Using A Fancy Trust Without An Advisor

 

I am a fan of charitable remainder trusts. These are (sometimes) also referred to as split interest trusts.

What is an interest in a trust and how can you split it?

In a generic situation, an interest in a trust is straightforward:

(1) Someone may have a right to or is otherwise permitted to receive an income distribution from a trust. This is what it sounds like: if the trust has income, then someone might receive all, some or none of it – depending on what the trust is designed to do. This person is referred to as an “income” beneficiary.

(2) When there are no more income beneficiaries, the trust will likely terminate. Any assets remaining in the trust will go to the remaining beneficiaries. This person(s) is referred to as a “remainder” beneficiary.

Sounds complicated, but it does not have to be. Let me give you an example.

(1)  I set up a trust.

(2)  My wife has exclusive rights to the income for the rest of her life. My wife is the income beneficiary.

(3)  Upon my wife’s death, the assets remaining in the trust go to our kids. Our kids are the remainder beneficiaries.

(4)  BTW the above set-up is referred to as a “family trust” in the literature.

Back to it: what is a split interest trust?

Easy. Make one of those interests a 501(c)(3) charity.

If the charity is the income beneficiary, we are likely talking a charitable lead trust.

If the charity is the remainder beneficiary, then we are likely talking a charitable remainder trust.

Let’s focus solely on a charity as a remainder interest.

You want to donate to your alma mater – Michigan, let’s say. You are not made of money, so you want to donate when you pass away, just in case you need the money in life. One way is to include the University of Michigan in your will.

Another way would be to form a split interest trust, with Michigan as the charity. You retain all the income for life, and whatever is left over goes to Michigan when you pass away. In truth, I would bet a box of donuts that Michigan would even help you with setting up the trust, as they have a personal stake in the matter.

That’s it. You have a CRT.

Oh, one more thing.

You also have a charitable donation.

Of course, you say. You have a donation when you die, as that is when the remaining trust assets go to Michigan.

No, no. You have a donation when the trust is formed, even though Michigan will not see the money (hopefully) for (many) years.

Why? Because that is the way the tax law is written. Mind you, there is crazy math involved in calculating the charitable deduction.

Let’s look at the Furrer case.

The Furrers were farmers. They formed two CRATs, one in 2015 and another in 2016.

COMMENT: A CRAT is a flavor of CRT. Let’s leave it alone for this discussion.

In 2015 they transferred 100,000 bushels of corn and 10,000 bushels of soybeans to the CRAT. The CRAT bought an annuity from a life insurance company, the distributions from which were in turn used to pay the Fullers their annuity from the CRT.

They did the same thing with the 2016 CRT, but we’ll look only at the 2015 CRT. The tax issue is the same in both trusts.

The CRT is an oddball trust, as it delays - but does not eliminate – taxable income and paying taxes. Instead, the income beneficiary pays taxes as distributions are received.

EXAMPLE: Say the trust is funded with stock, which it then sells at a $500,000 gain. The annual distribution to the income beneficiary is $100,000. The taxes on the $500,000 gain will be spread over 5 years, as the income beneficiary receives $100,000 annually.

Think of a CRT as an installment sale and you get the idea.

OK, we know that the Furrers had income coming their way.

Next question: what was the amount of the charitable contribution?

Look at this tangle of words:

§ 170 Charitable, etc., contributions and gifts.

           (e)  Certain contributions of ordinary income and capital gain property.

(1)  General rule.

The amount of any charitable contribution of property otherwise taken into account under this section shall be reduced by the sum of-

(A)  the amount of gain which would not have been long-term capital gain (determined without regard to section 1221(b)(3)) if the property contributed had been sold by the taxpayer at its fair market value (determined at the time of such contribution),

This incoherence is sometimes referred to as the “reduce to basis” rule.

The Code will generally allow a charitable contribution for the fair market value of donated property. Say you bought Apple stock in 1997. Your cost (that is, your “basis”) in the stock is minimal, whereas the stock is now worth a fortune. Will the Code allow you to deduct what Apple stock is worth, even though your actual cost in the stock is (maybe) a dime on the dollar?

Yep, with some exceptions.

Exceptions like what?

Like the above “amount of gain which would not have been long-term capital gain.”

Not a problem with Apple stock, as that thing is capital gain all day long.

How about crops to a farmer?

