Private Annuity SSRN-Id1503462

Electronic copy available at: http://ssrn.com/abstract=1503462

M I A M I L A W RESEARCH PAPER SERIES

Family Deferred Payment Sales Installment Sales, SCINs, Private Annuity Sales,

OID and Other Enigmas

Elliott Manning (w/Jerome Hesch)

Professor of Law 2009-29

This paper can be downloaded without charge from the

Research Network Electronic Paper Collection: http://ssrn.com/abstract=1503462


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FAMILY DEFERRED PAYMENT SALES INSTALLMENT SALES, SCINS, PRIVATE ANNUITY SALES, OID AND OTHER ENIGMAS

BY JEROME M. HESCH AND ELLIOTT MANNING1

¶ 200 Introduction

Ten years ago, we wrote about the taxation of private annuity sales in an in-

stallment sale world.2 The article was written when the Installment Sales Revision Act of

1980 (the "1980 Act") was new and was viewed as a major reform establishing the

installment method as the basic method for treating deferred payment sales.3 It was

written to forecast and, frankly, to influence promised regulations dealing with the re-

lationship between the 1980 Act and traditional private annuity sale treatment.

In the intervening ten years, the promised regulations have not appeared, even in

proposed form. There has been only one IRS pronouncement on the subject, and that

one, General Counsel's Memorandum 39503,4 is not even officially published. There

have, however, been a number of relevant developments. Amendments to the installment

sale provisions have reduced the scope of installment reporting, so that it is now available

primarily for casual sales of real estate and personal property, including only

nonmarketable securities.5 These changes raise doubts whether the installment method

remains the basic method of taxation for deferred payment sales.6

1The authors wish to acknowledge the contribution of Charles Schuetze (now practicing in Anchorage, Alaska), whose LL.M. thesis on private annuities provided research and other assistance with this paper.

2See Manning and Hesch, Private Annuities After the Installment Sales Revision Act, 6 J. INDIV. TAX. 20 (1982).

3Ginsburg, Future Payment Sales After the 1980 Revision Act, 39 NYU ANN. INST. ON FED. TAX'N, Ch. 43 (1981); Lobenhofer, The Income Taxation of Exchanges of Property for Private Annuities: History and a Proposal, 21 PAC. L.J. 271 (1990); Lefrak, When to Use Private Annuities, 40 NYU ANN. INST. ON FED. TAX'N, Ch. 2 (1982).

4G.C.M. 39503, Jun. 28, 1985, CCH IRS POSITIONS REP. ¶ 1791. For convenience, the complete text of G.C.M. 39503 is included as Appendix A.

5§ 453(b)(2), (f)(2), (k) and (l).

6See STAFF OF JOINT COMMITTEE ON TAXATION, GENERAL EXPLANATION OF THE TAX REFORM ACT OF 1986 at 490-91, 498-99 (1987) ("1986 BLUE BOOK") (relating to publicly-traded property); S. REP. NO.


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In addition, there have been major developments in the understanding of and

treatment of the time value of money for federal income tax purposes. These include

major revisions in the original issue discount ("OID") provisions and extension of the

OID rules to sales of property.7 There are now prescribed minimum interest rates known

as the applicable Federal rate ("AFR") for sales of property.8 Similar rules apply market

discount for the holder of a debt obligation,9 OID rules apply to loans with below market

interest rates,10 and compound-interest rules apply to debt premium.11 Needless to say,

none of these developments simplify or clarify the relation between the private annuity

sale and installment sale provisions. Collectively, they make deferred payment sales of

business or other financial assets within a family a true challenge to the tax professional.

Deferred payment sales of a business or other financial assets within a family can

serve a variety of functions. In many families, there comes a time when it is appropriate

to transfer management and control of a family business or other family financial assets,

or even nonfinancial property, to the next generation. Although this time may be

appropriate occasion for the making of major family gifts, frequently, the older

generation needs to retain some financial stake in the family business or other financial

assets to finance its retirement after it is time to transfer control. At the same time, those

taking over the closely-held business or other property usually do not have independent

313, 100th Cong., 1st Sess. 160-65 (1987) (relating to dealer dispositions and interest on deferral); Note, Fairness and Tax Avoidance in the Taxation of Installment Sales, 100 HARV. L. REV. 403 (1986).

7§§ 1271 to 1275 and 483; see STAFF OF JOINT COMMITTEE ON TAXATION, GENERAL EXPLANATION OF THE REVENUE PROVISIONS OF THE DEFICIT REDUCTION ACT OF 1984 at 108-23 (1984) ("1984 BLUE BOOK").

8§§ 1274(d)(1) and 1274A; see H.R. REP. NO. 432, Pt. 2, 98th Cont. 2d Sess 1241 (1984); S. REP. NO. 169 , 98th Cong., 2d Sess. 249 (1984); H.R. Rep. No. 87, 99th Cong., 1st Sess. 1 (1985); S Rep. No. 83, 99th Cong. 1st Sess. 1 (1985).

9§§ 1276 to 1278; see 1984 BLUE BOOK at 93-100.

10§ 7872; see 1984 BLUE BOOK at 524-38.

11§ 171(b)(3); SEE STAFF OF JOINT COMMITTEE ON TAXATION, EXPLANATION OF TECHNICAL CORRECTIONS TO THE TAX REFORM ACT OF 1984 AND OTHER RECENT TAX LEGISLATION at 13-14 (1987).

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financial resources to pay for them, and cannot, or are not willing to, obtain the necessary

financing from third-party commercial sources. A seller-financed, deferred payment sale

can fill the gap, and permits the future cash flow from the newly-acquired assets to

provide the primary source of funds needed to satisfy the obligation undertaken by the

purchasing younger family member. The deferred payment arrangement can be a

standard installment note, a self-cancelling installment note ("SCIN") or a private annuity

sale. A standard installment note calls for a specified number of fixed payments over a

set period with designated interest. A SCIN is simply a standard installment note that

also provides that the payments terminate upon specified contingencies, usually the death

of the selling senior family member or members. This termination feature means that the

value of a SCIN is less than that of a standard installment note providing for equivalent

payments over the maximum term. Accordingly, to provide an equivalent initial value, a

SCIN must provide greater interim and potential total payments than a standard

installment note. A private annuity sale provides for specified payments for a term of

uncertain duration, usually the life of the selling senior family member. Although a

private annuity sale, like any commercial annuity, involves an implicit interest factor, the

interest usually is not expressly stated.

Although there are significant differences in the financial terms and economic

risks associated with the three types of deferred payment financing, in the final analysis

all three provide economically equivalent payment arrangements for the assets trans-

ferred. Any difference in the risks related to the different payment terms should be taken

into account, either by difference in the amounts provided as deferred payments for the

assets or, if it is not, in the portion of the value of the assets transferred that is a gift,

compensation, or other taxable event. Nevertheless, the current differences in the Federal

income and transfer tax treatment of the three financing arrangements are dis-

proportionate to the financial differences among them.

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Under traditional tax principles, the timing of reporting any gain realized by the

senior family member seller under the annuity rules is significantly different from that

under the installment method. There are similar differences in the basis of the property to

the younger generation buyer. The buyer in a private annuity sale is entitled to an initial

basis for the property purchased measured by the actuarial value of the annuity and

capitalizes the amount treated by the selling senior family member as annuity income, but

the younger generation buyer in an installment sale involving contingent payments

includes the payments in basis only as made.

Even greater differences apply to the income taxation of the interest or other time

value of money factor inherent in each payment. Although the selling senior family

member reports interest income as such in an installment sale and, implicitly, as annuity

income in a private annuity sale, the reporting of the time-value of money is significantly

different. Similarly, although the younger generation buyer is entitled to an interest

deduction (subject to the investment interest or other interest limitations) in an

installment sale, the buyer is not allowed any deduction for the amount the selling senior

family member treats as annuity income in a private annuity sale. In addition, differences

can occur because only an unsecured private annuity sale is governed by the private

annuity rules, while a secured private annuity sale on identical terms is apparently

governed by the installment reporting rules. Another distorting factor is the use of

different interest rate and mortality assumptions for income tax purposes than those used

for transfer tax purposes. This distortion is exacerbated by the apparent use of the

income tax tables in determining whether a gift is made in installment sales, but not in

private annuity sales.

This paper seeks to provide a comparative analysis of the current income and

transfer tax treatment of these three financing vehicles (in so far as it is clear) to show

how the selling senior family member and younger generation buyer are taxed at the

following crucial times:

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1. the time of the initial sale;

2. the time each payment is made; and

3. the death of the senior family member seller during the payment period.

In so doing, the analysis questions how much of the traditional view, particularly the

taxation of private annuity sales, is proper, in light of the 1980 Act and subsequent de-

velopments.

This paper is divided into two parts. The first part provides a general comparative

analysis of the income tax treatment of fixed installment sale obligations, private annuity

sale obligations and SCINs under the existing cases, rulings and regulations. Part I

addresses: (i) fixed deferred payment obligations under the installment method; (ii)

traditional private annuity sale principles; (iii) contingent payment obligations under the

installment method; and (iv) the application of contingent payment installment sale

principles (a) to SCINs and (b) to private annuity sales. Part I also analyzes the transfer

tax treatment applicable to each approach, and the, sometimes surprising, differences

between similar transactions. It concludes with specific recommendations for the

treatment of all SCINs and private annuity sales as contingent payment installment sales,

with some modification of the current treatment. Specifically, the transfer tax treatment

of all such sales should be uniform, and should be determined under rules that are similar

to those now provided the installment method for the sale portion of any intrafamily

transfer. The analysis suggests, however, that the younger generation buyer's initial basis

in the property should reflect the actuarial value of the annuity obligation. This analysis

suggests that there may be a place for traditional private annuity sale income tax

treatment in cases in which the taxpayer elects out of the installment sale method, and,

possibly, for sales that do not qualify for the installment method.

Part II provides a more comprehensive description of the current treatment of

each of these types of transactions, including more detailed illustrations of the results of

current law and of adopting the suggestions made.

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PART I

COMPARATIVE ANALYSIS

¶ 201 Installment Method for Fixed Payment Obligations

¶ 201.1 In General

The installment method defers taxes; it allows a selling senior family member

who is to receive deferred payments on the sale of property to postpone reporting any

gain realized on from the date of sale to the time when payments are received. The in-

stallment method spreads the reporting of gain over the taxable years of payment by

linking the reporting of gain to the receipt of payment, Specifically, a fraction of each

payment, the gross profit ratio, which is the gross profit divided by the selling price, is

included in income.

Example 1: A senior family member sells family financial assets worth $1,000

that have a basis of $100, for ten payments of $100 each, plus adequate stated

interest. The gain, or gross profit, is $900 ($1,000 - $100). Under the installment

method, the gross profit ratio is 90% ($900/$1,000). Thus, 90% or $90 of each

$100 principal payment on the note is included in income as gain on the sale.

¶ 207.1 includes additional illustrations that show the effect of various payment ar-

rangements.

Regardless of the younger generation buyer's method of accounting, the obliga-

tion to make fixed principal payments is part of basis of the property acquired from the

date of sale. With de minimis exceptions, a portion of any is OID characterized as in-

terest unless interest, at prescribed rates, is payable at least annually.12

A selling senior family member can elect out of the installment method for a de-

ferred payment sale,13 and report the entire gain in the year of sale for most fixed pay-

12§§ 1273, 1274 and 1274A; Prop. Reg. § 1,.1273-2, 1.174-1 and 1.1274A-1; see ¶ 201.7.

13§ 453(d); Temp. Reg. § 15A.453-1(d).

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ment obligations and for many contingent payment obligations.14 A selling senior family

member who elects out of the installment method is rarely is permitted to recover basis

first.15

The senior family member can arrange for part or all of the family business in-

terest to be redeemed by the corporation or partnership instead of being purchased by the

younger generation family member. The redemption has the same economic effect as a

sale if the younger generation already owns an interest in the business, or if such an

interest is transferred as part of the transaction. A corporate redemption for deferred

payments, including one by an S corporation, that qualifies as a sale or exchange, and is

not a dividend, is an installment sale.16 Accordingly, the income tax treatment of the

selling senior family member is the same as in a direct sale to the younger family

member. Any interest deduction, however, belongs to the corporation (or S corporation

shareholders). The corporation does not have any basis in the shares redeemed and the

younger family members do not increase the basis of their shares for the redemption

price.17 The taxation of a deferred payment redemption of a partnership interest is

determined under special partnership provisions and not under installment method.18

14Temp. Reg. § 15A.453-1(d)(2).

15See ¶¶ 203.3 and 208.3.

16Prop. Reg. § 1.453-1(f)(4); see Stiles v. Commissioner, 69 T.C. 558 (1978), acq.; Priv. Ltr. Rul. 90-08-065 (Nov. 29, 1989) (redemption with deferred payments must be reported as installment sale; see also E. MANNING, CORPORATE BUY-SELL AGREEMENTS, (CCH TAX TRANS. LIB.) ¶ 708 (1991). See id. at ¶ 108 for a discussion of when a redemption in a family corporation qualifies for sale or exchange treatment.

17See Manning, supra note 16, at ¶ 108.

18See Reg. § 1,736-1(b)(5), (6) and (7). See MCKEE, NELSON AND WHITMIRE, FEDERAL TAXATION OF PARTNERS AND PARTNERSHIPS ¶ 22.02[4] (2d ed. 1990) and WILLIS, PENNELL AND POSTLEWAITE, PARTNERSHIP TAXATION § 155.03 (4th ed. 1989) for further discussion of the timing issues in deferred payment of redemptions of partnership interests.

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¶ 201.2 Terms of the Sale

All initial cash amounts received, and the value of all assets initially received

(other than the buyer's evidences of indebtedness), in a deferred payment sale of family

business or other financial assets are treated as payments in the year of sale under the

installment method. Demand obligations of the younger generation buyer, or obligations

of a corporate buyer regularly traded on an active securities market, do not qualify as the

buyer's evidence of indebtedness, so that the deferral under the installment method is not

available for these notes.19 The installment method is also not available for various types

of property.20

The buyer's evidences of indebtedness may be received in an installment sale

without immediate gain recognition, regardless of the solvency of the buyer. The in-

stallment method is the basic approach to taxing deferred payment sales that qualify; its

availability does not depend on the taxpayer's method of accounting or on lack of cer-

tainty of payment.21 All other amounts received, including any third party debt obliga-

tions, are payments in the year of sale and result in immediate recognition of gain.22

Gain realized on sale can be reported under the installment method even when the

younger generation buyer's obligation is secured.23 Common forms of security include a

mortgage on the property sold, a third-party guarantee or even a standby letter of credit.24

19§ 453(f)(4) and (5); Temp. Reg. § 15A.453-1(b)(3)(i) and (e)(1).

20See ¶ 201.9.

21See Ginsburg, Taxing the Sale for Future Payment, 30 TAX L. REV. 469 (1975).

22§ 453(c) and (f)(3); Temp. Reg. § 15A.453-1(b)(3)(i); see Holmes v. Commissioner, 55 T.C. 53 (1970) (third party note guaranteed by the buyer was payment).

23§ 453(f)(3); Temp. Reg. § 15A.453-1(b)(3)(i) and (iii); S. Rep. 1000, 96th Cong. 2d Sess. at 18.

24See Rev. Rul. 82-122, 1982-1 C.B. 80, Rev. Rul. 74-157, 1974-1 C.B. 115; Rev. Rul. 74-557, 1974-2 C.B. 301 (dealing with modifications of terms of installment sales secured by the property sold); Temp. Reg. § 15A.453-1(b)(3)(iii); S. Rep. 1000, 96th Cong., 2d Sess. at 18 (both relating to standby letters of credit); but cf. Holmes v. Commissioner, supra note 22.

