Tuesday, November 24, 2020
On this blog, I rarely repeat the coverage of an issue that I have already addressed. The only exception to that basic rule is when there is a major development that materially alters the content of the issue or issues discussed. But, sometimes I am reminded that some tax issues that seem to me to be obvious and well understood still need to be occasionally repeated. One of those times is today, based on several recent calls and emails.
The proper structuring of deferred payment contracts – it’s the topic of today’s post.
A cash-basis taxpayer accounts for income in the tax year that it is either actually or constructively received. The constructive receipt doctrine is the primary tool that the IRS uses to challenge deferral arrangements. Under Treas. Reg. §1.451-2(a)), a taxpayer is deemed to have constructively received income when any of the following occurs:
- The income has been credited to the taxpayer’s account;
- The income has been set apart for the taxpayer; or
- The income has been made available for the taxpayer to draw upon it, or it could have been drawn upon if notice of intent had been given, unless the taxpayer’s control of the receipt of the income is subject to substantial limitations or restrictions.
However, income received under a properly structured deferred payment contract is taxed under the installment payment rules. IRC §§453(b)(2); 453(l)(2)(A).
Basic Deferral Arrangements
The most likely way for a farmer to avoid an IRS challenge of a deferral arrangement is for the farmer to enter into a sales contract with a buyer that calls for payment in the next tax year. This type of contract simply involves the buyer’s unsecured obligation to purchase the agricultural commodities from the seller on a particular date. Under this type of deferral contract, the price of the goods is set at the specified time for delivery, but payment is deferred until the next year. If the contract is bona fide and entered into at arm’s length, the farm seller has no right to demand payment until the following year, and the contract (as well as the sale proceeds) is non-assignable, nontransferable and nonnegotiable, the deferral will not be challenged by the IRS.
The following criteria for a deferred payment contract should be met in order to successfully defer income to the following year.
- The seller should obtain a written contract that under local law binds both the buyer and the seller. A note should not be used;
- The contract should state clearly that under no circumstances would the seller be entitled to the sales proceeds until a specific date (i.e., a date in a future tax year). The earliest date depends on the farmer’s tax yearend.
- The contract should be signed before the seller has the right to receive any proceeds, which is normally before delivery. That means that the contract should have been executed before the first crop delivery. If the contract was not executed until after the crop proceeds were delivered, IRS can argue that the farmer actually had the right to the income, but later chose not to take possession of it until the next calendar year. An oral agreement to the contrary can be difficult to prove.
- The buyer should not credit the seller’s account for any goods the seller may want to purchase from the buyer during the year of the deferred payment contract (such as seed and/or fertilizer). Instead, such transactions should be treated separately when billed and paid.
- The contract should state that the taxpayer has no right to assign or transfer the contract for cash or other property.
- The contract should include a clause that prohibits the seller from using the contract as collateral for any loans or receiving any loans from the buyer before the payment date;
- The buyer should avoid sales through an agent in which the agent merely retains the proceeds. Receipt by an agent usually is construed as receipt by the seller for tax purposes.
- Price-later contracts (where the price is set in a later year) should state that in no event can payment be received prior to the designated date, even if a price is established earlier.
- The contract may provide for interest. Interest on an installment sale is reported as ordinary income in the same manner as any other interest income. If the contract does not provide for adequate stated interest, part of the stated principal may be recharacterized as imputed interest or as interest under the original issue discount rules, even if there is a loss. Unstated interest is computed by using the applicable federal rate (AFR) for the month in which the contract is made.
Contracts that lack these specifics run the risk of subjecting the seller to the constructive receipt rules with income recognition in the year of delivery. Simply delivering the grain under a contract where the grain is credited to an open account with a delay in payment until proper accounting for grain deliveries and other required administrative steps have occurred will not likely be enough to deflect an IRS assertion of constructive receipt. It may not matter much to the IRS that the farmer-seller is subject to administrative and processing delays and, as a result, cannot actually receive payment until the next tax year. The deferred payment contract must be in the proper form. A contract that states that payment is deferred until the next tax year and that it constitutes a voluntary extension of credit by the seller coupled with language stating that it can be changed in writing by the buyer’s authorized agents invites IRS scrutiny.