Not so much. Crops to a farmer are like yoga pants to Lululemon. That is inventory - ordinary income in nerdspeak - as what a farmer ordinarily does is raise and sell crops. No capital gain there.

Meaning?

The Furrers must reduce their charitable deduction by the amount of income that would not be capital gain.

Well, we just said that none of the crop income would be capital gain.

I see income minus (the same) income = zero.

There is no charitable deduction.

Worst … case … scenario.

I found myself wondering how the tax planning blew up.

In July 2015, after seeing an advertisement in a farming magazine, petitioners formed the Donald & Rita Furrer Charitable Remainder Annuity Trust of 2015 (CRAT I), of which their son was named trustee. The trust instrument designated petitioners as life beneficiaries and three eligible section 501(c)(3) charities as remaindermen.”

The Furrers should have used a tax advisor. A pro may not be necessary for routine circumstances: a couple of W-2s, a little interest income, interest expense and taxes on a mortgage, for example.

This was not that. This was a charitable remainder trust, something that many accountants might not see throughout a career.

Yep, don’t do this.

Our case this time is Furrer v Commissioner, T.C. Memo 2022-100.

The Obamacare Subsidy Cliff

 

I am looking at a case involving the premium tax credit.

We are talking about the Affordable Care Act, also known as Obamacare.

Obamacare uses mathematical tripwires in its definitions. That is not surprising, as one must define “affordable,” determine a “subsidy,” and - for our discussion – calculate a subsidy phase-out. Affordable is defined as cost remaining below a certain percentage of household income. Think of someone with extremely high income - Elon Musk, for example. I anticipate that just about everything is affordable to him.

COMMENT: Technically the subsidy is referred to as the “advance premium tax credit.” For brevity, we will call it the subsidy.

There is a particular calculation, however, that is brutal. It is referred to as the “cliff,” and you do not want to be anywhere near it.

One approaches the cliff by receiving the subsidy. Let’s say that your premium would be $1,400 monthly but based on expected income you qualify for a subsidy of $1,000. Based on those numbers your out-of-pocket cost would be $400 a month.

Notice that I used the word “expected.” When determining your 2022 subsidy, for example, you would use your 2022 income. That creates a problem, as you will not know your 2022 income until 2023, when you file your tax return. A rational alternative would be to use the prior year’s (that is, 2021’s) income, but that was a bridge too far for Congress. Instead, you are to estimate your 2022 income. What if you estimate too high or too low? There would be an accounting (that is, a “true up”) when you file your 2022 tax return.

I get it. If you guessed too high, you should have been entitled to a larger subsidy. That true-up would go on your return and increase your refund. Good times.

What if it went the other way, however? You guessed too low and should have received a smaller subsidy. Again, the true-up would go on your tax return. It would reduce your refund. You might even owe. Bad times.

Let’s introduce another concept.

ACA posited that health insurance was affordable if one made enough money. While a priori truth, that generalization was unworkable. “Enough money” was defined as 400% of the poverty level.

Below 400% one could receive a subsidy (of some amount). Above 400% one would receive no subsidy.

Let’s recap:

(1)  One could receive a subsidy if one’s income was below 400% of the poverty level.

(2)  One guessed one’s income when the subsidy amount was initially determined.

(3)  One would true-up the subsidy when filing one’s tax return.

Let’s set the trap:

(1)  You estimated your income too low and received a subsidy.

(2)  Your actual income was above 400% of the poverty level.

(3)  You therefore were not entitled to any subsidy.

Trap: you must repay the excess subsidy.

That 400% - as you can guess – is the cliff we mentioned earlier.

Let’s look at the Powell case.

Robert Powell and Svetlana Iakovenko (the Powells) received a subsidy for 2017.

They also claimed a long-term capital loss deduction of $123,822.

Taking that big loss into account, they thought they were entitled to an additional subsidy of $636.

Problem.

Capital losses do not work that way. Capital losses are allowed to offset capital losses dollar-for-dollar. Once that happens, capital losses can only offset another $3,000 of other income.

COMMENT: That $3,000 limit has been in the tax Code since before I started college. Considering that I am close to 40 years of practice, that number is laughably obsolete.

The IRS caught the error and sent the Powells a notice.

The IRS notice increased their income to over 400% and resulted in a subsidy overpayment of $17,652. The IRS wanted to know how the Powells preferred to repay that amount.