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It is possible to go too far. An obligation secured by an escrow or by a cash equivalent,

for example, government securities, is treated as a payment in the year of sale.25

¶ 201.3 Liabilities Transferred

When liabilities are transferred as part of the sale of the family business or other

financial assets, the liabilities are part of the selling price, included in both the selling

senior family member's amount realized and the younger generation buyer's basis.26

When property is sold subject to liabilities, special rules apply under the installment

method. The liabilities are, in effect, applied first against basis instead of simply being

considered additional payments. The contract price instead of the selling price is used to

calculate the gross profit ratio. It is defined as the selling price reduced by liabilities

transferred that do not exceed basis.27

Example 2: A senior family member sells property worth $1,000 with a basis of

$600, subject to a mortgage of $400, for ten principal payments of $60 each.

Although the sales price is $1,000, the contract price is $600 ($1,000 - the $400

mortgage), and the gross profit ratio is 66-2/3% ($400 gross profit/$600 contract

price). $40 of each $60 payment is included in income as gain on the sale.

If the amount of the selling senior family member's transferred liabilities exceeds

the basis for the business, the excess is "deemed" to be a payment in the year of sale,

because otherwise the gross profit ratio would exceed 100%.28

Example 3: A senior family member sells property worth $1,000 with a basis of

$100, subject to mortgage of $400, for ten principal payments of $60. The gross

25Temp. Reg. § 15A.453-1(b)(3)(i).

26Reg. § 1.1001-2(a); Crane v. Commissioner, 331 U.S. 1 (1947); Commissioner v. Tufts, 461 U.S. 300 (1983) (amount realized on transfer of property subject to nonrecourse liability is amount of liability even if value of property is less).

27Temp. Reg. § 15A.453-1(b)(2(iii).

28Temp. Reg. § 15A.453-1(b)(2)(iii) and (iv).

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profit is $900 ($1,000 price - $100 basis), and the contract price would be only

$600 ($1,000 price - $400 mortgage), resulting in a gross profit ratio of 133-1/3%.

To prevent this, the mortgage offset in determining the contract price is limited to

the $100 basis. Thus, the contract price is also $900, resulting in a gross profit

ratio of 100%. The $300 excess is a "deemed" payment in the year of sale. This

results in immediate recognition of gain in the amount of $300 because the entire

basis has been fully recovered against the liabilities.29

Taxpayers have succeeded in avoiding immediate gain recognition when liabili-

ties exceed basis by use of a wrap-around note.30 In a wrap-around note, the selling

senior family member does not transfer the liability, but remains primarily liable,

agreeing to make payment on the indebtedness as it becomes due.31 Although the IRS

initially resisted this result,32 it has now conceded that it works.33

Example 4: The facts are the same as in Example 3. The senior family member

may avoid the gain on the excess of the liability over basis in the year of sale by

agreeing to pay off the borrowing himself. He then receives ten annual principal

payments of $100 each, and must use part of each payment (or other resources) to

make the payments on the mortgage. He reports $90 of his gain as he collects

each principal payment, and has no deduction or other offset for the mortgage

payments.

29Temp. Reg. § 15A.453-1(b)(2)(iii) and (iv).

30See Professional Equities, Inc. v. Commissioner, 89 T.C. 165 (1987), acq.

31Wrap-around notes are used for other purposes than avoidance of the payment in year of sale, most commonly to preserve for the selling senior family member benefit of a low interest rate loan. Cf. Prop. Reg. § 1.1274-7(c) (wrapped-indebtedness not treated as assumed for purposes of OID rules).

32See Temp. Reg. 15A.453-1(b)(3)(ii).

33It has acquiesced in Professional Equities, supra note 30.

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¶ 207.3 discusses the problems that may arise if the younger generation buyer insists on

making a portion of the principal payments to the mortgagee to eliminate the risk of

selling senior family member default.

¶ 201.4 Disposition

Because the deferral of tax under the installment method is considered an ex-

traordinary benefit, almost any disposition by a selling senior family member of an in-

stallment obligation accelerates the unreported gain realized on the sale of the family

business.34 Even a gift by the selling senior family member is an early disposition that

accelerates the reporting of gain.35

A disposition occasioned by the selling senior family member's death, however,

does not accelerate the unreported gain. Instead, the deceased selling senior family

member's successor-in-interest steps into the decedent's shoes, and, in turn, is subject to

the early disposition provisions.36 The amount included in the selling senior family

member's gross estate should be the fair market value of the younger generation buyer's

debt obligation, determined under normal valuation principles, and not the unpaid

principal of the note.37 The results are the same if an installment obligation that is not a

SCIN is cancelled by a bequest to the younger generation buyer.38

34§ 453B; see Examples in ¶ 207.4. A transfer of an installment obligation incident to a divorce that meets the requirements for nonrecognition under § 1041 does not result in acceleration of gain, but transfers the unreported gain to the (often unsuspecting) transferee spouse. § 453B(g).

35Rev. Rul. 67-167, 1967-1 C.B. 107; see Examples in ¶ 207.4 A.

36§ 691(a)(2); see Examples 10, 11 and 12 in ¶ 207.4 B. Since the deferred gain is "income in respect of a decedent," § 691(a)(4) and Reg. § 1.691(a)-1(b), the successor-in-interest cannot obtain a tax-free step-up in basis for the unreported gain. § 1014(c).

37See G.C.M. 39503, Issue (3), supra note 4, determining that the unreported gain in a SCIN is income in respect of a decedent even though Issue (2)(A) concludes that no amount is included in the gross estate. This issue is discussed further in ¶¶ 207.4 A and 207.4 G.

38Reg. § 20.2033-1(b); see ¶ 207.4 B3.

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Finally, use of the installment note as collateral for a loan is treated the same as

an early disposition to the extent of the loan proceeds,39 with the result that all or a

portion of the deferred gain is reported at that time.40

¶ 201.5 Interest Charged by the Government

The benefit of the deferral of tax for large installment sales is lost, because the

selling senior family member must pay interest on part of the deferred tax, beginning in

1989.41 This interest is calculated at the interest rate applicable to tax deficiencies.42 If

the selling senior family member is an individual, the interest is, presumably, nonde-

ductible.43 This makes payment of interest prohibitively expensive.

¶ 201.6 Interest Deduction

Interest paid by noncorporate family buyers for shares of a family C corporation

is investment interest deductible only within the applicable limits.44 The character of

interest paid by a noncorporate family buyer of an S corporation is determined by an

allocation based on the nature of corporate assets, that is, business assets, investment

assets, etc.45 When the family buyer is a C corporation, the interest should be fully-

deductible as business interest.46

39§ 453A(d)(1).

40§ 453A(a)(1) and (b)(1); see Example 6 in ¶ 207.4.

41§ 453A(a)(1) and (b)(2); see ¶ 207.5.

42§ 453A(c)(2).

43§ 163(h); Reg. § 1.163-9T(b)(2)(i).

44§ 163(d)(5); Reg. § 1.163-8T(b)(3).

45See Notice 89-35, Sec. IV.A, 1989-1 C.B. 675, 676. In Priv. Ltr. Rul. 91-16-008 (Jan. 10, 1991), the IRS applied this approach to a redemption of an S corporation shares, determining the character of the interest by the nature of the corporate assets.

46See § 163(d)(1) and (h) (investment interest and personal interest limits apply only to taxpayers other than C corporations); see also ¶ 207.6.

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¶ 201.7 Original Issue Discount and Unstated Interest

The face or principal amount of a family buyer's deferred payment obligation

issued for family business shares (or other property) does not necessarily represent the

true purchase price. The difference may represent difficulty in valuing the shares or a

conscious attempt to disguise the true rate of return on the deferred payment obligation or

the true consideration paid for the family business shares. A set of complex, and not

wholly consistent, provisions is designed to prevent these considerations from distorting

the tax consequences of the sale.47 The difference between the principal or redemption

price of a debt obligation and its true value or issue price represents an additional charge

for the use of the money represented by the debt obligation,48 and is called original issue

discount ("OID") or unstated interest.49

A. Issue Price of Obligations Issued for Family Business Shares (or

Other Property)

The first of the key concepts in measuring OID is the issue price of the family

buyer's debt obligations. Although there are special rules when the shares of the family

corporation or the family buyer's debt obligations are publicly traded,50 in the usual case

when neither the family buyer's debt obligations nor family business's shares are publicly

traded,51 OID is measured by prescribed rates. The prescribed rates are used to discount

47§§ 1271 through 1275, 163(e), 171 and the regulations under them. See Lokken, The Time Value of Money Rules, 42 TAX. L. REV. 1 (1986) for a comprehensive analysis.

48§§ 1274 and 1274A.

49The technical definition of OID is any excess of the redemption price over the issue price, §§ 1273(a)(1), 483(b) and 163(e), or its equivalent in below-market related-party loans (including loans between a corporation and its shareholders), § 7872(e).

50§ 1273(b)(3); Prop. Reg. § 1.1273-2(c)(1). Public trading generally means there is no installment sale. See ¶¶ 201.9 and 207.9.

51§ 1273(b)(3); Prop. Reg. § 1.1273-2(c),

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all obligations except when regular interest payments are made, at least annually, at the

prescribed rate.52

In essence, the sales price of the family business's shares is determined indirectly

by use of the prescribed rates. The use of prescribed rates assumes that the time value of

money is easier to determine than the value of the property transferred.53 The prescribed

rates are based on the rate of interest on government obligations and are known as the

Applicable Federal Rate ("AFR"). The AFR varies depending on whether the period is

short- (three years or less), mid- (over three to nine years) or long- (over nine years)

term.54

B. Redemption Price

The second key definition, the stated redemption price, is a bit trickier. The re-

demption price includes all payments other than qualified interest, that is, express annual

interest at an unvarying rate (including certain floating rates).55 Accordingly, any

"interest holiday"56 provided in a family buyer's debt obligation (whether or not there is

public trading) of more than one year automatically results in OID.57 Thus, all payments,

whether labelled principal or interest, become stated redemption price. Similarly,

because contingent payments cannot provide for steady interest, any contingent payments

52§ 1273(a)(a) and (2); Prop. Reg. § 1.1273-1(a)(1) and (b)(1)(b). There is also a de minimis exception. § 1273(a)(3).

53Cf. Philadephia Park Amusement Corp. v. United States, 126 F. Supp. 184 (Ct. Cl. 1954) (in an ex-change of assets, amount realized and basis determined by using the value of property whose value is easiest to determine).

54§ 1274(d)(1); see ¶ 207.7 A.

55§ 1273(a)(2); Prop. Reg. § 1.1273-1(B).

56An interest holiday is any period during which no interest is paid, even though it may accrue for later payment.

57See Example 13 in ¶ 207.7 B.

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of purchase price more than one year after closing also inevitably involves OID, whether

or not there is public trading.58

C. Effect of AFR

Similarly, because the AFR determines issue price, there is OID whenever the

family buyer's debt obligation provides for interest at a rate below the AFR, even if

payable at least annually.59 As a practical matter, the OID provisions relating to the AFR

are of no concern if interest is paid at least annually at a rate at least equal to the AFR.

Moreover, when the family sale agreement provides for interest at less than the AFR, the

amount of the younger generation buyer's debt obligation, discounted at the AFR, and not

the principal amount of the obligation, determines the selling price of the family business

shares and the basis of those shares to the younger generation buyer.60

D. Effect of OID

Thus, there is OID whenever the deferred payment terms of the acquisition: (1)

do not provide for interest at a rate at least equal to the AFR; (2) provide for changes in

interest rate (other than under certain approved variable interest rate formulas); (3)

provide any interest holiday; or (4) provide contingent payments.61 When there is OID,

both the younger generation buyer and selling senior family member amortize the OID

over the life of the debt obligations on daily compound-interest accrual basis regardless

of their usual method of accounting.62 When interest (and principal) are paid annually at

58See Prop. Reg. § 1.1275-4 (c) to (f); see also ¶¶ 203.4 B and 209.4 B.

59The appropriate AFR is that in effect at the time of the contract, not at the time of closing. Prop. Reg. § 1.1274-6(e).

60See Example 14 in ¶ 207.7 C.

61Moore, Analyzing the Complex New Proposed Regs. on Imputed Interest and Original Issue Discount, 65 J. TAX'N 14, 19 (1986); Davis, Buying and Selling Property: The Determination and Treatment of Imputed Interest, 44 NYU INST. ON FED. TAX'N, Ch. 33 at 33-8 (1986).

62§ 1272(a); OID was amortized on a straight-line amortization for obligations issued between 1969 and 1982; § 1272(b), Reg. § 1.163-4; and on a cash basis for those issued between 1954 and 1969, § 1272, but the deduction may be determined on a compound-interest basis, Reg. § 1.163-3(a) and (b). There are similar rules treating market discount, that is, the difference between the basis of a debt obligation and its

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a low rate, the effect of the OID rules is to recharacterize the payments made so that part

of what is called principal is taxed as interest.63

E. Small Transactions

The OID accrual provisions do not apply for transactions of under $250,000.64

The similar unstated interest rules require that interest, at a maximum of 9%, be taken

into account for both income and deduction purposes at the time of payment, without

regard to the taxpayer's method of accounting.65 Selling family members can elect the

cash method of reporting OID for certain obligations with a stated principal not more

than $2,000,000.66 To qualify, the selling shareholder must not be an accrual basis tax-

payer; and the election must be joined the younger generation buyer.67

F. Liability Transfers

The OID rules do not apply to pre-existing liabilities transferred by the selling

senior family member to the younger generation buyer, for example, an old mortgage

with an interest rate below current interest rates that gives it a value significantly dif-

ferent from the unpaid principal amount or adjusted issue price. The OID rules do apply,

however, if the terms of the liability are modified as part of the transaction or the liability

is in excess of $10,000,000.68 The distortions this can create are discussed in ¶ 207.1 F.

redemption price as ordinary income, but only on sale, exchange or redemption unless the taxpayer elects current inclusion. See §§ 1276 and 1278; Lokken, supra note 47; see also ¶ 207.7 D.

63See Examples 15, 16 and 17 in ¶ 207.7 D.

64Determined by aggregating the amount of the sale. Prop. Reg. § 1.1274-1(b)(4)(iii).

65§ 483; Reg. § 1.483-2(a)(1)(ii).

66§ 1274A(c).

67See Example 18 in ¶ 207.7 E.

68§ 1274(c)(4); Prop. Reg. § 1.1274-7.

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G. Possible Unintended Gift for Gift Tax Purposes

When a senior family member seller takes back the younger generation buyer's

note as part of the sales price, he generally charges interest at the appropriate AFR in

order to avoid any OID or unstated interest problems. If the bona fide business exception

does not apply,69 the selling senior family member may find that he has made a gift for

purposes of the gift tax even though no gift was intended.70 The reason for this anomaly

is that § 7520(a)(2) requires that an interest rate equal to 120% of the mid-term AFR be

used for transfer tax purposes in valuing any annuity and any interest for a term of years.

If the buyer and seller are unrelated, it is highly likely that the transaction avoids any gift

issue as an "ordinary business transaction."71 When the buyer is a family member, it is

more difficult to establish that the sale is an ordinary business transaction. This may be

particularly difficult if the transfer is a part-sale, part-gift.72 Nevertheless, G.C.M. 39503

states that there is no requirement to use the transfer tax valuation tables in determining

the gift taxation of an installment sale. This position implicitly treats an installment sale,

even among family members, as a business transaction.73 Under this approach, § 7520

has no application. A possible limitation on this analysis is that the G.C.M. preceded the

enactment of § 7520.74 A similar and more persuasive argument is that an installment

note is not an annuity interest nor an interest for a term.75

69See Reg. §§ 25.2511-1(g)(1) and 25.2516-8

70See ¶ Example 20 in ¶ 207.7 G.

