a Deferred Sales Trust is that the Taxpayer proactively seeks to enter into an installment agreement type agreement for the sale of an asset. The asset is then moved into a trust where the transaction is facilitated through installment payment. Based on the terms of the sale, the owner of the asset through the trust will usually receive payments in monthly or semi-annual/annual installments. The benefit of this transaction is that the taxpayer will not receive all the money in one lump sum — which will reduce the overall taxes paid to some taxpayers. Instead, the transaction is extended throughout multiple years which helps to keep the overall capital gains amount less because the total amount of capital gain paid will be based on a lower net effective tax rate.

Section 453 Installment Method

In pertinent part:

• • • (a) General rule

      • Except as otherwise provided in this section, income from an installment sale shall be taken into account for purposes of this title under the installment method

    • (b) Installment sale define

      • For purposes of this section—

        • (1)I n general

          • The term “installment sale” means 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.

          • (2)Exceptions

            • The term “installment sale” does not include— (A)Dealer dispositions Any dealer disposition (as defined in subsection (l)). (B)Inventories of personal property A disposition of personal property of a kind which is required to be included in the inventory of the taxpayer if on hand at the close of the taxable year.

Why Does the IRS Care About Deferred Sales Trusts?

For taxpayers and promoters to comply where the Deferred Sales Agreement rules, it requires strict adherence to Internal Revenue Code section 453. Where the problem arises is that many tax promoters push strategies that push the envelope and ride the line of legality. The IRS issued a detailed analysis back in 2021 detailing their concerns with these types of transactions

IRS 2021 Installment Sale Analysis

As provided by the IRS

• • • This is in response to your request for our analysis regarding “Monetized Installment Sale” transactions. Note that because there are multiple promoters/sub-promoters, there could be variations in the way transactions are structured. Some of the points below might not apply to every transaction. However, there do seem to be common features that make the transactions problematic. And we generally agree that the theory on which promoters base the arrangements is flawed. The general structure raises a number of issues including, but not limited to, the following:

      •  1. No genuine indebtedness. At least one promoter contends that the seller receives the proceeds of an unsecured nonrecourse loan from a lender, but a genuine nonrecourse loan must be secured by collateral. A “borrower” who is not personally liable and has not pledged collateral would have no reason to repay a purported “loan.” See Estate of Franklin v. CIR, 544 F.2d 1045 (9th Cir. 1976). Therefore, the loan proceeds would be income.

      • 2. Debt secured by escrow. In one arrangement, the promoter states that the lender can look only to the cash escrow for payment. It appears that, in effect, the cash escrow is security for the loan to taxpayer. If so, taxpayer economically benefits from the cash escrow and should be treated as receiving payment under the “economic benefit” doctrine for purposes of section 453. Compare Reed v. CIR, 723 F.2d 138 (1st Cir. 1983).

      • 3. Debt secured by dealer note. Alternatively, the Monetization Loan to taxpayer is secured by the right to payment from the escrow under the installment note from the dealer. This would result in deemed payment under the pledging rule, under which loan proceeds are treated as payment of the dealer note. Section 453A(d).

      • 4. Section 453(f). The intermediary does not appear to be the true buyer of the asset sold by taxpayer. Under section 453(f), only debt instruments from an “acquirer” can be excluded from the definition of payment and thus not constitute 2 payment for purposes of section 453. Debt instruments issued by a party that is not the “acquirer” would be considered payment, requiring recognition of gain. See Rev. Rul. 77-414, 1977-2 C.B. 299; Rev. Rul. 73-157, 1973-1 C.B. 213; and Wrenn v. CIR, 67 T.C. 576 (1976) (intermediaries ignored in a back-to-back sale situation).

      • 5. Cash Security. To the extent the installment note from the intermediary to the seller is secured by a cash escrow, taxpayer is treated as receiving payment irrespective of the pledging rule. Treas. Reg. section 15a.453-1(b)(3)(“Receipt of an evidence of indebtedness which is secured directly or indirectly by cash or a cash equivalent . . . will be treated as the receipt of payment.”)

      •  6. NSAR 20123401F is distinguishable. The case addressed in the memorandum did not involve an intermediary. Further, loans to a disregarded entity wholly owned by seller were secured by the buyer’s installment notes, but the pledging rule of section 453A(d) was not applicable. There is an exception to the pledging rule for sales of farm property, which applied in the case.

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