The Powells – understandably stunned – played one of the best gambits I have ever read. Let’s read the instructions to the tax form:

We then turn to the text of Schedule D, line 21, for the 2017 tax year, which states as follows:

         If line 16 is a loss, enter ... the smaller of:

·      The loss on line 16 or

·      $3,000

So?

The Powells pointed out that a loss of $123,822 is (technically) smaller than a loss of $3,000. Following the literal instructions, they were entitled to the $123,822 loss.

It is an incorrect reading, of course, and the Powells did not have a chance of winning. Still, the thinking is so outside-the-box that I give them kudos.

Yep, the Powells went over the cliff. It hurt.

Note that the Powell’s year was 2017.

Let’s go forward.

The American Rescue Plan eliminated any subsidy repayment for 2020.

COVID year. I understand.

The subsidy was reinstated for 2021 and 2022, but there was a twist. The cliff was replaced with a gradual slope; that is, the subsidy would decline as income increased. Yes, you would have to repay, but it would not be that in-your-face 100% repayment because you hit the cliff.

Makes sense.

What about 2023?

Let’s go to new tax law. The ironically named Inflation Reduction Act extended the slope-versus-cliff relief through 2025.

OK.

Congress of course just kicked the can down the road, as the cliff will return in 2026.

Our case this time was Robert Lester Powell and Svetlana Alekseevna Iakovenko v Commissioner, T.C. Summary Opinion 2002-19.

Qualifying For Stock Loss Under Section 1244

 

I am looking at a case having to do with Section 1244 stock.

And I am thinking: it has been a while since I have seen a Section 1244.

Mind you; that is not a bad thing, as Section 1244 requires losses. The most recent corporate exit I have seen was a very sweet rollup of a professional practice for approximately $10 million. No loss = no Section 1244.

Let’s set up the issue.

We are talking about corporations. They can be either C or S corporations, but this is a corporate tax thing. BTW there is a technical issue with Section 1244 and S corporations, but let’s skip it for this discussion.

The corporation has gone out of business.

A corporation has stock. When the corporation goes out of business, that stock is worthless. This means that the shareholder has incurred a loss on that stock. If he/she acquired the stock for $5,000, then there is a loss of $5,000 when the corporation closes.

Next: that loss is – unless something else kicks-in – a capital loss.

Capital losses offset capital gains dollar-for-dollar.

Let’s say taxpayer has no capital gains.

Capital losses are then allowed to offset (up to) $3,000 of other income.

It will take this person a couple of years to use up that $5,000 loss.

Section 1244 is a pressure valve, of sorts, in this situation.

A shareholder can claim up to $50,000 of ordinary loss ($100,000 if married filing joint) upon the sale, liquidation or worthlessness of stock if:

 

(1)  The stock is be either common or preferred, voting or nonvoting, but stock acquired via convertible securities will not qualify;

(2)  The stock was initially issued to an individual or partnership;

(3)  The initial capitalization of the corporation did not exceed $1 million;

(4)  The initial capitalization was done with stock and property (other than stock and securities);

(5)  Only persons acquiring stock directly from the corporation will qualify; and

(6)  For the five tax years preceding the loss, the corporation received more than 50% of its aggregate gross receipts from sources other than interest, dividends, rents, royalties, and the sale or exchange of stocks or securities.

The advantage is that the ordinary loss can offset other income and will probably be used right away, as opposed to that $3,000 year-by-year capital loss thing.

Mind you, there can also be part Section 1244/part capital loss.

Say a married couple lost $130,000 on the bankruptcy of their corporation.

Seems to me you have:

                      Section 1244                     100,000

                      Capital loss                         30,000

Let’s look at the Ushio case.

Mr Ushio acquired the stock of PCHG, a South Carolina corporation, for $50,000.

PCHG intended to was looking to get involved with alternative energy. It made agreements with a Nevada company and other efforts, but nothing ever came of it. PCHG folded in 2012.

Ushio claimed a $50,000 Section 1244 loss.

The IRS denied it.

There were a couple of reasons:

(1)  Mr. Ushio still had to prove that $1 million limit.

 

The issue here was the number at the corporate level: was the corporation initially capitalized (for cash and property other than stock and securities) for $1 million or less? If yes, then all the issued stock qualified. If no, the corporation must identify which shares qualified and which shares did not.