71Reg. § 25.2512-8.

72See ¶ 201.10.

73See Prop. Reg. § Prop. Reg. § 25.7872-1 (taxing gift loans under § 7872, which uses the AFR to value the loan); Cf. Prop. Reg. § 1.7872-2(a)(2)(ii) (excluding sales of property from loans under the below-market loan provisions).

74§ 7520 was enacted by § 5031(a) of P.L. 100-647, the Technical and Miscellaneous Revenue Act of 1988, while G.C.M. 39503 was published in 1985.

75Cf. § 1275(a)(1)(B) (defining annuity contracts excluded from the OID rules as ones dependent on the life expectancy of an individual).

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H. Premium

The provisions for amortization of premium, which is the mirror image of dis-

count, are elective for the selling family member,76 but apparently are mandatory for the

younger generation buyer if on the accrual basis,77 and, possibly, on the cash basis as

well. If the selling senior family member does not elect to amortize the premium, the

excess of the basis of the family buyer's debt obligation over the amount received on sale

or retirement generally is a capital loss.78

Unlike the OID provisions, the premium provisions do not provide for the use of

the AFR (or any other prescribed rate) to determine the amount of premium in the selling

price of the family corporation shares.79 Accordingly, it is not clear whether premium

can arise when the family buyer issues deferred payment obligations for the family

business.80

¶ 201.8 Convertible Obligations

Debt obligations convertible into shares of the family corporate buyer can qualify

for the installment method in the same manner as straight debt obligations.81 Although

conversion of a convertible security is normally not a recognition event,82 the IRS has

76§ 171 and the regulations under it.

77Reg. § 1.61-12(c). Amortization of premium attributable to a conversion privilege is not permitted for either the issuer or the holder. § 171(b)(1); Reg. § 1.61-12(c)(2); see ¶ 207.8.

78See § 1271(a)(1) providing that retirement is a sale or exchange.

79§ 171.

80See Example 21 in ¶ 207.7 H.

81The value of the conversion privilege of convertible obligations does not give rise to OID, but the value of any stock or warrants issued as part of a package does give rise to OID. Reg. § 1.1232-3(b)(2)(ii) (these regulations should continue to apply although issued before the 1984 amendments).

82Rev. Rul. 72-265, 1972-1 C.B. 222; see Fleischer and Cary, The Taxation of Convertible Bonds and Stock, 74 HARV. L. REV. 473, 476-88 (1961).

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ruled that the entire value of shares received on conversion is taxable as a disposition of

an installment obligation.83

¶ 201.9 Exclusions

When the family sale is of business assets rather than corporate stock, the in-

stallment sale rules (including contingent payment rules), are applied separately to each

asset.84 The ordinary income portion of the gain realized upon the sale under the de-

preciation recapture rules is not eligible for deferral under the installment method.85

Instead, the recapture portion of the gain must be reported in the year of sale. In addition,

gain on (i) sales of personal property that is inventory, (ii) sales by dealers,(iii) sales of

depreciable property between related parties, and (iv) sales of marketable securities, are

all not eligible for installment reporting.86 There is no installment reporting of loss.87

When property eligible for installment reporting and ineligible property are both sold in a

single transaction, the price must be allocated to determine the portions eligible for the

installment method.88

¶ 201.10 Part-Sale, Part Gift

The senior family member may not find it necessary to receive full value for

family business or financial assets transferred to the younger generation. If any in-

stallment note is worth less than the value of the property transferred, the transaction is a

part-sale, part-gift. When this is the case, the senior family member seller can apply her

entire basis in the property transferred to the sale portion, in determining gain realized on

83Rev. Rul. 72-264, 1972-1 C.B. 131; G.C.M. 34595 (Aug. 25, 1971); see Example 22 in ¶ 207.8.

84See Williams v. McGowan, 152 F.2d 570 (2d Cir. 1945).

85§ 453(i); see Example 23 in ¶ 207.9.

86§ 453(b)(2), (f)(2), (k) and (l).

87Rev. Rul. 68-13, 1968-1 C.B. 195.

88Rev. Rul. 68-13, supra note 87.

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the transaction.89 Similarly, the younger generation buyer's basis in the property is the

greater of the price paid or the senior family member's basis.90 A transferred basis may

be increased by any gift tax paid.91

¶ 202 Private annuity sale Obligations

Private annuity sales are arrangements that permit a senior family member to

receive a fixed amount periodically for the remainder of the seller's life or some other

period. The traditional tax treatment of private annuity sales developed in a series of

rulings and cases as an application of cash accounting principles in combination with

some of the rules that apply to primarily commercial annuities, all without specific

statutory authority.92

¶ 202.1 Tax Treatment of Annuities in General

An individual having a savings account with a bank must report the annual in-

terest earned under the doctrine of constructive receipt even when he does not withdraw

any monies from the account.93 If the same individual saves by purchasing an annuity

from an insurance company, the reporting of the interest income is deferred until with-

drawals are made.94

Under an annuity arrangement, the insurance company receives one or more

premium payments and agrees to make a prescribed series of future payments, usually

measured by the annuitant's life, a specified term or some combination. The payments

represent not only return of the premium but also an implicit interest element for the

89§ 1011(a); Reg. § 1.1001-1(e); see Example 24(a) in ¶ 207.10.

90§ 1015(a), Reg. § 1.1015-4; see Example 24(b) and (c) in ¶ 207.10.

91§ 1015(d); Reg. § 1.1015-5.

92See ¶ 202.2.

93See Example 25 in ¶ 208.1.

94Under the tax rules that apply to life insurance companies, the insurance company also avoids tax on the income set aside for annuities. See §§ 805(a)(2) and 807(b)(2) and (3).

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annuity term. Under § 72, a portion of each annuity distribution is treated as a tax-free

return of the annuitant's initial deposit by use of a mechanism called the "exclusion ra-

tio," and the balance, representing the time value of money, is annuity income.95 In

effect, any distributions representing the annuitant's cost in the annuity contract, referred

to as the "investment in the contract,"96 is a tax-free return of basis.97 This investment in

the contract, the numerator of the exclusion ratio, is the total of premiums the annuitant

paid the insurance company. The denominator of the exclusion ratio is the total of all

amounts the annuitant expects to receive under the annuity contract (without discounting

to present value) determined by actuarial tables,98 referred to as the "expected return."99

The exclusion ratio in annuity taxation has a function similar to that of the gross profit

ratio in the installment method as the mechanism for defining the recovery of basis.100

The exclusion ratio, like the OID and unstated interest rules, determines the amount of

income that effectively represents the time value of money. It differs in that it provides a

straight-line allocation of the income on a cash basis rather than the compound-interest

accrual approach of the OID and unstated interest rules.

When annuity payments are payable for a period measured by a life, the annuitant

can die before or after the actuarial provided in the mortality table. An annuitant dies

exactly when his actuarial life expectancy ends, excludes from income an amount exactly

equal to the premiums paid. An annuitant who dies prematurely, is permitted to deduct

95§ 72(b)(1); Reg. § 1.172-4.

96§ 72(c)(1); Reg. § 1.72-6.

97§ 72(b)(1); Reg. § 1.72-3.

98See Reg. § 1.72-9.

99§ 72(c)(3); Reg. § 1.72-5.


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the unrecovered "investment in the contract" on the final income tax return.101 An

annuitant who survives beyond the table's life expectancy, recovers the entire investment

in the contract and can no longer exclude any portion of subsequent annuity payments.102

¶ 202.2 Private Annuity Sales

When a senior family member sells family business or other financial assets to a

junior family member on terms that measure the payments by the selling senior family

member's (or another person's) life, the transaction is a private annuity sale. Traditional

private annuity sale treatment is a special application of cash accounting principles, in

which the gain on the sale is allocated over the payment period using the principles of

annuity taxation.103 A redemption by a family corporation can be a private annuity

sale.104

During the actuarial life expectancy of the selling senior family member in a

private annuity sale, the annuity payments are divided into three parts: (1) a basis re-

covery element, determined by allocating the basis of the shares over the selling share-

holder's life expectancy under the income tax annuity tables; (2) a (capital) gain element,

measured by any excess of the value of the annuity under the gift tax actuarial tables over

the basis of the shares, which is also allocated over the income tax life expectancy; and

(3) an annuity (or interest) income element, measured by the difference between the

101§ 72(b)(3)(A); H.R. Rep. No 426, 99th Cong., 1st Sess. 731 (1985); S. Rep. NO. 313, 99th Cong. 1st Sess. 607 (1986). No deduction for unrecovered basis is permitted if the annuitant dies before the annuity starting date.

102§ 72(b)(2). Prior to 1987, the annuitant could exclude a portion of all annuity payments, including the mortality gain payments, and no deduction was permitted for unrecovered basis if there was a mortality loss. See Manning and Hesch, supra note 2, at 27.

103Rev. Rul. 69-74, 1969-1 C.B. 43. The IRS revoked its earlier position in Rev. Rul. 239 where it applied the open transaction approach and allowed all principal payments to first be a recovery basis. See also Rev. Rul. 55-119, 1955-1 C.B. 352, dealing with the family buyer's basis.

104Cf. Fehrs Finance Co. v. Commissioner, 487 F.2d 184 (8th Cir. 1983), cert. den. 416. U.S. 938 (applying § 304 to a redemption through a related corporation with the price paid in the form of a private annuity).

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amount of the payment and the first two items, using the lower of the fair market value of

the shares or the present value of the annuity.105 Thus the recovery exclusion in a private

annuity sale is divided between the recovery of the selling senior family member's basis

in the family assets transferred and any unrealized gain inherent in those assets.

Accordingly, private annuity sale treatment parallels the installment method, but with

significant differences.106

If the selling senior family member outlives his life expectancy, all subsequent

payments are ordinary annuity income.107 If the family seller dies before recovering his

entire basis, the reporting of gain stops,108 and he is entitled to a loss deduction on the

final income tax return for the unrecovered basis.109 The same considerations apply to

the timing and character of the deduction and its possible eligibility for election under §

1341(a)(5) as for contingent payment installment sales.110

Traditional private annuity sale treatment is not available for secured private an-

nuity sales.111 Although G.C.M. 39503 seems to assume that being ineligible for private

annuity sale treatment means immediate recognition of gain,112 this is questionable. The

105Rev. Rul. 69-74, 1969-1 C.B. 43; G.C.M. 39503, Issue (2)(C)(1)(a), supra note 4; see Reg. § 1.1011-2(c) Example (8); see also Example 29 in ¶ 207.2.

106See generally, Manning and Hesch, supra note 2 at 23-27.

107§ 72(b)(2). There was previously a conflict between Rev. Rul. 69-74, supra note 103, and Reg. § 1.1011-2(c) Example (8) about what happened if the selling family member lived beyond the actuarial pe-riod.

108G.C.M. 39503, Issue (2)(C)(1)(b)(iii), supra note 4.

109§ 72(b)(3)(A).

110See ¶¶ 202.1 and 208.1.

111See Estate of Bell v. Commissioner, 60 T.C. 469 (1973); 212 Corp. v. Commissioner, 70 T.C. 788 (1978); G.C.M. 39503, Issue (2)(C)(1)(a), supra note 4, but see Priv. Ltr. Rul. 81-02-029 (Oct. 14, 1980) (applying traditional private annuity sale analysis to basis determination in a secured private annuity sale without comment).

112G.C.M. 39503, Issue (2)(C)(1)(A), supra note 4.

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cases requiring immediate recognition for secured private annuity sales did so as an

application of cash accounting principles and did not discuss installment sales, because,

at that time, contingent deferred payment sales were not eligible for installment sale

treatment. This is no longer true.113 Accordingly, the IRS position may create an

anomaly in that an unsecured SCIN or private annuity sale is taxed under annuity

principles, while an identical secured one is an installment sale. This distinction is

questionable and should be eliminated.114

The buying family member is not entitled to any interest deduction even though

the portion of the payment representing the time value of money is annuity income for

the selling family member.115 On the other hand, the buyer's initial basis of the family

assets transferred is measured by the anticipated payments to the extent of the fair market

value of the annuity obligation.116 Both of these results are inconsistent with those that

apply to contingent payment installment sales,117 but are consistent with the exclusion of

annuity transactions from the OID rules.118 Even with that exclusion, the denial of an

interest deduction for the younger generation buyer is questionable.119

113See ¶ 203.

114See ¶ 206.1 F.

115See, e.g., Dix v. Commissioner, 392 F.2d 313 (4th Cir. 1968); G.C.M. 39503, Issue (2)(C)(3), supra note 4.

116Rev. Rul. 55-119, supra note 103; G.C.M. 39503, Issue (2)(C)(2)(a), supra note 4. As the buying family member makes further payments, they are added to basis, apparently without regard to fair market value of the property. This converts the excess payment, a substantial part of which represents the time value of money, into a capital loss on disposition of the family business or financial assets.

117See ¶ 203.2 and 203.4 B; Example 28 in ¶ 208.2 A.

118§ 1275(a)(1)(B) (debt obligation does not include amounts taxed as annuities). In G.C.M. 39503, supra note 4, and Priv. Ltr. Rul. 90-09-064 (Dec. 8, 1989), the IRS indicated that it will continue to apply the § 72 annuity rules instead of the § 453 installment method to private annuity sales.

119See Manning and Hesch, supra note 2, at 37-38.

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The younger generation buyer's initial tentative basis for the property is increased

when payments exceed the initial basis estimate.120 Because there is no interest

deduction, this occurs well before the end of the selling senior family member's actuarial

life expectancy.121 If the family seller dies before payments equal the tentative basis, the

basis is reduced to payments already made.122 A younger generation buyer who disposes

of the property during the selling family member's lifetime, generally computes gain or

loss using the tentative basis at the time of the sale; subsequent payments are additional

losses on sale of the family assets.123

When a private annuity sale provides the consideration for a transfer that is part-

sale, part-gift, the IRS view is that gift portion of the transaction is determined using the

transfer tax tables instead of the AFR. Otherwise, the principles are the same as for part-

sale, part-gift in a fixed payment installment sale.124

¶ 202.3 Impact of Chapter 14

When the intended source of payment for the deferred payment obligation to

purchase the family business (or other family financial assets) is the income generated by

the assets purchased, and the payment is dependent on the selling senior family member's

life, there is an appearance of a retained interest in the property transferred.

Nevertheless, the family financial assets sold should not be included in the gross estate of

the selling senior family member as a retained life estate under § 2036(a) or as a retained

interest under Chapter 14. Under former § 2036(c) such interests required inclusion of

the transferred property unless the interests met the requirements as qualified debt, which

120Rev. Rul. 55-119, supra note 103; G.C.M. 39503, Issue (2)(C)(2)(a), supra note 2.

121See Manning and Hesch, supra note 2, at 26-27; Example 30 in ¶ 208.2 B.

122Rev. Rul. 55-119, supra note 103; G.C.M. 39503, Issue (2)(C)(2)(a), supra note 4; see Example 32 in ¶ 208.2 B.

123See Rev. Rul. 55-119, supra note 103; see also ¶ 208.2.

124See ¶¶ 201.10 ad 207.10; Example 33 in ¶ 207.2 C.

