An Installment Sale as Part of An Estate Plan

Overview

One step in the estate planning process involves an examination of possible alternatives for disposing of property during life including a sale for cash, an installment sale, a private annuity or a part-gift, part-sale transaction.  As for an installment sale, it can be used in an estate plan to “freeze” the value of an estate (typically that of a parent), and simultaneously shift future appreciation in asset value caused by inflation or improvements to the next generation successor-operator.  Structured as an installment sale with an appropriate rate of interest, the transaction does not constitute a gift, and can provide a stream of income for the parents (as the sellers).  In addition, if the value of the assets subject to the installment sale drop in value, the transaction can be renegotiated and the purchase price decreased while still maintaining installment sale tax treatment. 

Transitioning the farm via an installment sale – that’s the topic of today’s post.

Gift Facilitation

One way to facilitate the transfer of farm assets from one generation to the next is via the installment sale.  Given that the current level of the present interest annual exclusion for gift tax purposes is $14,000, an installment sale transaction could be established whereby farm assets could be conveyed to a child, for example, for a $14,000 principal amount interest-bearing note, payable semi-annually.  This provides an income stream to the parents and does not trigger any gift tax.  That’s because installment sales are not within the scope of I.R.C. §2701.  But, if the parents desire to make a gift to the child, they could forgive the payments as they become due.  In that situation, it might be possible to discount the gift below the face value of the installment obligation.  Also, if a gift is made within three years of death, any gift tax that the decedent (or the estate) pays on the gift is pulled back into the estate.  I.R.C. §2035.  In addition, in an estate, an installment obligation is income in respect of decedent (IRD).  It is not an item of property.  That means that there is no basis step-up in accordance with I.R.C. §1014 in the hands of the recipient of the obligation.

IRS Position

Of course, the IRS has its own view of the tax treatment of installment sales.  It may assert that the entire value of the property involved in an installment sale is a gift.  Indeed, in Rev. Rul. 77-299, 1977-2 C.B. 343, the IRS said that an installment sale of land to grandchildren where the annual payments were forgiven constituted a gift of the full amount of the land in the year the transaction was entered into.  The IRS said that was the result because the grandparent had made been gifting property to his grandchildren in prior years and because they didn’t have any other source of income.  The courts, however, don’t tend to agree with the IRS position.  That’s especially true if the notes involved are legally enforceable, subject to sale to third parties or assignable, and the property involved is subject to foreclosure if the buyer defaults.  See, e.g., Estate of Kelley v. Comr., 63 T.C. 321 (1974); Haygood v. Comr., 42 T.C. 936 (1964); Hudspeth v. Comr., 509 F.2d 1224 (9th Cir. 1975).

The IRS may also assert that a gift may occur on an installment sale of land if the interest rate is below a market rate of interest.  The IRS, U.S. Tax Court, the Eighth and Tenth Circuit Courts of Appeals and the United States District Court for the Northern District of New York agree that the use of an interest rate in an installment sale other than the market rate of interest results in a gift of the present value of the difference in interest rates.  See, e.g., Ltr. Rul. 8804002, Sept. 3, 1987; Frazee v. Comm’r, 98 T.C. 554 (1992); Krabbenhoft v. Comm’r, 939 F.2d 529 (8th Cir. 1991), cert. denied, 502 U.S. 1072 (1992); Schusterman v. Comm’r, 63 F.3d 986 (10th Cir. 1995), cert. denied, 116 S. Ct. 1823 (1996); Lundquist v. United States, 99-1 U.S. Tax Cas. (CCH) ¶60,336 (N.D. N.Y. 1999).  The 7th Circuit Court of Appeals disagrees, however. Ballard v. Comm’r, 854 F.2d 185 (7th Cir. 1988).  The U.S. Supreme Court has twice declined to resolve the conflicting views of the Circuit Courts of Appeal.  Krabbenhoft v. Comm’r, 939 F.2d 529 (8th Cir. 1991), cert. denied, 502 U.S. 1072 (1992); Schusterman v. Comm’r, 63 F.3d 986 (10th Cir. 1995), cert. denied, 116 S. Ct. 1823 (1996).

The take home is that if the transaction is an arm’s length transaction where the parents are not legally obligated to forgive payments or make cash gifts to enable the buyer (child(ren)) to make the payments, then the installment sale should be respected and not gift in the year the transaction is entered into would result.  This is particularly the case is the parents actually do receive payments in the early years of the installment sale and a market rate of interest is utilized.

Variation – The Sale-Leaseback

For parents that aren’t ready to retire from farming/ranching, a sale-leaseback transaction might be a consideration.  Under this structure, the parents sell the property to the children and then lease it back.  While this type of transaction would result in gain recognition to the parents, that gain could be at least partially offset by a deduction for rent.  In addition, the rental payment that the parents make to the children will help the children make the payments.  A bona fide sale-leaseback transaction will result in the children being able to deduct interest on the installment obligation to the extent the children use the rental payments they receive from the parents to repay the mortgage on the property purchased under the installment sale.  There won’t be any interest deduction allowed for annual payments attributable to cash gifts.  The sale-leaseback transaction works if ownership is completely transferred to the children and they have a non-contingent obligation to pay.  See, e.g., Hudspeth v. Comr., 509 F.2d 1224 (9th Cir. 1975); Stiebling v. Comr., No. 95-70391, 1997 U.S. App. LEXIS 11447 (9th Cir. 1997).

Are There Any Related Party Concerns?

Of course, concerns about sales to related parties arise.  That’s because when depreciable property is sold to a “related party” ordinary income is the result.  I.R.C. §1239.  In addition, the seller can’t use the installment method to report the income unless a principal purpose of the sale was something other than the avoidance of federal income tax.  I.R.C. §453(g)(2); see, e.g., Priv. Ltr. Rul. 9926045 (Apr. 2, 1999).  A “related party” is for this purpose is defined under I.R.C. §1239(b). 

When a related party resells the property within two years of the original sale, gain is accelerated to the original seller.  There are some exceptions to the two-year rule.  See, e.g., I.R.C. §453(e)(6)).  A primary one is that a disposition after the death of the seller or buyer to the original transaction is not treated as a second disposition.  That’s probably also the case when there is a death of a joint tenant with respect to jointly owned property.  But, any installment sale contract should contain language that bars any disposition by the buyer within two years of the original sale unless the original seller consents.  The same can be said with respect to pledging the property.  In that instance, the original buyer should continue to bear any risk of loss associated with the property.      

Conclusion

There are various ways to transition the family farm/ranch.  An outright gift or an outright sale are two options.  Another one is the installment sale.  An installment sale can provide a means to transfer the assets to the next generation in a tax efficient manner.  But, as with any transaction, the details must be paid close attention to in order to achieve the desired tax (and legal) result.  The drafting of the installment sale contract must be crafted with care.  Of course, as with any complex legal transaction, competent legal (and tax) advice and counsel should be sought and obtained.