        

It is possible that PCHG was not even close to $1 million in capitalization, in which a copy of its initial tax return might be sufficient. Alternatively, PCHG’s attorney or accountant might/should have records to document this requirement.        

 

(2)  PCHG never had gross receipts.

 

This means that PHGC could not meet the 50% of gross receipts requirement, as it had no gross receipts at all.

 

Note that opening a savings or money market account would not have helped. PCHG might then have had gross receipts, but 100% of its gross receipts would have been interest income – the wrong kind of income.

Mr Ushio did not have a Section 1244 loss, as PCHG did not qualify due to the gross-receipts requirement. You cannot do percentages off a denominator of zero.

My first thought when reviewing the case was the long odds of the IRS even looking at the return, much less disallowing a Section 1244 loss on said return. That is not what happened. The IRS was initially looking at other areas of the Ushio return. In fact, Ushio had not even claimed a capital loss – much less a Section 1244 loss – on the original return. The issue came up during the examination, making it easy for the IRS to say “prove it.”

How would a tax advisor deal with this gross-receipts hurdle in practice?

Well, the initial and planned activity of PCHG failed to produce any revenues. It seems to me that an advisor would look to parachute-in another activity that would produce some – any – revenues, in order to meet the Section 1244 requirement. The tax Code wants to see an operating business, and it uses gross receipts as its screen for operations.

Could the IRS challenge such effort as failing to rise to the level of a trade or business or otherwise lacking economic substance? Well, yes, but consider the alternative: a slam-dunk failure to qualify under Section 1244.

Our case this time was Ushio v Commissioner, TC Summary Opinion 2021-27.

Income, Clearly Realized

 

What is income?

Believe it or not, there is a line of cases over decades developing the tax concept of income.

Some instances are clear-cut: if you receive wages or salary, for example, then you have income.

Some instances may not be so clear-cut.

For example, let’s say that you receive a stock dividend. The company has a good year, and you receive – as an example – 1 additional share for every 5 shares you own.  

Do you have income?

Let’s talk this out. Let’s say that the company is worth $25 million before the stock dividend and has 1 million shares outstanding. After the stock dividend it will have 1.2 million shares outstanding. What are those extra 200,000 shares worth?

This is an actual case – Eisner v Macomber - that the Supreme Court decided in 1920. Congress had changed the tax law to tax this stock dividend, and someone (Myrtle Macomber) brought suit arguing that the law was unconstitutional.

Her argument:

·      The company was worth $25 million before the dividend

·      The company was worth $25 million after the dividend

·      She may have more shares, but her shares represent the same proportional ownership of the company.

·      She did not have any more money than she had before.

She had a point.

The Bureau of Internal Revenue (that is, the IRS) came at it from a different angle:

There was income – the income generated by the company.  The company was “distributing” said income by means of a stock dividend.

The Court reasoned that one could have income from labor or from capital. The first did not apply, and it could find nothing to support the second had happened to Mrs Macomber.

The Court decided that she did not have income.

Let’s continue.

The Glenshaw Glass Company sued the Hartford-Empire Company for damages stemming from fraud and for treble damages for business injury.

The two companies settled, and Hartford was paid approximately $325 thousand in punitive damages.

Glenshaw had no intention of paying tax on that $325 grand. That money was not paid because of labor or because of capital. It was paid because of injury to its business - returning Glenshaw to where it should have been if not for the tortious behavior.

Not labor, not capital. Glenshaw was draped all over that earlier Eisner v Macomber decision.

But the IRS had a point – in fact, 325 thousand points.

Here is the Court:

Here we have instances of undeniable accessions to wealth, clearly realized, and over which taxpayers have complete dominion. The mere fact that the payments were extracted from the wrongdoers as punishment for unlawful conduct cannot detract from their character as taxable income.”

The Court levered away from its earlier labor/capital impasse and clarified income to be:

·      An increase in wealth

·      Clearly realized, and

·      Over which one has (temporary or permanent) discretion or control

In time Glenshaw has come to mean that everything is taxable unless Congress says that it is not taxable. While not mathematically precise, it is precise enough for day-to-day use.

I have a question, though.

At a conceptual level, what are the limits on the “clearly realized” requirement?

I get it when someone receive a paycheck.

I also get it when someone sells a mutual fund.