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annuity interests could not do.125 Section 2701 applies only to retained equity interests,

and, thus, does not apply to debt obligations. Accordingly, a bona fide deferred payment

sale should fall outside of § 2701 even when the payment is in the form of a private

annuity sale, but not if the payments are dependent on earnings.126

¶ 203 Contingent Payment Installment Sales

To deal with valuation and other uncertainties, a family sale arrangement may

include terms making part or all of the price for the family business contingent on future

gross income, net profits or some other measure of performance.. To the extent the sale

is intended to provide financial security for the senior family member, payments may

also be dependent on his or her life.127 Contingent price sales qualify as installment

sales.128

¶ 203.1 Recovery of Basis

When an installment sale of family financial assets involves a contingent price, a

significant problem is allocating the selling shareholder's basis in the property among the

contingent payments. The three basic approaches for basis recovery under the temporary

regulations determine the gross profit based on the terms of the contingency, that is,

whether there is a maximum price, a maximum payment period or neither.129

A. Stated Maximum Selling Price

If the agreement for the sale of the family business provides a maximum selling

price, computation of the gross profit ratio assumes that the maximum price will be re-

125See Notice 89-99, Part V(C), 1982-2 C.B. 422,430.

126See Leimberg, Johnson, Doyle and Kurlowicz, Sections 2701-2704: Good Motives But A Tough Law To Follow, 16 Tax Management Est. Gifts & Tr. J. 83, 88 (1991).

127See ¶¶ 202 and 204.

128§ 453(j); Temp. Reg. § 15A.453-1(d)(2)(iii); Under prior law, the selling price had to be fixed and determined in order to be eligible for installment reporting. In re Steen, 509 F.2d 1398 (9th Cir. 1975).

129Temp. Reg. § 15A.453-1(c).

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ceived, and that, in estimating imputed interest or original issue discount,130 all contin-

gent payments will be received on the earliest possible date.131 These dual rules have the

effect of maximizing the estimated selling price and gross profit. This, in turn, means

that a larger portion of the early payments is gain, and a smaller portion is recovery of

basis because a portion of basis is reserved to be allocated to the last possible dollar of

contingent payment.132 If less than the maximum contingent payment is received

ultimately, any unrecovered basis at the end is deducted as a loss.133 The loss should be

characterized as a loss on the property sold, not a loss on the annuity obligation.134

B. Maximum Payment Period

If there is no maximum selling price for the family financial assets, but there is a

maximum term, the selling family member's basis in the property sold is allocated ratably

over the term.135 In other words, the portion of the annual principal payments that is

recovery of basis is determined by dividing the selling senior family member's basis for

the family financial assets transferred by the fixed term of the buyer's obligation.136 All

principal payments for each year that exceed the annual basis allocation are gain realized

from the sale of the asset. If in any year the payments received are less than the basis

allocated to that year, the excess basis is not a loss, but is carried forward.

130See ¶ 201.7.

131Temp. Reg. § 15A.453-1(c)(2).

132See Example 34 in ¶ 208.1 A.

133Temp. Reg. § 15A.453-1(c)(2)(iii) Example (8).

134See ¶ 209.1 A.

135Temp. Reg. § 15A.453-1(c)(3).

136See Examples 35 and 36 in ¶ 209.1 B.

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C. Neither Stated Maximum Selling Price Nor Maximum Payment

Period

If the sales contract does not limit the amount of the younger generation buyer's

obligation and does not limit the periodic payments to a fixed period, the selling senior

family member can recover basis ratably over an arbitrary 15-year period, commencing

with the date of sale.137 This also has the potential for distorting basis recovery.138 The

temporary regulations also caution that the transaction may not constitute a sale.139

D. Special Basis Recovery

To deal with the basis recovery problems highlighted above, the regulations make

a limited provision for adjustment of the systems provided for basis recovery under the

maximum-price, maximum-time and 15-year provisions by the IRS either on its own

initiative or upon a taxpayer ruling request.140 The IRS has been relatively liberal in

allowing realistic adjustments when there are both fixed and contingent payments.141

¶ 203.2 Determining the Buyer's Basis

The temporary installment sale regulations determine only the tax consequences

to the selling senior family members; the younger generation buyer's basis is determined

under the proposed regulations relating to original issue discount ("OID") and unstated

interest. These regulations apply because contingent payments almost inevitably involve

OID or unstated interest.142 Those proposed OID and unstated interest regulations, in

137Temp. Reg. § 15A.453-1(c)(4).


139See ¶ 209.1 C.

140See Temp. Reg. § 15A.453-1(c)(2)(i), (c)(3)(i), (c)(4) and (c)(7); (allow use of other methods to prevent substantial acceleration or deferral of basis recovery).

141See ¶ 208.1 D.

142Prop. Reg. §§ 1.483-5 and 1.1274-4; see ¶ 203.1. If the terms of the sale provide for interest payable at the time of a principal payment at a fixed or qualified variable rate in excess of the AFR, there is tech-nically no OID or unstated interest. Cf. Temp. Reg. 15A.453-1(c) Example (4) (providing a payment

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contrast to the temporary installment sale regulations, take the approach that younger

generation buyer cannot obtain any basis for undertaking a contingent obligation, but that

basis includes payments only as they become fixed.143 This approach is inconsistent with

the rules contained in the contingent payment installment sale regulations for determining

the selling senior family member's gain and basis recovery.144145 Although the proposed

regulations recognize the inconsistency, they does not explain or justify it.146

¶ 203.3 Electing Out of Installment Method

A selling senior family member who desires to recognize the entire gain realized

on a sale in the year of the sale, instead of deferring the gain under the installment

method, can accelerate reporting gain by electing out of the installment method.147 The

entire gain is realized in the year of sale, with the fair market value of the contingent

obligation presumed to be at least equal to the fair market value of the family business or

other assets sold or the fair market value of the contingent payment obligation itself.148

¶ 203.4 OID and Unstated Interest

The contingent payment OID and unstated interest regulations provide radically

different approaches to determining the inherent interest when the family business or

other financial assets are publicly traded and when they are not.

recharacterization provision to avoid the penalty interest rate under § 483 prior to amendment by the Tax Reform Act of 1984).

143Prop. Reg. §§1.483-5(b)(3)(iv), 1.483-5(d) Example (3)(i); 1.1275-4(d)(2). See Albany Car Wheel v. Commissioner, 40 T.C. 831, aff'd per curiam, 332 F.2d 653 (2d Cir. 1964) denying the buyer a basis for his contingent obligation. Payments contingent only as to time may provide basis.

144Temp. Reg. §15A.453-1(c); see ¶¶ 203.1, Example 39 in ¶209.2, 203.4 B and 209.4 B. See also G.C.M. 39503, Issue (2)(C)(2)(b) discussed in ¶ 204.3 B3.

145See ¶¶ 203.4 B and 209.4 B.

146Prop. Reg. § 1.1275-4(d)(2)(i).

147§ 453(d).

148Temp. Reg. § 15A.453-1(d)(2)(iii); see ¶ 209.3.

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A. Publicly-Traded Property

It is the rare family situation in which either the shares of the family business or a

family corporate buyer's debt obligations are publicly traded, but less rare for other

family assets to be traded. When they are, generally there is no installment sale.149 For

sales of such assets, the market prices determine the sale price of the property sold and

the related issue price of the buyer's debt obligation.150 If the buyer's debt obligations are

publicly traded, their market price controls. If they are not traded, but the family

business shares are, the share price controls. The timing of the recognition of the

inherent interest then depends on whether any fixed payments exceed the issue price.151

B. Property That Is Not Publicly Traded

When the agreement for the sale of a family business or other financial assets

provides for contingent payments, it is difficult to provide for qualified interest pay-

ments.152 When there is no public trading to establish the issue price, it is impossible to

accrue the corresponding original issue discount on the younger generation buyer's

obligations until the contingencies are resolved and the payments become fixed.153 When

the contingencies are resolved, the proposed OID regulations provide that for sales of

family business shares where this is no public trading of the shares or the debt

obligations, each payment, when made, is allocated between principal and interest with

the portion equal to the discounted value of the payment made as of the initial sale date

149§ 453(k)(2); see ¶ 201.9.

150§ 1273(b)(3); Prop. Reg. §§ 1.1273-2(c)(1).

151Prop. Reg. § 1.1275-4(e)(1) and (f)(1); see Example 40 in ¶ 209.4 A.

152A provision for an additional payment equal to interest at a fixed or qualified variable rate on the amount of the payment from the date of sale technically is qualified interest. Cf. Temp. Reg. § 15A.453-1(c)(4) Example (4) (providing a payment recharacterization provision to avoid the penalty interest rate under § 483 prior to amendment by the Tax Reform Act of 1984). The effect is the same as not providing a separate interest calculation.

153See Prop. Reg. § 1.1275-4((a)(3).

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treated as principal and the balance as interest.154 This method of computing interest

treats a greater portion of the earlier payments as principal than would be the case if

interest were computed on the entire stated principal, that is, it back-load the interest.

When the terms of sale provide a maximum price, the stated maximum price limits the

amount of the contingent payments that is principal and the younger generation buyer's

maximum potential basis.155

The approach of the proposed OID regulations is different from that of the tem-

porary installment sale regulations dealing with maximum price contingent payment

sales.156 Under the temporary installment sale regulations, the maximum price is to be

determined by discounting deferred payments at the prescribed rate for what is called

"internal interest" and on the assumption that the maximum payments will be made at the

earliest possible date.157 This also has the effect of back-loading the interest, but, in

addition, maximizes the potential sales price and defers the recovery of basis.

¶ 204 Self-Cancelling Installment Notes

¶ 204.1 When Used?

A family seller not primarily concerned about building up her estate for tax or

other purposes, may desire a sale in which the payments are limited by her life ex-

pectancy. When the arrangement involves a fixed term with a limit based on life, it is

sometimes called a self-cancelling installment note ("SCIN"). When the payment period

extends throughout the selling family member's life with no other limit even if it has a

minimum number of payments, it is a private annuity sale.

154Prop. Reg. §§ 1.1275-4(c)(3) and 1.483-5(b)(3); see Examples 41 and 42 in ¶ 209.4 B.

155Prop. Reg. §§ 1.1275-4(c)(3)(ii) and 1.483-5(b)(3)(iii).

156The proposed regulations recognize the inconsistency, but do not explain or justify it. Prop. Reg. § 1.1275-4(d)(2). See ¶ 209.4 B.

157Temp Reg. § 15A.453-1(c)(2)(i)(A) and (c)(4) Example (2).

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A SCIN is appropriate when the selling family member does not feel the need to

receive payments for his or her entire life, as long as he or she receives an adequate

capital value. The maximum term places a cap on how much the younger generation

buyer pays, but limits the selling senior family member's life-time security. A SCIN is a

hybrid, using the installment approach in determining the maximum amount the younger

generation buyer will pay, and the private annuity sale approach in the event the selling

senior family member dies before the end of the payment term. Because the selling

senior family member no longer has a right to payment when the SCIN is terminated by

its own terms on death, no amount is included in the gross estate.158

A major advantage of a private annuity sale to the senior family member seller is

that the periodic payments for the life continue to fund his retirement even if he or she

survives beyond the actuarial life expectancy age. The corresponding advantage to the

younger generation buyer is that if the selling senior family member dies sooner than

actuarially indicated, he or she may receive a bargain, paying less for the property than it

is worth. Because of this risk, private annuity sales and SCINs are generally used only in

sales between family members.

The IRS apparently resolves the ambiguity created by the hybrid nature of a SCIN

by classifying SCINs as private annuity sales when the maximum period exceeds the

selling senior family member's actuarial life expectancy and as contingent payment

installment sales when it does not.159

¶ 204.2 Valuation of a SCIN

Because there is both a cap on the amount the younger generation buyer will pay

and a possibility the buyer will pay less than the maximum, the amount of each annual

payment, and the potential total price if the seller lives to receive all payments, under a

158Estate of Moss v. Commissioner, 74 T.C. 1239 (1980). acq; Cain v. Commissioner, 37 T.C. 185 (1961)..

159See ¶ 204.3.

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SCIN must be greater than the annual payments under an installment sale to have the

same present value.160 In other words, the risk factor attributable to the fact that the

selling senior family member may die prematurely creates a premium that must be

reflected if the parties want the present value of a SCIN obligation to equal the value of

the property purchased. And, since there is a maximum term for the payments, this factor

must also be recognized, resulting in an annual payment for a SCIN that is also larger

than for a private annuity sale payment that extends throughout the selling senior family

member's life.161

Comparing installment sales, private annuity sales and SCINs is complicated be-

cause the transfer tax valuation tables162 use shorter life expectancies in determining the

value of a deferred payment obligation than the annuity tables under § 72, and because §

7520 mandates use of a discount rate of 120% of the AFR.163 Therefore, the principal

amount of a deferred payment obligation determined for income tax purposes using the

AFR and, if applicable, the annuity tables under § 72, may be greater than the value

determined for transfer tax purposes.

The IRS position is that the transfer tax mortality tables and discount rates de-

termine whether a gift has been made in the private annuity sale.164 However, the IRS

goes on to state that there is no requirement to use these transfer tax tables in valuing an

installment sale, including a contingent payment sale, but that facts and circumstances

160Banoff and Hartz, Sales of Property: Will Self-Cancelling Installment Notes Make Private Annuities Obsolete?, 59 TAXES 499, 501 (1981)


162Reg. §§ 20.2031-7(f) and 25.2512-5(f) and Actuarial Values Alpha Volume: Remainder, In-come and Annuity Factors for One Life, Two Lives, and Term Certains. Interest Rates from 2.2 Percent to 26.0 Percent. For Use in Income, Estate, and Gift Tax Purposes including Valuation of Pooled Income Fund Remainder Interest, IRS PUBLICATION 1457 (8-89) (the "ALPHA VOLUME") Table 80 CNSMT page 6-1 (using 1980 census data).

163See ¶ 201.7 G.

164G.C.M. 39503, Issue (2), supra note 4.

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approach may be used.165 The anomaly is that a SCIN treated as an installment sale can

use the AFR and the longer life expectancy multiples found in Reg. § 1.72-9 in

determining its value for transfer tax purposes than a SCIN treated as a private annuity

sale.166

¶ 204.3 Income Tax Treatment of a SCIN

It is not entirely clear when a SCIN is taxed under the installment reporting rules

of § 453 or under the annuity rules of § 72. The IRS position is that if the selling senior

family member's life expectancy, using the mortality assumptions in Reg. § 1.72-9, is less

than the maximum term of the SCIN, it is a private annuity sale under § 72, and if the

seller's life expectancy is greater than the loan term, it is taxable as an installment sale

with a contingent sales price under Temp. Reg. § 15A.453-1(c).167 In addition to the

effects of life expectancy and discount rate differences,168 there are several crucial

income tax differences between these two approaches. The timing of the selling senior

family member's gain and ordinary income, the buyer's deductions for the time value of

money, the buyer's basis, and the effect of the seller's premature death all differ. There is

further confusion because a private annuity sale cannot be secured,169 but an installment

sale can.170

165Id.

166See ¶ 204.3.

167G.C.M. 39503, supra note 4. In Rev. Rul. 86-72, 1986-1 C.B. 253, the IRS discussed how the in-stallment sale rules under § 453B and § 691(a) applied upon the death of a seller under a SCIN. The maximum term of the obligation in this ruling was 4 years and the seller's life expectancy was 21 years. See Example 44 in ¶ 210.3.

168See ¶¶ 204.3 and 210.3.

169See ¶ 202.2.

170See ¶ 201.2.

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A. Under the Annuity Rules

The annuity rules applied to a SCIN are the same as for a straight private annuity

sale with only minor modifications to reflect the maximum term.

