What if you could transfer depreciable assets from one legal entity that you own to another legal entity that you own, without reporting the gain from the sale until some future year, and still step up the tax basis in the assets due to the sale and taking increased depreciation deductions in the current year using the stepped-up tax basis? Too good to be true? The court considered this fact pattern in Vest v. Commissioner, T.C. Memo. 2016-187.
Facts & Procedural History
The taxpayer in this case was a CPA who owned several partnerships. One of the partnerships developed technology that helped optimize the delivery of internet ads.
In 2008, this internet ad partnership sold computer equipment and intangible assets to other partnerships controlled by the taxpayer for a profit of $3,223,858. The sales were reported on an installment basis, and no payments of principal or interest were made during 2008, 2009, or 2010.
On audit by the IRS, the IRS determined that these sales did not qualify for installment sale treatment given that the principal purpose of these sales was to avoid federal income tax. Litigation ensued in the U.S. Tax Court.
The Installment Sale Rules
The general rule is that the sale of assets between entities that the taxpayer owns is usually a taxable event and the gain from the sale is subject to tax for the selling entity in the year of the sale.
The installment sale rules provide an exception to this general rule, allowing the gain from the sale of the property to be recognized ratably as the payments are received (these rules are the basis of several tax strategies, including the monetized installment sale).
There is an exception to the installment sale rules for sales of depreciable property between related persons, where all of the gain is recognized in the year of sale even though the payments are to be received in subsequent tax years. When this exception applies, all of the gain is recognized in the year of sale even though the payments are to be received in subsequent tax years.
However, there is an exception to this exception, where the installment sale rules do not apply “if it is established to the satisfaction of the Secretary that the disposition did not have as one of its principal purposes the avoidance of Federal income tax.”
One of its Principle Purposes
In Vest, the taxpayer argued that the principal purpose for the related-party sales was not to avoid federal income tax. It argued that it had a valid business purpose for the related-party sales: to isolate distinct assets in three separate partnerships as a prelude to a possible sale.
The court did not agree with this argument, stating that it was not clear why a potential buyer would care in which entity the assets happened to be located. The court went on to say that:
This tax-avoidance purpose is particularly clear with respect to the intangible assets sold…. Those assets had a zero cost basis in [the first entity’s] … hands, thus yielding zero amortization deductions to it. But [the second entity] … claimed a stepped-up basis in those assets of $2,885,175, yielding amortization deductions of $192,345 annually. The enhanced amortization deductions claimed by [the second entity], totaling $644,772 for 2008-2010 alone, dwarf the $29,798 gain that [the first entity] reported for 2008.
The court also considered the taxpayer’s argument that there was no tax avoidance purpose given that it had significant net operating losses (“NOLs”) that eliminated his tax liability. Since the NOLs only offset regular tax and not Alternative Minimum Tax (“AMT”), the court concluded that the taxpayer’s argument failed. Thus, without explanation, the court concluded that the AMT is a “federal income tax liability” that is to be considered for this purpose.
The court concluded that the taxpayer’s principal purpose was to avoid federal income tax. As such, the taxpayer was required to recognize the gain in the current year rather than benefitting from the installment sale rules.
This case highlights the limitations of the exception to the installment sale rules for sales of depreciable property between related persons.
The court determined that the principal purpose of the transfer of assets was to avoid federal income tax, despite the taxpayer’s argument that it had a valid business purpose. This decision is consistent with prior case law and indicates that the exception to the exception will not apply when there is any tax benefit, including an AMT benefit.
This raises the question of when this exception may be applicable, as the transfer of depreciable assets that get a stepped up basis will result in some tax benefit. The exception to the exception appears to be a limitation on the ability to transfer assets between related parties, but it remains unclear if there are any specific situations where it would be applicable.