But what if your IRA has gone up in value, but you haven’t taken a distribution?

Or the house in which you raised your family has appreciated in value?

Do you have an increase in wealth?

Do you have discretion or control over said increase in wealth?

Do you have “income” that Congress can tax under Glenshaw?

ProShares Bitcoin ETF and Futures Taxation

 

This week something happened that made me think of a friend who passed away last year.

I remember him laboring me on the benefits of CBD oil and the need to invest in Bitcoin.

When he and I last left it (before COVID last year), Bitcoin was around $10 grand. It is over $60 grand presently.

Missed the boat and the harbor on that one.

This past week ProShares came out with a Bitcoin ETF (BITO). I read that it tripped the billion-dollar mark after two or three days of trading.

With that level of market acceptance, I suspect we will see a number of these in the near future.

This ETF does not hold Bitcoin itself (whatever that means). It instead will hold futures in Bitcoin.

Let’s talk about the taxation of futures.

First, what are futures and what purpose do they serve?

Let’s say that you are The Hershey Company and you want to lock-in prices for next year’s cacao and sugar. These commodities are a significant part of your costs of production, and you want to have some control over the price you will pay. You are a buyer of futures commodity contracts – in cacao and sugar – locking in volume, price and date of delivery.

Whereas you do not own the cacao and sugar yet, if their price goes up, you would have made a profit on the contract. The reverse is true, of course, if the price goes down. Granted, the price swing on the futures contract will likely be different than the swing in spot price for the commodity, as there is the element of time in the contract.  

That said, there is always someone looking to make a profit. Problem: if commodity traders had to actually receive or deliver the commodity, few people would do it. Solution: separate the contract from actual product delivery.  The contract can then be bought and sold until the delivery date; the buyers and sellers just settle-up any price swings between them upon sale.

It would be also nice to have a market that coordinates these trades. There are several, including the Chicago Mercantile Exchange. The Exchange allows the contracts to be standardized, which in turn allows traders to buy and sell them without any intent to ever receive or deliver the underlying commodity.

The ETF we are discussing (BITO) will not own any Bitcoin itself. It will instead buy and sell futures contracts in Bitcoin.

Bitcoin futures are considered “Section 1256 contracts” in tax law.

Section 1256 brings its own idiosyncrasies:

* There is a mark-to-market rule.

The term “mark” to an accountant means that something is reset to its market price. In the context of BITO, it means that – if you own it at year-end – it will be considered to have been sold. Mind you, it was not actually sold, but there will be a “let’s pretend” calculation of gain or loss as if it had been sold. Why would you care? You would care if the price went up and you had a taxable gain. You will soon be writing a very real check to the IRS for that “let’s pretend” mark.

* The 60/40 rule

This rule is nonintuitive. Whether you have capital gains or losses, those gains and losses are deemed to 60% long-term and 40% short term. The tax Code (with exceptions we will ignore for this discussion) does not care how long you actually owned the contracts. Whether one day or two years, the gain or loss will be deemed 60/40.

Mind you, this is not necessarily a bad result as long-term capital gains have favorable tax rates.

* Special carryback rule

If you have an overall Section 1256 loss for the year, you can carryback that loss to the preceding three years. There is a restriction, though: the carryback can only offset Section 1256 gains in those prior years.

This is a narrow rule, by the way. I do not remember ever seeing this carryback, and I have been in tax practice for over 35 years.

I do not know but I anticipate that BITO will be sending out Schedules K-1 rather than 1099s to its investors, as these ETFs tend to be structured as limited partnerships. That does not overly concern me, but some accountants are wary as the K-1s can be trickier to handle and sometimes present undesired state tax considerations.

Similar to my response to Bitcoin investing in early 2020, I will likely pass on this opportunity. There are unusual considerations in futures trading – google “contango” and “backwardation” for example – that you may want to look into when considering the investment.

Section 1202 Stock And A House Tax Proposal

I am not a fan of fickleness and caprice in the tax law.

I am seeing a tax proposal in the House Ways and Means Committee that represents one.

It has been several years since we spoke about qualified small business stock (QSBS). Tax practice is acronym rich, and one of the reasons is to shortcut who qualifies – and does not qualify – for a certain tax provision. Section 1202 defines QSBS as stock:

·      issued by a C corporation,

·      with less than $50 million in assets at time of stock issuance,

·      engaged in an active trade or business,

·      acquired at original issuance by an eligible shareholder in exchange for either cash or services provided, and

·      held for at least five years.

