Installment Methods and Obligations

Paul Lee and Cassady Brewer presented at the 57th Annual Heckerling Institute on Estate Planning in special session entitled “Shedding More Light on Planning with Installment Obligations.”  Below are some of the highpoints of this session.

Two of the most common estate planning tools are promissory notes (intra-family loans) and installment obligations (sale of property to an “intentionally defective grantor trust” in exchange for an installment note).  In most cases these transactions are between a grantor and a grantor trust that is not includable in the grantor’s estate.  When a grantor enters into a transaction with his grantor trust, there are no income tax consequences because the trust is a disregarded entity.  However, grantor trust status is not permanent, and when grantor trust status is lost, such as upon the grantor’s death, there are income consequences.

Income tax planning often involves tax deferral strategies.  A common method of deferring tax is to take advantage of the installment method of accounting.  The tax consequences of an installment sale to a grantor trust are different from an installment sale to a nongrantor trust.  Taxpayers should be concerned with what happens when grantor trust status is lost; it appears that the nontaxable installment sale will become taxable.

Not all property sales are eligible for installment sale treatment.  Generally, one cannot defer gain using an installment sale in the case of dealer property (property used by a person who regularly sells or otherwise disposes of personal property), personal property that is included in the taxpayer’s inventory, marketable securities, depreciable property sold to related persons, and depreciable property subject to recapture under IRC Secs. 1245 or 1250 (or IRC Sec, 751) when sold.

With a taxable installment sale, the installment method will apply by default unless the taxpayer elects out.  The taxpayer may want to elect out of the installment method if the taxpayer has capital losses he wants to use.  Furthermore, if the installment method is elected, there is an additional interest charge when the outstanding note exceeds $5 million at the end of the taxable year.

The taxpayer must also consider state taxes.  Not all states recognize the installment method of taxation.  Some states recognize installment sales if an election is made and a bond is posted (states want to make sure taxes on deferred gain are collected even if the seller moves out of state).  There may also be an opportunity to enter into an installment sale while the seller resides in a high tax state, and then for him to avoid state taxes altogether by moving to a state without an income tax.

There is a lot to consider when entering into an installment sale.  A tax professional should be consulted to assist with the tax planning opportunities and pitfalls associated with such a transaction.