1. The seller. In calculating the "expected return," the two factor life ex-

pectancy multiple under Reg. § 1.72-9, Table VIII must be used. A SCIN is a "temporary

life annuity" because it has a maximum duration. The "exclusion ratio" so determined

allocates the same amount of principal and annuity income to each payment.171

2. The buyer. Even though the income tax consequences are determined

using the annuity tables of § 72, the younger generation buyer uses an initial tentative

basis equal the present value of the SCIN obligation under the transfer tax valuation ta-

bles. As for a standard private annuity sale, the younger generation buyer is not per-

mitted an interest deduction.172

3. When the SCIN is cancelled. When the annuity rules apply, and the

SCIN is cancelled by the selling senior family member's death before the maximum

payment term, the younger generation buyer's final basis under the annuity rules is

limited to payments made.173 Neither the selling senior family member nor the estate

reports the remaining gain inherent in the cancelled payments because the early dispo-

sition rules of § 453B apply only to obligations reported on the installment method. The

annuity reporting rules permit the selling senior family member to deduct any remaining

basis on his final income tax return.174




174§ 72(b)(3)(A); see ¶ 202.1; see also Example 49 in ¶ 210.3 C.

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B. Under the Installment Method

When a SCIN is treated as an installment sale under the IRS approach, the in-

stallment method as applied to contingent payment sales,175 employs dramatically dif-

ferent rules from those that pertain to a SCIN classified as a private annuity sale.

1. The seller. A SCIN is a contingent payment sale with a stated maximum

selling price.176 The maximum selling price is the "selling price" that is used in the

denominator of the "gross profit ratio," and determines the "gross profit" used in the

numerator.177

It is not clear whether the entire premium representing the risk that the selling

senior family member will die before the end of the note term must be treated as addi-

tional principal, or can be treated as additional interest as long as the interest does not

become so high as to be excessive.178 The IRS has not issued any guidance on this is-

sue.179

2. The buyer. The proposed contingent payment regulations, Prop. Reg. §

1.1275-4(d)(2), take the position that a younger generation buyer does not have any

initial basis for undertaking a contingent payment obligation. Instead, basis is obtained

only as principal payments under the contingent payment obligation become fixed.180

175See ¶¶ 204 and 209.

176Temp. Reg. § 15A.453-1(c)(1) and (2).

177Temp. Reg. § 15A.453-1(c)(2)(i)(A),(b)(2)(ii) and (b)(2)(v).

178See ¶ 207.7 H.

179There has been a debate on the treatment of this risk premium. Compare Blum, Self-Cancelling In-stallment Notes -- The New SCIN Game?, 60 TAXES 183 (1982), with Banoff and Hartz, It's No Sin to SCIN! A Reply to Professor Blum, 60 TAXES 187 (1982). See Examples 50 to 53 in ¶ 210.3 B

180See Example 54 in ¶ 210.3 B.

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3. When the SCIN is cancelled. If the tax treatment of a SCIN is governed

by the contingent payment installment reporting rules, the remaining capital gain is

accelerated upon cancellation of the obligation of a related party.181

Although the entire capital gain inherent in the deferred payment obligation is

reported even though the obligation is cancelled, there may be no symmetrical treatment

for the younger generation buyer's basis. Under the proposed contingent payment

regulations, the buyer undertaking a contingent payment obligation may obtain basis only

for principal payments actually made.182 This anomalous result should not apply and the

younger generation buyer's basis should equal the principal amount of the obligation.183

4. Treatment as contingent payment sale with a maximum selling price.

If a SCIN is taxable as an installment sale, it is a contingent deferred payment obligation

with a maximum selling price, and the tax consequences are governed by the treatment

described in Temp. Reg. § 15A.453-1(c)(2).184

¶ 204.4 Comparing SCINS as Installment Sales and Private Annuity Sales

The selling senior family member's interest income and the younger generation

buyer's potential interest deduction are matched when the installment method applies, but

the buyer does not deduct the equivalent of the selling senior family member's annuity

income for a private annuity sale. The younger generation buyer is allowed a tentative

initial basis when the SCIN is taxed as private annuity sale, but not when it is an

installment sale.

181Rev. Rul. 86-72, supra note 167, and G.C.M. 39503, supra note 4; see ¶ 201.4.

182Prop. Reg. §§ 1.483-5(b)(3)(iv) and 1.1275-4(c)(4) Example (1)(iii); but see G.C.M. 39503, Issue (2)(C)(2)(b), supra note 4 allowing the buyer who purchases for a contingent price to include the maxi-mum principal amount of the obligation in basis.



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Nothing is included in the selling senior family member's gross estate when a

SCIN is taxed under the installment method or as a private annuity sale. The remaining

unreported capital gain is accelerated when the related party buyer's SCIN obligation

terminates on the senior family member's death under the installment method, but not

under the private annuity sale rules. To maintain symmetry, the related buyer's basis

should equal the principal amount of the SCIN under the installment method, but is

limited to payments made in a private annuity sale. Because of the lack of anything re-

sembling an interest deduction for the buyer under the private annuity sale rules, the

buyer's ultimate basis may greatly exceed the fair market value of the property under any

reasonable assumption if the senior family member seller lives for any significant period

after the sale.185

¶ 205 Private Annuity Sales as Installment Sales

Just as a SCIN can (and should) qualify under the installment method, a standard

private annuity sale can also qualify under the statutory definition of an installment sale

as:

[A] disposition of property where at least 1 payment is to be received after the

close of the taxable year in which the disposition occurs.186

The IRS, picking up on a portion of the legislative history of the 1980 Act that

stated that the Act "does not deal directly" with private annuities,187 has stated that it will

not treat private annuity sale transactions under the installment method.188 As is


186§ 453(b)(1). See Temp. Reg. § 15A.453-3(d)(2)(iii).

187See H.R. Rep. No. 1042, 96th Cong., 2d Sess. 10, note 12 (1980); S. Rep. No. 1000, 96th Cong., 2d Sess. 12, note 12 (1980) (emphasis added).

188In G.C.M. 39503, the IRS took this position because it felt that the intent of the 1980 Act was to cover only those cases where the contingency relates to the profitability of the property purchased. In Priv. Ltr. Rul. 90-09-064 (Dec. 8, 1989), the IRS ruled that a private annuity sale of a remainder interest in property is subject to the § 72 annuity rules described in Rev. Rul. 69-74.

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discussed later in this paper, there are compelling reasons to treat private annuity sales as

contingent payment installment sales eligible for the installment method.

¶ 205.1 In General

The application of the installment method to pure private annuity sales is no more

difficult than doing so for SCINs, either theoretically or practically. The only additional

complication is the absence of a maximum price.

¶ 205.2 Application of the Contingent Payment Regulations to Private

Annuity Sales

If it is classified as an installment sale, a private annuity sale appears to be one

with neither a maximum price nor a maximum payment period.189 Nevertheless, it is not

unreasonable to tax it by analogy as one with a tentative fixed period based on the

actuarial life expectancy or with a maximum price computed on the same basis as is done

under the traditional private approach.190

A. Treatment as an Installment Sale with Neither Maximum Price nor

Fixed Period

Under the terms of a private annuity sale, the payments are not limited to a

maximum term and there is no limitation on the aggregate of the payments. Therefore,

treatment as a contingent payment installment sale requires the use of a 15-year amorti-

zation period to determine the return of basis inherent in each principal payment.191

Under a parity of reasoning, the contingent payment OID and unstated interest rules

apply to treat each payment as a separate OID debt obligation for purposes of deter-

mining the interest inherent in the payment with the consequent back-loading of inter-

est.192

189See ¶¶ 203.1 and 209.1

190See Manning and Hesch, supra note 2, at 27 to 32.

191Temp. Reg. § 15A.453-1(c)(4); see Example 60 in ¶ 211.2.

192Prop. Reg. § 1.483-5(b)(3)(i) and 1.1275-4(c)(3)(ii).

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B. Treatment as an Installment Sale with a Maximum Selling Price or

Fixed Term

Since the contingent payment installment sale regulations presume that the value

of a contingent payment obligation equals the value of the property sold,193 a private

annuity sale can be viewed as a contingent sale with a maximum selling price. In other

words, the value of the property, or, in a part-sale, part-gift, the actuarial value of the

buyer's annuity obligation, can be treated as the maximum selling price. Further, as for a

contingent sale having a maximum stated principal amount, once the aggregate of the

portion of the contingent payments treated as principal equals this maximum amount, any

additional contingent payments are treated entirely as interest.194

Similarly, the actuarial life expectancy can be viewed as a fixed payment period.

Under this approach, the selling senior family member's basis in the property is spread

ratably over the actuarial life expectancy in a manner similar that now provided for a

private annuity sale.195

Either of these approaches appears to provide a more sensible approach to basis

recovery than the arbitrary 15-year period. Accordingly, either should be available under

a liberalized version the regulation's provision for alternate methods.196

Although the proposed contingent payment regulations under § 1275 do not

permit the younger generation buyer to obtain an initial basis for incurring a contingent

193Temp. Reg. § 15A.453-1(d)(2)(iii) takes this view for election out purposes under § 453(d).

194Prop. Reg. §§ 1.483-5(b)(3)(iii) and 1.1275-4(c)(3)(ii); see Example 61 in ¶ 211.2 B. This approach should be contrasted with a contingent payment sale having neither a maximum selling price nor a fixed term where the principal portion of all payments continues to be treated as additional amount realized, thereby generating capital gain.

195See ¶ 203.1 B, 209.1 B and 202.2.

196See ¶¶ 203.1 D and 209.1 D.

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obligation,197 this approach should not apply to a private annuity sale treated as a con-

tingent payment installment sale with a maximum selling price.198

C. Private Annuity Sale of Publicly-Traded Property

A private annuity sale of publicly-traded property cannot qualify under the in-

stallment method.199 Nevertheless, it is more appropriate to apply the publicly-traded

contingent payment sale regulations that use the AFR to determine the accrued interest,

than to use the § 7520 rate.200

¶ 205.3 Comparison of Installment Method and Annuity Treatment

As set forth in ¶ 211.3, we have identified at least eighteen differences between

private annuity sale and installment sale treatment. Some are the result of the historic

development of the private annuity sale as a special application of cash accounting as

discussed above, but many are attributable to the inapplicability of recent limitations on

installment reporting to private annuity sales. We are not so vain as to suggest that our

list of eighteen is comprehensive. We do suggest that most of these differences simply

should not exist in a sound tax system. Moreover, the IRS can correct most of the

problems without further legislation if it abandons the positions it has taken in G.C.M.

39503 and makes the installment method applicable to all deferred payment sales, even

those measured by one or more lives.201

¶ 206 Recommendations for Changes in the IRS's Position

All private annuity sale obligations and all SCINs should be treated as contingent

installment sale obligations with the same limitations and other rules. Since all of these

197Prop. Reg. §§ 1.483-5(b)(3)(iv) and 5(d) Example (3)(i), and 1.1275-4(c)(4) Example (1)(iii); see ¶¶ 203.2 and 209.2.

198See ¶¶ 204.3 B2 and 210.3 B2.

199§ 453(k)(2)(A); see ¶ 201.9.


201See ¶ 206.

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deferred payment vehicles are similar and have similar financial objectives, the tax

treatment of all three should be consistent. Consequently, all three financing vehicles

should be subject to the subject to the temporary contingent payment installment sale

regulations,202 including the exclusions from deferral of gain,203 and to the proposed

contingent payment OID and unstated interest regulations.204 Simply stated, private

annuity sales and SCINs should no longer be treated as annuities subject to the § 72

annuity rules, even if they do not qualify under the installment method. A possible

compromise approach is to make private annuity sale treatment available for those

electing out of the installment method and possibly for sales that do not qualify under the

installment method, relying on the denial of the interest deduction to limit abuses.205

Treating private annuity sales and all SCINs as contingent payment obligations

under the temporary and proposed regulations would achieve three objectives. The first

is symmetrical treatment between the younger generation buyer and the selling senior

family member in the same transaction, so that both the younger generation buyer and the

selling senior family member would treat the time value of money and the gain and basis

aspects of the transaction consistently. The second eliminates the valuation disparities

between the income tax and transfer tax treatment of the same transaction. The third

maintains the integrity of the various safeguards and eligibility requirements found in the

§ 453 installment reporting rules.

¶ 206.1 Symmetrical Treatment of the Buyer and Seller

Treating private annuity sales and all SCINs as contingent payment installment

sales would have the following results:

202Temp. Reg. § 15A.453-1(c).

203See ¶ 201.9.

204Prop. Reg. §§ 1.483-5 and 1.1275-4.

205See Manning and Hesch, supra note 2, at 21.

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A. Eliminate the Application of § 72

If § 72 does not apply to a transaction, the OID and unstated interest rules do.206

This provides for consistent reporting of the selling senior family member's interest

income and the younger generation buyer's possible interest deduction. As a contingent

payment obligation the interest element inherent in a private annuity sale obligation is

reported, either back-loaded or front-loaded as the case may be, as it is deemed to have

accrued.207

B. Permit the Buyer a Tentative Basis for SCINS and Private Annuity

Sales

Elimination of private annuity sale treatment and the application of the OID and

unstated interest provisions apparently denies the younger generation buyer a tentative

basis for the value of the annuity obligation, and provide basis only as payments become

fixed.208 Nevertheless, the experience with the private annuity sale rules shows that a

tentative basis is feasible and does not raise the same type of problems as other types of

contingent obligations, particularly the transfer of contingent liabilities.209 Accordingly,

the proposed OID and unstated interest regulations should be amended to provide such a

tentative basis for SCIN and private annuity sale obligations, particularly in light of the

fact that the application of the installment method to related party sales insures that the

inherent gain will be reported.

206See ¶ 202.2.

207See ¶ 203.4 A and B.

208See ¶ 203.2.

209See ¶ 202.2.

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C. Report Gain on Obligations Terminated by Death on the Seller's

Final Return for Related Party Sales

Rev. Rul. 86-72 requires the selling senior family member's estate to treat the

cancelled payments from a related party as having been received by the estate.210 If the

capital gain inherent in the cancelled payments is to be reported, the IRS is wrong in

requiring that the capital gain be reported by the selling senior family member's estate.

Instead, that gain should be reported on the seller's final income tax return.211 This places

the gain where it belongs, and when the related party rules do not apply, permits the

proper loss deduction for any unrecovered basis. It is also consistent with not including

anything in the selling senior family member's gross estate. The provisions of § 691

should not be applicable since, following the seller's death, the SCIN is neither included

in the seller's gross estate nor transferred to or possessed by the estate.212

D. Apply the Same Rules to All SCINS

The distinction used in G.C.M. 39503 to determine when a SCIN is treated as an

installment sale and when it is treated as a private annuity sale makes no sense.213

Treating private annuity sales as contingent payment installment sales gives this dis-

tinction a proper burial.

210Supra note 163. G.C.M. 39503, supra note 4, consistently gives the buyer a basis is the property equal to the amount of the note. See ¶ 203.2. This G.C.M. was issued in 1985, a year before the proposed OID and unstated interest regulations were issued and may be superseded on this point by the regulations if they become final in their present form. The inconsistency only affects related party sales under which the seller is required to report the gain in all events. If the buyer is an unrelated party, the unreported gain disappears if the obligation is cancelled by its terms. See ¶ 210.3 A.

211§ 453B(f). See Banoff and Hartz, supra note 160, at 150.

212§ 691 is applicable only when income in respect of a decedent is not reported on the final income tax return.

213See ¶¶ 204.2 and 204.3.

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E. Eliminate the Disparity Between Secured and Unsecured Private

Annuity Sales

Under present case law and IRS views, a secured private annuity sale probably is

eligible for installment reporting while an unsecured private annuity sale is not.214

Treating all private annuity sales as contingent payment obligations eliminates another

unjustified distinction.

F. Treat All SCINS and Private Annuity Sales as Maximum Price

Sales.

Treating all SCINs and private annuity sales as contingent payment sales with a

maximum selling price, provides a sensible front-loading of interest,215 an appropriate

allocation of basis,216 eliminates the SCIN-PRIN, SCIN-INT quandary,217 and is con-

sistent with providing a tentative basis.218 The maximum selling price approach requires

that the principal amount of the obligation be equal to the value of the property

purchased, which is the actuarial value of the annuity. Consequently, the risk factor for

all SCINs is interest.