The purpose of this provision is to encourage – supposedly – business start-ups.

How?

A portion of the gain is not taxed when one sells the stock.

This provision has been out there for approximately 30 years, and the portion not taxed has changed over time. Early on, one excluded 50% (up to a point); it then became 75% and is now 100% (again, up to a point).

What is that point?

The amount of gain that can be excluded is the greater of:

·      $10 million, or

·      10 times the taxpayer’s basis in the stock disposed

Sweet.

Does that mean I sell my tax practice for megabucks, all the while excluding $10 million of gain?

Well, no. Accounting practices do not qualify for Section 1202. Not to feel singled- out, law and medical practices do not qualify either.

I have seen very few Section 1202 transactions over the years. I believe there are two primary reasons for this:

                 

(a)  I came into the profession near the time of the 1986 Tax Reform Act, which single-handedly tilted choice-of-entity for entrepreneurial companies from C to S corporations. Without going into details, the issue with a C corporation is getting money out without paying double tax. It is not an issue if one is talking about paying salary or rent, as one side deducts and the other side reports income. It is however an issue when the business is sold. The S corporation allows one to mitigate (or altogether avoid) the double tax in this situation. Overnight the S corporation became the entity of choice for entrepreneurial and closely-held companies. There has been some change in recent years as LLCs have gained popularity, but the C corporation continues to be out-of-favor for non-Wall Street companies. 

 

(b)  The sale of entrepreneurial and closely-held companies is rarely done as a stock purchase, a requirement for Section 1202 stock. These companies sell their assets, not their stock. Stock acquisitions are more a Wall Street phenomenon.

So, who benefits from Section 1202?

A company that would be acquired via a stock purchase. Someone like … a tech start-up, for example. How sweet it would have been to be an early investor in Uber or Ring, for example. And remember: the $10 million cap is per investor. Take hundreds of qualifying investors and you can multiply that $10 million by hundreds.

You can see the loss to the Treasury.

Is it worth it?

There has been criticism that perhaps the real-world beneficiaries of Section 1202 are not what was intended many years ago when this provision entered the tax Code.

I get it.

So what is the House Ways and Means Committee proposing concerning Section 1202?

They propose to cut the exclusion to 50% from 100% for taxpayers with adjusted gross income (AGI) over $400 grand and for sales after September 13, 2021.

Set aside the $400 grand AGI. That sale might be the only time in life that someone ever got close to or exceeded $400 grand of income.

The issue is sales after September 13, 2021.

It takes at least five years to even qualify for Section 1202. This means that the tax planning for a 2021 sale was done on or before 2016, and now the House wants to retroactively nullify tax law that people relied upon years ago.

Nonsense like this is damaging to normal business. I have made a career representing entrepreneurs and their closely-held businesses. I have been there – first person singular - where business decisions have been modified or scrapped because of tax disincentives. Taxing someone to death clearly qualifies as a business disincentive. So does retroactively changing the rules on a decision that takes years to play out. Mind you – I say that not as a fan of Section 1202.

To me it would make more sense to change the rules only for stock issued after a certain date – say September 13, 2021 – and not for sales after that date. One at least would be forewarned.   

Should bad-faith tax proposals like this concern you?

Well, yes. If our current kakistocracy can do this, what keeps them from retroactively revoking the current tax benefits of your Roth IRA?  How would you feel if you have been following the rules for 20 years, contributing to your Roth, paying taxes currently, all with the understanding that future withdrawals would be tax-free, and meanwhile a future Congress decides to revoke that rule - retroactively?

I can tell you how I would feel.

Sell Today And Pay Tax in Thirty Years

Sometimes I am amazed to the extent people will go to minimize, defer or avoid taxes altogether.

I get it, though. When that alarm clocks goes off in the morning, there is no government bureaucrat there to prepare your breakfast or drive you to work. Fair share rings trite when yours is the only share visible for miles.

I am looking at an IRS Chief Council Advice.

Think of the Chief Counsel as the attorneys advising the IRS. The Advice would therefore be legal analysis of an IRS position on something.

This one has to do with something called Monetized Installment Sale Transactions.

Lot of syllables there.

Let’s approach this from the ground floor.

What is an installment sale?

