The Timing Trap: Failed Installment Sales

One of the best tax planning strategies is simply to accept payment over time. This is a simple, but effective tax planning strategy as it can allow taxpayers to spread out their tax liability over time. This is possible given the installment sale rules.

What happens if you sell an asset and are to receive payments in the future, but your accountant fails to elect the installment method? Do you have to report the full amount of the gain in the year of sale? What happens if the buyer fails to make the payments in subsequent years? The IRS addresses this fact pattern in private letter ruling 201943004.

Facts & Procedural History

The taxpayer is a business taxed as an S corporation. It agreed to sell its assets to a third party.

The taxpayer was to be paid over a three-year period. The buyer made the payment at closing, but failed to make later payments. The taxpayer sued the buyer and the lawsuit was pending.

The taxpayer filed its Form 1120S, U.S. Income Tax Return for an S Corporation, for the year of the sale. The tax return reported the payment the S corporation received, but it failed to report the payment on Form 6252, Installment Sale Income.

The new accounting firm questioned whether reporting the down payment without Form 6252 was an election out of the installment method. The taxpayer submitted a ruling request to get a ruling that they had not elected out of the installment method.

About the Installment Method

The installment method is a way for taxpayers to spread out the recognition of gain from the sale of property over multiple tax years. Instead of recognizing the entire gain in the year of the sale, the taxpayer can report the gain proportionally as they receive payments from the buyer over time.

This can be particularly beneficial for managing the tax consequences of a large gain, as it allows the taxpayer to defer the recognition of income and the associated tax liability.

There are several tax planning techniques involving installment sales. For example, the combination of an S corporation and the installment sale rules can be used to defer the recognition of gain. This can be particularly helpful in cases like this where the property sold consists of business assets. Suffice it to say that sellers usually want to take advantage of the installment sale method rules. We’ll come back to this point in a minute.

Electing Out of the Installment Method

So how does one elect out of the installment method? The regulations provide the answer. They explain that the election out is made as follows:

A taxpayer who reports an amount realized equal to the selling price including the full face amount of any installment obligation on the tax return filed for the taxable year in which the installment sale occurs will be considered to have made an effective election.,..

The regulations go on to say that the election out is irrevocable. But they allow the IRS to grant the taxpayer the ability to revoke the election retroactively.

Why Would a Taxpayer Want to Use the Installment Method?

The installment method can be particularly helpful if spreading the tax over time results in the taxpayer being in a lower tax bracket or the gain is allocated to tax years in which the taxpayer is in a lower tax bracket or has offsetting tax attributes.

Depending on the S corporation’s accounting method (cash or accrual), the installment sale method is also needed to avoid a situation where the corporation has to report the full sale proceeds in year one even though the payments may not be received until later years. This is likely what is at stake with the taxpayer who submitted this ruling.

With facts in this ruling, one can see the problem. The buyer failed to make the subsequent installment payments. If the IRS audited the tax return and required the taxpayer to realize the full gain on the sale in year one, the taxpayer would have a large taxable gain without ever receiving the payments. Presumably, the taxpayer would then be entitled to an offsetting tax loss in a later year after the litigation concluded. But this could be several years later.