G. Limit Basis to Fair Market Value

Treating all SCINs and private annuity sales as contingent payment sales with a

maximum selling price limits the younger generation buyer's basis to the value of the

property purchased.219 Once the aggregate of the principal payments reaches this

maximum, any subsequent payments are interest. Therefore, the buyer's basis for assets

purchased is properly related to its value.

214See ¶¶ 202.2 and 203.

215See ¶ 203.4 A and B.

216See ¶¶ 204.3 B and 205.2 B.

217See ¶ 210.3 B.

218See ¶ 206.1.

219See ¶ 203.4 B.

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H. Clarify Character of Loss on Unrecovered Basis Upon Cancellation

In a SCIN or private annuity sale treated as a contingent payment installment sale,

if the selling senior family member has not recovered all of his basis in the asset sold

before the payments terminate, the selling senior family member deducts any unre-

covered basis when the sale is not to a related party.220 The character of that deduction

should be determined by reference to the character of the asset sold and not as a loss on

an independent obligation.221

¶ 206.2 Eliminate Valuation Anomaly

The same valuation rules should be used for all types of intra-family deferred

payment sales.

A. Eliminate Unintended Gift Issue

Treating all SCINs and private annuity sales as installment sales means that the

AFR determines the discount rate.222 If the same valuation principles are used for both

income and transfer tax purposes, valuation disparities for the same transaction can be

avoided. Therefore, § 7520 does not apply. Consequently, the unintended gift problem

and other distortions can be avoided.223

B. Use Uniform Mortality Tables of § 72

Treating all SCINs and private annuity sales as installment sales also means that

the more realistic and longer mortality assumptions found in the § 72 regulations ap-

ply.224 Consequently, the same valuation approach is used to determine the proper

payment for income and transfer tax purposes.

220See ¶ 204 B3.

221See Arrowsmith v. Commissioner, 344 U.S. 6 (1952); see also ¶¶ 204.3 B3 and 209.

222See ¶¶ 201.7 G and 204.2.

223Even if the income and gift tax use the same mortality assumptions and the same interest rates, this disparity can be reduced but not eliminated entirely. See Temple, Real and Apparent Anomalies in the Private Annuity Tables, 2 TAX LAW J. 147, 156-62 (1985).

224See ¶ 204.2.

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C. Eliminate Abuses in Private Annuity Sales

An approach not rigidly tied to the transfer tax tables that allows resort to facts

and circumstances in valuations, results in more realistic valuation and eliminates the

abuse found in some private annuity sales. Frequently, a private annuity sale is used

when the selling senior family member is expected to die before reaching his actuarial

life expectancy age. The installment sale approach allows the IRS to take into account

the selling senior family member's health in determining the real value of the private

annuity obligation for gift tax purposes, instead of relying strictly upon the mortality

assumptions used in the transfer tax valuation tables.225

¶ 206.3 Maintain the Integrity of the § 453 Rules

There is no statutory support for denying deferral under the § 72 annuity rules for

situations that are not eligible for deferral under the § 453 installment rules. Further,

there are other safeguards in the § 453 installment rules not found in the § 72 annuity

rules. Treating private annuity sales and all SCINs as a contingent payment installment

sales, applies the installment sale eligibility rules and other safeguards. Specifically, the

following eligibility rules and safeguards are preserved:

1. The anti-Rushing rule applies.226

2. Dealer and inventory sales do not qualify.227

3. Sales of publicly-traded securities do not qualify.228

4. Depreciation recapture cannot be deferred.229

5. The early disposition rules apply.230

225See ¶ 207.7 G.

226§ 453(e); see G.C.M. 39503, Issue (2)(C)((1)(ii).

227§ 453(b)(2); see¶ 201.9.

228 § 453(k)(2); see ¶ 201.9.

229§ 453(i); see ¶ 201.9.

230§ 453B; see ¶ 201.4.

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6. Gain is accelerated when an obligation is pledged as collateral for a

loan.231

7. Interest must be paid on deferred gain on large sales.232

8. The basis first approach is not available.233

231§ 453A(d); see ¶ 201.4.

232§ 453A(a)(1).

233Temp. Reg. § 15A.453-1(d); Rev. Rul. 69-74, supra note 103; ¶¶ 202.2 and 203.3.

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PART II

COMPREHENSIVE DESCRIPTION

¶ 207 Installment Method for Fixed Payment Obligations

¶ 207.1 In General

It is easy to compute the gross profit ratio and apply the installment method to

simple sales. When the facts become more complicated, particularly when the property is

mortgaged, so does the computation. Example 1 sets forth the basic facts that are used in

many of the examples that follow. S is a senior family member who wishes to transfer

control of family financial assets to B, a younger family member.

Example 1: S owns land held as a capital asset with a basis of $1,700,000 and a

value of $2,500,000. The land is subject to a $1,750,000 mortgage.

B purchases the property from S on December 31, 1989, paying no cash at the

December 31 closing. The sales contract requires B to pay $150,000 cash one

day later on January 1, 1990, and take the property subject to the outstanding

mortgage. At closing B delivers a note with a face or principal amount of

$600,000, providing annual payments of $50,000, starting on January 1, 1991.

The note also requires B to pay 10% interest on the unpaid balance with each

annual payment. The long-term AFR at the date of sale was 8.75%, so there is no

imputed interest.

The amount realized of $2,500,000 is composed of the $150,000 cash received the

following day, the $1,750,000 mortgage, and the $600,000 principal of B's note.

Accordingly, S's realized gain on the sale is $800,000.

For purposes of reporting the $800,000 capital gain under the installment method,

the gross profit ratio is 100%. Even though the gross profit is $800,000 and the

"sale price" is $2,500,000,234 it is the "contract price" that is used as the

234Temp. Reg. § 15A.453-1(b)(2)(ii); see also ¶¶ 201.2 and 207.2.

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denominator of the gross profit ratio. The contract price is defined as the selling

price reduced by the portion of the qualifying indebtedness which does not exceed

S's basis in the property.235 In other words, the amount of the mortgage is

subtracted from the selling price, but the maximum reduction in the denominator

cannot be more than S's basis in the property sold. The remaining $50,000 of the

mortgage is treated as a deemed payment at the time of sale. Therefore, the gross

profit ratio is 100%, computed as follows:

(i) $2,500,000 - $1,700,000 = $800,000, contract price

(ii) $800,000/$800,000 = 100%, gross profit ratio

In effect, the entire $1,700,000 basis in the land is applied against $1,700,000 of

the outstanding mortgage. In other words, the deemed receipt of $1,700,000 is

treated in its entirety as a return of basis. S's basis in the installment note is zero.

Accordingly, the $800,000 gain is reported as follows:

At time of sale (excess liability) $ 50,000

Jan. 1 of next year (down payment) 150,000

Annually (as payments received) 600,000

Total Gain $800,000

Postponing receipt of actual payments does not postpone reporting of the deemed

payment attributable to the excess liability transferred.

If S elects out of the installment method under § 453(d), she reports the entire

$800,000 capital gain in year of sale,236 so that her basis in the $600,000 note is

equal to its face amount. Thus, all principal payments on the note are a nontax-

able recovery of basis.

235Temp. Reg. § 15A.453-1(b)(2)(iii); see also ¶¶ 201.3 and 207.3.

236Temp. Reg. § 15A.453-1(d)(2)(i) and (ii); see also ¶¶ 203.3 and 209.3

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B's basis in the land is $2,500,000 from the date of sale, whether S uses the in-

stallment method or elects out.

A. Standard Installment Sale

In a standard installment sale with interest on the entire balance paid with each

principal payment, the portion of each payment that is gain remains constant, but the

amounts of total payments and of interest are greater in the earlier years.

Example 2: Following the sale described in Example 1, S collects all principal

and interest payments on the $600,000 note. The following schedule shows the

amount, character and timing of the income reported by S under the installment

method:

Total Capital Year Payments Basis Gain Interest

1989237 $ 50,000 -0- $ 50,000 -0- 1990 150,000 -0- 150,000 -0- 1991 110,000 -0- 50,000 $60,000 1992 105,000 -0- 50,000 55,000 1993 100,000 -0- 50,000 50,000 1994 95,000 -0- 50,000 45,000 1995 90,000 -0- 50,000 40,000 1996 85,000 -0- 50,000 35,000 1997 80,000 -0- 50,000 30,000 1998 75,000 -0- 50,000 25,000 1999 70,000 -0- 50,000 20,000 2000 65,000 -0- 50,000 15,000 2001 60,000 -0- 50,000 10,000 2002 55,000 -0- 50,000 5,000

Totals $1,190,000 -0- $800,000 $390,000

In this and the following examples, the gain is labelled capital gain for conve-

nience in distinguishing it from the interest income (or in private annuity sales,

the annuity income). If the family business or financial assets transferred are not

237Because the $1,750,000 mortgage exceeds S's $1,700,000 basis by $50,000, that excess amount is treated as a fictional payment of cash received in the year of sale. Temp. Reg. § 15A.453-1(b)(3)(i); see ¶¶ 201.3, 207.1 and 207.3.

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capital assets, the gain may be ordinary income. In some cases the assets

transferred may not qualify for the installment method.238

B. Installment Sale with Level Annual Payments

Generally, interest is reported as it financially accrues.239 Accordingly, the an-

nual payments for a deferred payment sale with level principal payments decrease each

year as the unpaid balance and the interest accruing on it decline. This type of install-

ment sale is referred to as a "decreasing payment" obligation. The selling senior family

member may prefer level annual payments over the term of the note. This type of

installment sale is called a "level payment" obligation. Residential mortgages are ex-

amples of level payment obligations. Although the younger generation buyer's obligation

is, in effect, equivalent to guaranteed annuity for a fixed term, it is not an annuity subject

to annuity treatment under § 72 for purposes of the OID and unstated interest rules.240 It

is not dependent on anyone's life nor is it issued by an insurance company.

Since the value of this level payment obligation is the same as in a decreasing

payment sale, the realized gain on the sale is the same. It is a self-amortizing installment

obligation under the OID rules,241 that does not involve OID or unstated interest as long

as the stated interest rate used to determine the payments is at least equal to the AFR.242

Nevertheless, the reporting of interest resembles a mortgage amortization table or an OID

238See ¶¶ 201.9 and 207.9.

239In Example 2, the $60,000 of interest for 1990 represents the interest accrued during the 1990 calendar year on the $600,000 principal outstanding during that 12-month period and paid on January 1, 1991. If B and S are cash basis taxpayers, they are eligible to elect to report the interest income and interest deduction in the year paid under § 1274A(c) because the principal amount of the note does not exceed $2,000,000. Therefore, S can defer reporting the interest income by one year but only if B defers the interest deduction. For a method of reporting the interest that is more realistic with financial principles, see Bankman and Klein, Accurate Taxation of Long-Term Debt: Taking into Account the Term Structure of Interest, 44 TAX L. REV. 335 (1989).

240Prop. Reg. § 1.1275-1(b)(2).

241Reg. § 1.1273-1(b)(iii) and (iv).

242Reg. § 1.1274-2(b)(1).

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computation, with an increasing portion of each subsequent payment treated as a

principal payment on the note. The gross profit ratio is applied to the principal payments

received each year. The total amount of the payments and interest is greater than with

level principal payments because the principal is amortized more slowly.

Example 3: The facts are the same as in Examples 1 and 2, but B agrees to pay

the $600,000 balance over 12 years in level annual payments. In determining the

level annual payment necessary to purchase an asset worth $600,000 at a 10%

rate of interest over a 12-year term, the factor is 6.8137.243 Therefore, the annual

payment is $88,058 per year for 12 years ($600,000 divided by 6.8137). This

produces a deferred payment obligation (using a 10% discount rate) with a

present value of $600,000. S's amount realized is $2,500,000 (the $150,000 cash,

the $1,750,000 mortgage and the $600,000 value of the level payment obligation).

S's realized gain is the same $800,000 as for a decreasing payment obligation.

For purposes of reporting gain under the installment method the gross profit ratio

is 100% because the liability transferred exceeds the basis of the property

transferred.

The following schedule shows the amount, character and timing of the income

reported by S:

243See Reg. § 20.2031-7(f) (fixed-term annuity tables); ALPHA VOLUME, supra note 162, Table B, page 3-20.

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Total Payments Capital Year Received Gain.244 Interest

1989245 $ 50,000 $ 50,000 -0- 1990 150,000 150,000 -0- 1991 88,058 28,058 $ 60,000 1992 88,058 30,864 57,194 1993 88,058 33,950 54,108 1994 88,058 37,345 50,713 1995 88,058 41,080 46,978 1996 88,058 45,188 42,870 1997 88,058 49,707 38,351 1998 88,058 54,677 33,381 1999 88,058 60,145 27,913 2000 88,058 66,160 21,898 2001 88,058 72,775 15,283 2002 88,058 80,781 7,277

Totals $1,256,696 $800,000 $456,696

A comparison of the financial consequences of the two types of installment sales

shows that the level payment approach results in additional payments of $66,694.56 over

the 12-year term. This additional amount is interest and is attributable to the fact that the

level payment does not amortize the principal on the loan as quickly as does the

decreasing payment illustrated in Example 2. The outstanding principal during the term

of the note for both payment arrangements is as follows:

244The principal payment on the note and the capital gain reported under the installment method are the same because the gross profit ratio is 100%. When there is basis to be recovered, the principal portion of the payment is divided between gain and basis recovery using the gross profit ratio.

245Fictional payment because liability exceeds basis.

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Principal Balance on the Note

Decreasing Level Payments Payments Example 2 Example 3

1990 $600,000 $600,000 1991 550,000 571,942 1992 500,000 541,078 1993 450,000 507,128 1994 400,000 469,783 1995 350,000 428,703 1996 300,000 383,516 1997 250,000 333,810 1998 200,000 279,133 1999 150,000 218,988 2000 100,000 152,829 2001 50,000 80,780 2002 -0- -0-

Interest Income Reported

Decreasing Level Payments Payments Example 2 Example 3

1990 $ 60,000 $ 60,000 1991 55,000 57,194 1992 50,000 54,108 1993 45,000 50,713 1994 40,000 46,978 1995 35,000 42,870 1996 30,000 38,351 1997 25,000 33,381 1998 20,000 27,913 1999 15,000 21,899 2000 10,000 15,283 2001 5,000 7,277 2002 -0- -0-

Totals $390,000 $456,696

The choice of deferred payment arrangement depends on the financial needs of

the parties. Although the level payment arrangement defers more of the income until the

later years, it does not provide as large an annual payment for the earlier years of the

term. In Example 3, the income reported for 1992 by the selling senior family member

using a decreasing payment obligation totals $105,000 ($55,000 interest and $50,000

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gain), while a selling senior family member using a level payment obligation reports only

$88,058 of income for 1992 ($57,294 interest and $30,864 gain).

¶ 207.2 Terms of Sale

Although the installment method is available even when the younger generation

buyer's obligations are secured,246 certain forms of security can convert the buyer's

obligation into a current payment. Specifically, security in the form of a cash equivalent,

such as a certificate of deposit, loses the deferral privilege.247 The same is true for any

form of escrow.248 Later substitution of an escrow or cash equivalent terminates the

deferral for a previously qualified installment sale.249 On the other hand, a standby letter

of credit is permissible security.250 Thus, as a practical matter, when security other than

the property sold is needed, a qualifying standby letter of credit should be used.

A selling senior family member may have suspended passive losses, for example,

losses of an S corporation owned by a shareholder who does not materially participate or

passive losses that were suspended when an activity was contributed in a § 351

transaction.251 A sale reported under the installment method is not a complete disposition

that permits immediate deduction of suspended passive losses.252 Instead, the suspended

246§ 453(f)(3); see ¶ 201.2.