This is a tax provision that allows one to sell approved asset types and spread the tax over the years as cash is collected. Say you sell land with the purchase price paid evenly over three calendar years. Land is an approved asset type, and you would pay tax on one-third of your gain in the year of sale, one-third the following year and the final third in the third year.

It doesn’t make the gain go away. It just allows one to de-bunch the taxation on the gain.

Mind you, you have to trust that the buyer can and will pay you for the later years. If you do not trust the buyer’s ability (or intention) to do so, this may not be the technique for you.

What if the buyer pays an attorney the full amount, and that attorney in turn pays you over three years? You have taken the collection risk off the table, as the monies are sitting in an attorney’s escrow account.

You are starting to think like a tax advisor, but the technique will almost certainly not work.

Why?

Well, an easy IRS argument is that the attorney is acting as your agent, and receipt of cash by your agent is the equivalent of you receiving cash. This is the doctrine of “constructive receipt,” and it is one of early (and basic) lessons as one starts his/her tax education.

What if you borrow against the note? You just go down to Fifth Third or Truist Bank, borrow and pledge the note as collateral.

Nice.

Except that Congress thought about this and introduced a “pledging” rule. In short, a pledge of the note is considered constructive receipt on the note itself.

Not to be deterred, interested parties noticed a Chief Council’s Memorandum from 2012 that seemed to give the OK to (at least some of) these transactions. There was a company that need cash and needed it right away. It unloaded farm property in a series of transactions involving special purpose entities, standby letters of credit and other arcane details.

The IRS went through 11 painful pages of analysis, but wouldn’t you know that – at the end – the IRS gave its blessing.

Huh?

The advisors and promoters latched-on and used this Memorandum to structure future installment sale monetization deals.

Here is an example:

(1)  Let’s say I want to sell something.

(2)  Let’s say you want to buy what I am selling.

(3)  There is someone out there (let’s call him Elbert) who is willing to broker our deal – for a fee of course.

(4)  Neither you or I are related to Elbert or give cause to consider him our agent.

(5)  Elbert buys my something and gives me a note. In our example Elbert promises to pay me interest annually and the balance of the note 30 years from now.

(6)  You buy the something from Elbert. Let’s say you pay Elbert in full, either because you have cash in-hand or because you borrow money.

(7)  A bank loans me money. There will be a labyrinth of escrow accounts to maintain kayfabe that I have not borrowed against my note receivable from Elbert.

(8)  At least once a year, the following happens:

a.    I collect interest on my note receivable from Elbert.

b.    I pay interest on my note payable to the bank.

c.    By some miraculous result of modern monetary theory, it is likely that these two amounts will offset.

(9)  I eventually collect on Elbert’s note. This will trigger tax to me, assuming someone remembers what this note is even about 30 years from now.

(10)      Having cash, I repay the bank for the loan it made 30 years earlier.

There is the monetization: reducing to money, preferably without taxation.

How much of the original sales price can I get using this technique?

Maybe 92% or 93% of what you paid Elbert, generally speaking.

Where does the rest of the money go?

Elbert and the bank.

Why would I give up 7 or 8 percent to Elbert and the bank?

To defer my tax for decades.

Do people really do this?

Yep, folks like Kimberly Clark and OfficeMax.

So what was the recent IRS Advice that has us talking about this?

The IRS was revisiting its 2012 Memorandum, the one that advisors have been relying upon. The IRS lowered its horns, noting that folks were reading too much into that Memorandum and that they might want to reconsider their risk exposure.

The IRS pointed out several possible issues, but we will address only one.

The company in that 2012 Memorandum was transacting with farmland.

Guess what asset type is exempt from the “pledging” rule that accelerates income on an installment note?

Farmland.

Seems a critical point, considering that monetization is basically a work-around the pledging prohibition.

Is this a scam or tax shelter?

Not necessarily, but consider the difference between what happened in 2012 and how the promoters are marketing what happened.

Someone was in deep financial straits. They needed cash, they had farmland, and they found a way to get to cash. There was economic reality girding the story.   

Fast forward to today. Someone has a big capital gain. They do not want to pay taxes currently, or perhaps they prefer to delay recognizing the gain until a more tax-favorable political party retakes Congress and the White House. A moving story, true, but not as poignant as the 2012 story.   

For the home gamers, this time we have been discussing CCA 2019103109421213.