IRS cracking down on 'potentially abusive' monetized installment sales

A tax strategy that seeks to delay expensive hits from the sale of assets like a real estate property or a business would face greater scrutiny from the IRS under a new proposed rule.

The Treasury Department and the IRS issued a potential regulation last week that would turn certain "monetized installment sales" into listed transactions required to be reported to the government. After identifying the method earlier this year as a "potentially abusive transaction" scheme often targeting high-income filers trying to defer paying taxes on the asset sales, the IRS is cracking down on what regulators say is illegal avoidance of the liability from the purchase based on the use of loans flowing between the seller, an intermediary and another third party apart from the buyer of the appreciated property or business. 

Regulators "are aware that promoters are marketing transactions that purport to convert a cash sale of appreciated property by a taxpayer (seller) to an identified buyer (buyer) into an installment sale to an intermediary (who may be the promoter) followed by a sale from the intermediary to the buyer," according to the proposal.

"The promotional materials for these transactions assert that engaging in the transaction will allow the seller to defer the gain on the sale of the property under Section 453 until the taxpayer receives the balloon principal payment in the year the note matures, even though the seller receives cash from the purported lender in an amount that approximates the amount paid by the buyer to the intermediary," the proposal continued. 

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Here's how the transactions work: Rather than transferring the asset to the buyer directly, the seller signs up for one loan with an intermediary that agrees to pay interest on the sale proceeds and another liability with a different third party. That other third party collects interest from the seller equal to the amount received from the intermediary, and the sale proceeds from the intermediary firm. In theory, the seller can then avoid paying taxes on the proceeds until the balloon principal payment comes back to the seller at the end of the loan terms. In fact, the IRS is rejecting that use and interpretation of the rules around installment sales.

Intermediaries often pitch asset sellers on potential tax savings in the millions or more through the seemingly complex strategy, according to accountant Chris Whalen of Red Bank, New Jersey-based Chris Whalen, CPA.

For the sake of simplicity, Whalen suggests thinking of monetized installment sales as two transactions; one is the purchase of the underlying asset and the other is the loan between the third-party institution and the seller. Even without the newly proposed rule, taxpayers may already run into difficulties in an audit when there's "total linkage" across the two transactions, Whalen said.

"It could work only if you are going to get this money on the other side in a completely different transaction with collateral involved," he said. "You need to be able to present both transactions as completely different transactions as best we can to make sure that they stand on their merits."

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Three or four people call Whalen's office each week about the monetized installment sales after noticing a blog post and podcast on his website about them. They often leave the conversation discouraged from the idea of working with an intermediary set to collect commissions as high as 5% or 6% without any responsibility for the unpaid taxes, he said.

The IRS may penalize the seller with a fine of between 20% and 40% of the unpaid sum on top of paying back the government for the underpaid income liability, the agency noted as part of its annual "Dirty Dozen" list in March. The loans from the intermediary enable the seller to get "the lion's share of the proceeds" while "improperly [delaying] the recognition of gain on the appreciated property until the final payment on the installment note," according to the IRS. 

"These are examples of potentially abusive arrangements that taxpayers should avoid, many of which are now advertised online," the agency said earlier this year. "The IRS recommends that taxpayers considering these types of arrangements carefully review the legal requirements underlying them and consult with competent, independent, qualified advisors before engaging or claiming any purported tax benefit."

In essence, the new rule proposal is answering a question about the transactions saying, "Delay payment of taxes on gains but still have cash in the taxpayer's hands (Too good to be true?  Yes, per the IRS.)," CPA Ed Zollars wrote last week on the Kaplan Financial Education Current Federal Tax Developments blog.

The IRS is accepting comments on the proposal until Oct. 3, with a public hearing scheduled for Oct. 12.