247Temp. Reg. § 15A.453-1(b)(3)(i). This regulation effectively overrules Porterfield v. Commissioner, 73 T.C. 91 (1979) (installment sale qualified even though the buyer's note was secured by escrow when court found escrow was intended as security not source of payment); see also Sprague v. Commissioner, 627 F.2d 1044 (10th Cir. 1982) (impractical to evaluate security and whether its quality creates risk).

248Oden v. Commissioner, 56 T.C. 569 (1971) (certificates of deposit placed in escrow); Pozzi v. Com-missioner, 49 T.C. 119 (1967) (escrow); Rev. Rul. 73-451, 1972-2 C.B. 158 (cash in escrow).

249Rev. Rul. 77-294, 1977-2 C.B. 173, revoking Rev. Rul. 68-246. 1968-1 C.B. 198, amplified by Rev. Rul. 79-91, 1979-1 C.B. 179 (installment sale ceased to qualify when escrow substituted for mortgage security).

250Temp. Reg. § 15A.453-1(b)(3)(iii); S. Rep. 1000, 96th Cong. 2d Sess. at 18.

251See R. LIPTON AND D. EVAUL, PASSIVE ACTIVITY LOSSES II (CCH TAX TRANS. LIB.) ¶ 1303.02 (198 ).

252§ 469(g).

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passive losses are deducted as gain is recognized.253 By a parity of reasoning, losses

suspended under the at-risk rules254 should be deductible only as gain is recognized.255

Losses of a partnership or S corporation that have been suspended because the selling

senior family member's basis was not sufficient,256 do not become deductible at the time

of disposition. The sale does not provide the requisite basis. This is not inappropriate,

since if deduction of the loss is taken, basis in the shares is reduced,257 and gain on the

sale is equivalently larger.

¶ 207.3 Liabilities Transferred

Liabilities relating to shares in a family corporation may include purchase money

indebtedness, funds borrowed by the shareholder to contribute to the corporation,258 or

other liabilities related to the corporate business,259 that may be transferred at the time of

the sale.260 Any transfer to the family buyer of obligations incurred by the selling

shareholder in connection with the sale, such as any of the seller's legal or accounting

fees, is a payment, and does not receive the benefit of being deducted in determining the

contract price.261 Similarly, any borrowing immediately before the sale to take advantage

253See 1986 BLUE BOOK at 226.

254§ 465.

255See Prop. Reg. § 1.456-66.

256§§ 704(d) and 1366(d).

257§ 1367(b)(2)(B).

258Cf. Estate of Leavitt v. Commissioner, 875 F.2d 420 (4th Cir. 1989) (borrowing by S corporation guaranteed by shareholder not treated as individual borrowing and contribution to capital); Selfe v. Com-missioner, 778 F.2d 769 (11th Cir. 1985) (such borrowing may be treated as shareholder borrowing and contribution).

259Cf. Rev. Rul. 73-555, 1973-2 C.B. 159 (liabilities related to going business transferred).

260See ¶ 201.3.

261Rev. Rul. 76-109, 1976-1 C.B. 125.

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of the application of liabilities first against basis, is a sham.262 Thus, the selling senior

family member cannot receive tax-free cash in the transaction by borrowing immediately

before the sale. Cancellation of any obligation owed by the selling shareholder to the

family buyer is a payment rather than transfer of a liability.263

Any transfer of liabilities, whether recourse or nonrecourse, is part of the pur-

chase price. This means that the liabilities transferred are part of the amount realized by

the selling senior family member, and part of the basis for the buyer.264 There is some

dispute whether a recourse liability is transferred if the selling senior family member

remains primarily or secondarily liable. The IRS takes the position that a liability is

transferred when the buyer agrees to pay it even if the seller is not released.265 The courts

have been more reluctant to ignore retained liability, and have occasionally allowed the

seller to avoid the consequences of the transfer of the liability at least at the time of the

asset transfer.266 Although the cases cannot be completely reconciled, the better view is

262Temp. Reg.§ 15A.453-1(b)(3)(i).

263§ 453B(a); Temp. Reg. § 15A.453-1(b)(3)(i); Big "D" Development Corp. v. Commissioner, 30 T.C.M. (CCH) 646 (1971), aff'd per curiam, 453 F.2d 1365 (5th Cir. 1972), cert. den. 406 U.S. 945; but see Kniffen v. Commissioner, 39 T.C. 553 (1962), acq. (liability to controlled corporation transferred in § 351 transaction treated as assumed and not boot); Connell v. Commissioner, 42 T.C.M. (CCH) 423 (1981) (30% initial payment limited under prior law not violated by mutual pledging of notes of buyer and seller; notes did not offset each other).

264Reg. § 1.1001-2(a); Crane v. Commissioner, supra note 26; Tufts v. Commissioner, supra note 26 (amount realized on transfer of property subject to nonrecourse liability is amount of liability even if value of property is less); see ¶ 201.3.

265Reg. § 1.1001-2(a)(4)(ii); but cf. Reg. § 1.752-1(d) (partner assumes partnership liability only when creditor is aware of assumption and has direct rights against partner).

266See Jackson v. Commissioner, 708 F.2d 1402 (9th Cir. 1983) (transferor shareholder does not recognize gain under § 357(c) on transfer of joint venture interest where corporate transferee did not assume primary liability and transferor remained liable); Maher v. Commissioner, 469 F.2d 225 (8th Cir. 1972) (taxpayer did not recognize gain under § 304 on transfer of shares subject to liability to controlled corporation even though corporation assumed liability, since shareholder remained secondarily liable; taxpayer did realize dividend when corporation paid liability); Weeden v. Commissioner, 685 F.2d 1160 (9th Cir. 1982) (donor recognizes gain on "net gift" when transferees pay tax, not in year of transfer since donor remained liable until tax paid). The Jackson opinion has been severely limited if not overruled in Owen v. Commissioner, 881 F.2d 832 (9th Cir. 1989), cert. denied 101 S.Ct. 1113 (1990) (partnership recognizes gain on transfer to wholly owned corporation measured by full amount of liabilities not reduced for liabilities guaranteed by

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that a liability is transferred unless the transferor expressly agrees to make the required

payments as in a wrap-around note.267

When a wrap-around note is used to avoid immediate gain recognition for the

selling senior family member, the younger generation buyer obviously wants to be sure

that the wrapped indebtedness will be paid when due and may seek to make a portion of

the payments on account of the wrap note directly to the creditor. If the buyer is suc-

cessful, the wrapped indebtedness probably is transferred despite the form of the trans-

action.268

Example 4: The facts are the same as in Example 2. S may avoid the gain on

the excess of the liability over basis in the year of sale by agreeing to pay off the

mortgage himself. He receives the $150,000 down payment and a wraparound

note for the entire $2,350,000 balance. The tax results at the time of sale are the

same as for a sale of unmortgaged shares. The gross profit percentage is 32%

($800,0000/$2,500,000). Accordingly, S reports 32% of the $150,000 down

payment ($256,000) and 32% of each subsequent principal payment on the wrap-

around note as gain, even though he is obligated to use a portion of the payments

(or other funds) to pay the mortgage.

If S and B agree that B will pay directly to the mortgagee the amount of the

mortgage payments, to assure B that these payments are made, the wraparound

note is likely to be disregarded and the mortgage treated as transferred, with the

tax results described in Example 2.

partners or for which they remained liable). See also ¶ 201.3 relating to wraparound liabilities in installment sales.

267See Professional Equities, Inc. v. Commissioner, supra note 30; cf. Prop. Reg. § 1.1275-7.

268See Voight v. Commissioner, 68 T.C. 99 (1977), aff'd, 614 F.2d 94 (5th Cir. 1980); Goodman v. Commissioner, 74 T.C. 684 (1980); Lamberth v. Commissioner, 31 T.C. 302 (1958).

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A selling senior family member who does not account for the liability at the time

of the transfer has additional tax consequences if the younger generation buyer

subsequently pays the liability.269 In most cases, the buyer's payment is an additional

payment on account of the sale price, treated as a payment on account of the installment

sale,270 unless the selling senior family member has elected out or is not eligible.271 A

portion of the younger generation buyer's liability payment is likely to be interest under

the OID and unstated interest rules.272

Obligations that represent accrued expenses that have been deducted by the

selling senior family member are also part of amount realized.273 The transfer should not

invoke the tax-benefit doctrine, which treats a previously deducted item as ordinary

income when an event that is fundamentally inconsistent with the deduction occurs.274

Certain of the obligations transferred may not have been deducted or otherwise

taken into account for tax purposes by the selling family member by the time of the

269See Maher v. Commissioner, supra note 266; Weeden v. Commissioner, supra note 266; Professional Equities, Inc. v. Commissioner, supra note 30.

270See Reg. § 1.1060-1T(f) providing for allocation of adjustments in consideration.

271See ¶¶ 201.1,203.3 and 209.3 concerning election out; ¶¶ 201.9 and 207.9 concerning exclusions from the installment method.

272See ¶¶ 203.4 B B and 209.4 B B.

273See Commercial Security Bank v. Commissioner, 77 T.C. 145, (1981) (cash basis corporation which sold it assets under § 337 entitled to deduct cash basis obligations not deducted prior to sale; transfer of assets tantamount to payment since purchase price reduced to reflect obligations); Commissioner v. Allan, 856 F.2d 1169 (8th Cir. 1988) (interest and taxes accrued and deducted by partnership but paid by mort-gagee to protect its interest and added to mortgage is part of amount realized on surrender of the property in lieu of foreclosure; not ordinary income under tax-benefit principle).

274See Hillsboro National Bank v. Commissioner, 457 U.S. 1103 (1983) (tax-benefit gain recognized in former § 333 liquidation on distribution of feed properly deducted when purchased but still on hand when distributed by farming corporation; leaves open question whether gain measured by original cost or basis to shareholder). The sale is fundamentally inconsistent with the deduction. Manning, The Service Corporation--Who is Taxable on Its Income: Reconciling Assignment of Income Principles, Section 482 and Section 351, 37 U. MIAMI L. REV. 657, 672-74 (1983).

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transfer.275 These include such items as accounts payable and accrued expenses of cash

basis taxpayers, and items where deduction is subject to delay under §§ 404(a)(5) or

(d),276 461(h),277 or similar provisions.278 When these payables or similar obligations are

transferred in connection with a family sale, the obligations should be included in the

amount realized.

When obligations that have not been deducted are transferred, the corollary of

including them in the amount realized is that the selling senior family member should be

entitled to a deduction at the time of transfer,279 unless the deduction is delayed under one

of the special provisions described above. Such obligations cannot be deducted by the

buyer when paid.280 When the obligation is fixed, the delay in the selling family

members deduction may cause a similar delay inclusion in the amount realized.281 There

is no reason for a similar delay in including the liability in the buyer's basis. If the

275See § 357(c)(3) (such obligations are not liabilities for purposes of the liability over basis rule of § 357(a)); 704(c) (similar rule for partnerships); former Reg. § 1.752-1T(g) (definition of liabilities that does not include amounts that have not given rise to a deduction; this provision was deleted without explanation in the final regulations); Rev. Rul. 80-198, 80-2 C.B. 113 (applies rule similar to § 357(c)(3) prior to the effective date).

276§§ 404(a)(5) and (d) postpone deductions for amounts of deferred compensation to employees or inde-pendent contractors until the recipient includes the amount in income. § 83(f) delays the deduction for property transferred in connection with performance of services at the time the recipient recognizes in-come.

277§ 461(h) postpones deductions by accrual basis taxpayers until "economic performance" has occurred, which, in many cases means payment. See Prop. Reg. § 1.461-4(g)(i).

278See, e.g., § 267(a)(2) postponing deductions for payments to related taxpayers, and § 467 (providing for a special accrual method for certain payments for goods and services.

279See Commercial Security Bank v. Commissioner, supra note 273; Crane, Accounting for Assumed Lia-bilities Not Yet Accrued by the Seller: Is a Buyer's Deduction Really Costless?, 48 TAX NOTES 225 (1990); Shoukup, Accounting for Assumed Liabilities Not Yet Accrued by the Seller: A Response, 48 TAX NOTES 637 (1990).

280See David R. Webb Co. v. Commissioner, 837 F.2d 309 (7th Cir. 1983).

281See Prop. Reg. § 1.461-2(g)(ii)(C) (indicating that payment and inclusion in amount realized are si-multaneous).

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deduction is delayed and the selling family member dies, the deduction may be lost,282

but it should be a deduction in respect of a decedent under § 691(b).

Example 5(a): The facts are the same as in Example 2 except that the mortgage

includes $25,000 of accrued interest. The transfer of the accrued interest is as

much a transfer of a liability as the transfer of the principal obligation. S is

entitled to deduct the accrued interest at the time of the sale without regard to

when B makes the mortgage payment. B cannot deduct the interest when he

makes the payment. Instead, B's basis in the land includes the entire $1,725,000

principal plus the $25,0000 accrued interest on the mortgage.

Example 5(b): The facts are the same as in Example 5(a) except that the

$1,750,000 liabilities transferred includes an obligation to make annual payments

of $5,000 per year for five years (plus interest) to a slip-and-fall victim. The

$25,000 liability may not be deducted by S or included in basis by B at the time

of the transfer, but only when paid to the victim. S apparently includes the $5,000

payments in his amount realized and the interest payments in his income when B

makes the payments. S should be entitled to deduct the damages and interest at

the same time. B cannot deduct either the damages or the interest. Instead, the

$25,000 liability should be part of his basis from the time of the sale.

¶ 207.4 Disposition

Although the statutory language "[i]f an installment note is . . . otherwise dis-

posed of," generally requires gain recognition on any disposition of an installment obli-

gation,283 this does not apply when the installment obligation is transferred by the selling

family shareholder to a controlled corporation in a transaction under § 351 or in certain

282See Tech. Adv. Mem. 87-41-001 (Jun. 16, 1989) (hypothetical seller under § 338 election has gain at time of election with no offsetting deduction because not in existence when deduction arises at time of payment) and Tech. Adv. Mem. 89-39-002 (Jun. 15, 1989).

283See generally Hesch, Disposition of Installment Obligations by Gift or Bequest, 17 TAX MANAGEMENT EST. GIFTS AND TR. J. 137 (1991)

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other transfers in nonrecognition transactions with a transferred basis. Instead, the

deferred installment gain is transferred and reported by the transferee when the obligation

is collected or otherwise disposed of.284 If a family shareholder who made an installment

sale during lifetime dies, transmission of the obligation at death does not accelerate the

unreported gain. Instead, the unrealized gain in the installment obligation is shifted to

and eventually reported by her estate or other successor as income in respect of a

decedent that does not receive a step-up in basis at death.285 This is discussed further in ¶

207.4 B. A gift, on the other hand, is a disposition. This is discussed in more detail in ¶

207.4 A.

If the senior family member's estate uses the note to satisfy an obligation of the

estate, such as to fund a pecuniary formula marital deduction bequest, an early disposi-

tion occurs, because the estate is treated as having sold the note and the previously de-

ferred gain is immediately reported in estate income.286 The amount of gain accelerated

upon an early disposition is (a) either (i) the amount realized if the note is sold or used to

satisfy an obligation, or (ii) the value of the note, if transferred for no consideration, over

(b) the selling senior family member's remaining unrecovered basis.287 Unrecovered

basis is the excess of the face amount of the note over the income that would have been

reported if all remaining payments under the note had been received by the selling senior

family member.288

If the aggregate sales price for the selling family member's shares is more than

$150,000, the taxpayer loses the right to defer gain under the installment method for sales

284Reg. § 1.453-9(c).

285§§ 453B(c), 691(a)(4) and (5) and 1001(c); Reg. § 1.691(a)-2(b) Example (4).