Is There a Way To Provide Security?
After an agricultural commodity is delivered to the buyer but before payment is made, the seller is an unsecured creditor of the buyer. In an attempt to provide greater security for the transaction, a farmer-seller may use letters of credit or an escrow arrangement. This could lead to a successful challenge by the IRS on the basis that the letters of credit or the escrow can be assigned, with the result that deferral is not accomplished.
Although the general rule is that funds placed in escrow as security for payment are not constructively received in the year of sale, it is critical for a farmer-seller to clearly indicate that the buyer is being looked to for payment and that the escrow account serves only as security for this payment. In addition, any third-party guarantee or standby letter of credit should be nonnegotiable and set up so that it can only be drawn upon in the event of default. If the escrow account is set up properly, the funds held in escrow, and the accrued interest on those funds, is taxable as income in the year that it provides an economic benefit to the taxpayer.
For deferred sales that are structured properly and achieve income tax deferral, installment reporting is automatic unless the taxpayer makes an election not to use it. An installment sale is a sale of property with the taxpayer receiving at least one payment after the tax year of the sale. Thus, if a farmer sells and delivers grain in one year and defers payment until the next year, that transaction constitutes an installment sale. If desired, the farmer can elect out of the installment-sale method and report the income in the year of sale and delivery.
The election must be made by the due date, including extensions, of the tax return for the year of sale and not the year in which payment is to be received. The election is made by simply recognizing the entire gain on the taxpayer’s applicable form (i.e., Schedule D or Form 4797), rather than reporting the installment sale on Form 6252, Installment Sale Income.
Because of the all-or-nothing feature (on a per-contract basis) of electing out of installment reporting, it may be advisable for farm taxpayers to utilize multiple deferred payment sales contracts in order to better manage income from year to year. The election out is made by simply reporting the taxable sale in the year of disposition. But, when the election out of the installment method is made by reporting the income in the year of the sale, the seller must be careful to make sure that the gain recognized is also not recognized in the following year. A way to make sure that is done is to record a receivable for the amount of the accelerated sales, with the entry reversed after yearend.
Generally, if the taxpayer elects out of the installment method, the amount realized at the time of sale is the proceeds received on the sale date and the fair market value of the installment obligation (future payments). If the installment obligation is a fixed amount, the full principal amount of the future obligation is realized at the time of the acquisition.
What About An Untimely Death?
If a seller dies before receiving all of the payments under an installment obligation, the installment payments are treated as income in respect of a decedent (IRD). I.R.C. §691(a)(4). Therefore, the beneficiary does not get a stepped-up basis at the seller’s death. The beneficiary of the payments includes the gain on the beneficiary’s return subject to tax at the rate applicable to the beneficiary. The character of the payments is tied to the seller. For example, if the payments were long-term capital gain to the seller, they are long-term capital gain to the beneficiary.
Grain farmers often carry a large inventory that may include grain delivered under a valid deferred payment agreement. Grain included as inventory but more properly classified as an installment sale may not qualify for stepped-up basis if the farmer dies after delivering the grain but prior to receiving all payments.
The only way to avoid possible IRD treatment on installment payments appears to be for the seller to elect out of installment sale treatment. IRD includes sales proceeds “to which the decedent had a contingent claim at the time of his death.” Treas. Reg. §1.691(a)-1(b)(3). The courts have held that the appropriate inquiry regarding installment payments is whether the transaction gave the decedent at the time of death the right to receive the payments. See, e.g., Estate of Bickmeyer v. Comm’r, 84 TC 170 (1985). This means that the decedent holds a contingent claim at the time of death that does not require additional action by the decedent. In that situation, the installment payments are IRD.
Chapter 9 of the IRS Farmers Audit Technique Guide (ATG) provides a summary of income deferral and constructive receipt rules. The ATG provides a procedural analysis for examining agents to use in evaluating deferred payment arrangements. The ATG is available https://www.irs.gov/businesses/small-businesses-self-employed/farmers-atg.
Agricultural producers typically have income streams that are less consistent from year to year than do nonfarm salaried individuals. Deferred payment contracts can be used as key income tax planning tool for farmers. But, it’s important to make sure they are structured properly to produce the desired tax results.