286Cf. Rev. Rul. 55-159, 1955-1 C.B. 391, Shannon v. Commissioner, 29 T.C. 702 (1958).

287§ 453B(a).

288§ 453B(b).

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made beginning in 1989, to the extent that she borrows against the family buyer's

installment obligations, and pledges the installment obligations as security for the bor-

rowing.289 The provision applies to senior family members who sell family business or

financial assets for more than $150,000, even if the installment portion of the price is less

than $150,000, and may apply to selling senior family members who receive less than

$150,000 for their assets when the total price for property sold in a single transaction

exceeds $150,000.290 The theory is that since the taxpayer has the cash, she should pay

the tax. This provision is triggered only if the taxpayer gives a direct security interest in

the installment obligation. Accordingly, a selling senior family member who is able to

borrow on an unsecured basis, albeit indirectly as a result of an improved balance sheet

that includes the installment obligation, the tax is not accelerated. When the acceleration

provision applies, the loan proceeds are treated as payments on the installment obligation,

with the appropriate gross profit percentage of the loan proceeds treated as gain.

Subsequent collections on the installment obligation are tax-free until they equal the

amount of borrowing previously treated as payment.

Example 6: The facts are the same as in Example 2. In 1992 after collecting two

payments, S pledges B's note as security for a $200,000 loan. She is treated as

having received payments of $200,000 and immediately reports gain of $200,000.

She does not, however, report any additional gain when he receives the next

$200,000 in principal payments on B's note.

289§ 453A(a)(1), (b)(1) and (d).

290Cf. Prop. Reg. § 1.1274A-1(d)((2) Example (3) (aggregating sales pursuant to a tender offer for pur-poses of the $2,800,000 limitation under § 1274A(d); and Prop. Reg. §§ 1.1274-1(b)(2)(iii), 1.1274-1(b)(4)(iii) and 1.483-1(c)(2)(ii), adopting it by reference for purposes of other amount limits.

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A. Disposition by Gift

A gift of an installment obligations is an early disposition of the note within the

meaning of § 453B(a).291 On the other hand, the transfer of the note to an irrevocable

grantor trust on which the seller-grantor remains taxable on trust income under the

grantor trust rules,292 is not a disposition; the grantor is treated as the owner of the

property in trust, and since one cannot make a gift to himself, no early disposition oc-

curs.293

The fair market value of the obligation, not its face amount, determines the

amount of gain to be accelerated upon the gift. As long as the donee is not the obligor on

the note, so that the note continues in existence, it is irrelevant whether the donee is

related (in the tax sense) to the selling senior family member.

Example 7(a): The facts are the same as in Example 2. In 1996, when $300,000

of principal remains outstanding, S gives it to his son, as a gift. The donee-son is

not B, the obligor on the note. Thereafter, the son collects all remaining

payments on the note. At the time of the gift the note was worth $300,000. Since

S's basis in the note is zero, S must report the remaining $300,000 capital gain at

the time of the gift. Accordingly, the son's basis in the note is $300,000.

Therefore, the son only reports the stated interest upon collection of the payments

under the note.

Example 7(b): The fact are the same as in Example 7(a) except that at the time

of the gift the note is worth only $280,000. S must report a $280,000 capital gain

at the time of the gift. His son's basis in the note is only $280,000. Therefore, the

291See, e.g. Rev. Rul. 67-167, 1967-1 C.B. 107 (gratuitous transfer of an installment note to an irrevocable reversionary trust distributing all income for the trust term to the grantor's sister is a taxable early disposition)

292§ 677(a).

293Rev. Rul. 81-98, 1981-1 C.B. 40.

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son reports not only the interest income, but also treats the additional $20,000 of

principal on the note as income.

The note is a market discount debt obligation in the hands of the son because he

has, in effect, acquired it at a "tax cost" less than its face amount.294 Therefore,

the $20,000 represents market discount.295 All $20,000 is ordinary income,296 and

the son reports $20,000 in income ratably as the annual payments on the note are

received. In effect, $20,000 of capital gain is converted into ordinary income.

If there is a gift of a note to the obligor, the obligation becomes unenforceable

because of the state law doctrine of merger. A gift of the note to the obligor is the

functional equivalent of a cancellation.297 If an installment obligation is cancelled, it is

treated as an early disposition by gift, with one difference.298 If the buyer and the seller

are related parties,299 the fair market value of the cancelled obligation is treated as at least

equal to the face amount for purposes of determining the accelerated gain recognized on

the disposition.300 If the buyer and seller are not related parties, such as a son-in-law,

then the actual value of the note is used in computing the amount of gain accelerated

under the early disposition rule.

Example 8: The facts are the same as in Example 2 except that B, the buyer and

obligor on the note, is S's son. In 1996, when $300,000 of principal remains

outstanding on the note, S gives it to B as a gift, thereby effectuating a

294§ 1278(a)(1)(A).

295§ 1278(a)(2)(A).

296§ 1276(a)(1).

297In Rev. Rul. 55-157, 1955-1 C.B. 293, a taxable disposition occurred each time by foregoing the annual principal payments as they become due.

298§ 453B(f)(1).

299As defined in § § 453(f)(1), 318(a) and 267(b),

300§ 453B(f)(2).

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cancellation on the note. At the time of the gift, the value of the note is only

$280,000. B is a related party within the definition contained in § 267(c)(4).

Since S's basis in the note is zero (all basis was, in effect, absorbed by the out-

standing mortgage), and its value is deemed to be the $300,000 face amount, S

must report a $300,000 capital gain in 1996. The amount of the gift for purposes

of the gift tax is based on the actual value of the note, not its face amount. B's

basis in the property he purchased from S remains $2,500,000.

In either case, the actual fair market value of the note, not its principal amount,

should determine the amount of the gift for gift tax purposes. The value used to deter-

mine the gift tax should be the fair market value of the younger generation buyer's debt

obligation using market interest rates, and not the AFR at the time of the sale or the time

of death. Although § 483 states that it applies for all purposes of the Internal Revenue

Code and § 1272 contains similar language that implicitly applies to § 1274, these

provisions apply to the initial sale transaction and not to subsequent transfers.

Accordingly, the logic of the Ballard case,301 discussed in ¶ 207.4 G should not apply.302

G.C.M. 39503 recognizes that the income and estate results are not required to be

consistent when it concludes that no amount is included in the gross estate for a SCIN,

but that the deferred gain is reported as income in respect of a decedent.303

A corollary of using the lower market value in determining the amount of the gift

and the amount realized by when the seller and buyer are not related parties should be

that the buyer's basis is adjusted for the difference. The message of the Tufts case304 and

301Ballard v. Commissioner, 854 F.2d 185 (7th Cir. 1988), rev'g 53 T.C.M. (CCH) 325 (1987).

302But see Henderson, Using the Imputed Interest Safe Harbor for Intrafamily Installment Sales, 74 J. TAX'N 100, 103 (1991) (suggesting that the logic of finding no gift for the a sale of farm land using the 6% safe harbor rate might imply that principal should be used for estate tax value but recognizing that including the entire principal in the gross estate taxes value that is not real).

303G.C.M. 39503, Issues (2)(a) and (3), supra note 4.

304Commissioner v. Tufts, supra note 26; Reg. § 1.1001-2(c) Example (8); Rev. Rul. 990-16, 1990-1 C.B. 12; Rev. Rul. 91-31, 1991-20 I.R.B. 4..

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Reg. § 1.1001-2 is that the amount of a liability that has been taken into account for tax

purposes must be accounted for when the liability is discharged. If the amount of the gift

is the fair market value of the note, only that amount is entitled to exclusion under § 102.

The balance is discharge of indebtedness that must be income or purchase price

adjustment for a solvent taxpayer.305

Example 9: The facts are the same as in Example 8 except that B, the obligor is

S's son-in-law and the gift is made to B. The $280,000 market value of the note

determines the income reported by S upon the early disposition. Therefore, S

must recognize a $280,000 capital gain in 1996. B's original $2,500,000 basis in

the property he purchased is reduced by $20,000 under § 108(e)(5).

By treating the gift as only $280,000 for income tax purposes, the remaining

$20,000 on the note is discharge of indebtedness income under § 61(a)(12).306

Since the obligor on the note is also the buyer of the property, § 108(e)(5) treats

the $20,000 cancellation on the debt as a purchase price adjustment. This

treatment is necessary in order to maintain tax symmetry between B and S. If S

does not have to report $20,000 of his gain, B certainly should not get a basis with

respect to that portion of the liability that initially gave rise to that unreported

gain.

The only time a gift of an installment obligation does not trigger the early dis-

position rule is if it is a gift to a spouse while married or incident to a divorce.307 Instead,

305This may be seen more clearly by considering a situation in which a note is issued for cash. The original receipt of cash is not income because of the obligation to repay, nor is it a gift because of the note. If the note is discharged for a cash payment less than its face, there is discharge of indebtedness income even if the payment is the full fair market value of the obligation at the time of payment. See United States v. Kirby Lumber Co., 284 U.S. 1 (1931); see also Commissioner v. Jacobson, 336 U.S. 28 (1949). The same result follows if the note is cancelled as a gift and the amount of the gift is limited to the fair market value of the note; the obligor still has the cash.

306Cf. Rev. Rul. 90-16, 1990-1 C.B. 12; G.C.M. 39503, Issue (3), supra note 4.

307§§ 453B(g) and 1041(a).

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the seller's spouse, or ex-spouse, steps into his shoes, and reports the remaining capital

gain under the installment method. Even if the seller sells his installment note to his

spouse for adequate consideration, the early disposition rule does not apply because

under § 1041 even a sale to a spouse in entitled to nonrecognition.308

B. Disposition by Bequest

Unpaid amounts due on an installment note arising from a fixed payment in-

stallment sale are included in the gross estate of the selling senior family member.

1. Transfer of the note. A bequest of an installment obligation to a bene-

ficiary who continues to hold and collect on the deceased selling senior family member's

note is not an early disposition.309 Instead, the beneficiary steps into the shoes of the

deceased seller, and continues to report the gain and interest in the same manner that the

seller would have had he survived.310 Although the value of the note is included in the

selling senior family member's gross estate under § 2033 as property owned at the time of

his death, there is no tax-free step-up in basis under § 1014(a) for the deferred capital

gain. The gain deferred under the installment method is income in respect of a

decedent.311 Similarly, on a transfer of the installment obligation by the estate to a

specific or residuary beneficiary, the estate does not recognize income, but the

beneficiary does when the obligation is collected or disposed of.312 When the beneficiary

or other successor reports the capital gain upon the receipt of each installment payment,

he is eligible for an income tax deduction under § 691(c), for the estate tax attributable to

the unrealized gain in the selling senior family member's gross estate. The § 691(c)

308§ 1041(a) applies to "all" transfers between spouses; Reg. § 1.1041-1T, Q&A-2 and Q&A-12 (dealing with sales between spouses).

309§ 453B(c).

310Reg. § § 1.453-9(e) and 1.691(a)-5, and § 691(a)(3).

311§§ 691(a)(4)(A) and 1014(c); Reg. § 1.691(a)-5(a).

312 § 691(a)(2); Reg. § 1.691(a)-4(b)(3) and -5(a) and (b); Priv. Ltr. Rul. 90-07-016 (Nov. 16, 1989).

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deduction may not be as favorable as deduction of the tax on the unrealized gain as a debt

of the senior family member's estate that would apply if the gain is reported on the

decedent's final return.313

As for a gift of the installment obligation, the value of the note should be de-

termined under normal valuation principles and not fixed by the AFR either at the time of

sale or the time of death.314 The amount of the deduction for the estate tax attributable to

the gain under § 691(c) should similarly be based on the amount actually included in the

gross estate, not the principal amount.315 Any difference between the amount included in

the gross estate and the principal of the younger generation buyer's debt obligation should

not be market discount. The difference between the principal amount and the selling

senior family member's basis of the obligation is excluded from the definition of market

discount because it arose at original issue as part of the installment sale and the estate or

other successor acquires the obligation with a transferred basis.316

Example 10: The facts are the same as in Example 2. S dies in 1996 when the

unpaid principal balance of the obligation is $300,000. At the date of S's death

the AFR is 12%, which would give the notes a present value of $284,262, but a

realistic interest rate for B's debt obligation is 15%, which gives the note a present

value of $263,074. The amount that should be included in S's gross estate for B's

debt obligation is $263,074, the realistic value. Nevertheless, the entire $300,000

gain is reported by his estate or other successor as the payments are made. The

313Reg. § 20.2053-1(f).

314See ¶ 207.4 A.

315G.C.M. 39503 does not discuss the deduction under § 691(c), possibly because of its conclusion that nothing is included in the gross estate for a SCIN taxed under the installment method. But cf. Reg. § 1.753-1(b) (the entire partnership distributive share for the period in which death occurs even though only part is unwithdrawn at the date of death and identified on the estate tax return); this provision is distinguishable because the income withdrawn by the decedent is indirectly reflected by assets owned at death.

316§ 1278(a)(1)(C).

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deduction under § 691(c) should be computed using the amount actually included

in the gross estate.

A transfer of the installment obligation by either the selling senior family mem-

ber's estate or the devisee can trigger the early disposition rule.317 For example, an early

disposition can occur if the estate sells the note to raise funds to pay estate expenses or to

fund pecuniary bequests.318 A distribution to the residuary devisee is not an early

disposition by the estate.319

2. Cancellation of the obligation. If the selling senior family member

cancels the note by a clause in his will or indirectly effects a cancellation because he

bequeaths the note to the obligor, the fair market value of the note is still property in-

cluded in the selling senior family member's gross estate.320 A cancellation of a note on

the death of the seller is, however, a disposition that results in the immediate reporting of

gain previously deferred under the installment method.321

In Rev. Rul. 86-72,322 the IRS reached the questionable result that the accelerated

gain upon the cancellation of a SCIN is reported by the estate.323 A better view is that the

accelerated gain should be reported on the selling senior family member's final income

tax return.324 Under the IRS view, the "transfer" treated as an early disposition within the

317Reg. § 1.691(a)-5(b).

318Reg. § 1.691(a)-5(c) example.

319§ 691(a)(2), last sentence, and Reg. § 1.691(a)-5(b).

320Reg. § 20.2033-1(b) specifically provides that "[n]otes . . . held by the decedent are likewise included [in the decedent's estate] even though they are cancelled by the decedent's will." The rule is different for a SCIN, which expires upon the selling family member's death by its own terms. See ¶¶ 203.3 A3 and 210.3 A3.

321§ 691(a)(5)(A)(ii).

3221986-1 C.B. 253.

323§ 691(5)(A)(iii).

324See discussion at ¶ 206.1 C.

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context of § 691(a)(2) does not automatically occur at the moment of death. The IRS has

ruled that the triggering transfer, and related recognition of gain, does not occur until the

earlier of (i) the executor's assent to the distribution of the notes under state law, (ii) the

cancellation of the notes by the executor under state law, (iii) the note becoming

unenforceable, or (iv) termination of the estate administration for Federal income tax

purposes.325 In other words, state law controls when the obligations are transferred for

purposes of determining when the taxable early disposition has occurred.

Example 11: S's residuary estate passes to her child, B, including installment

notes owed her by B. Gain to the estate under § 691(a)(2) is reported in the year

in which the notes are actually distributed to B or otherwise cancelled.326

If the obligor under the cancelled note is related to the decedent-seller and the

value of the note is less than its face amount, then the amount (fair market value) in-

cluded in the gross estate for estate tax purposes is irrelevant for income tax purposes.

Instead, for purposes of determining the gain reported by the estate, the face amount of

the note is determinative.327 Thus, although the theory is different, the amount of gain

recognized is the same as for a gift.

Example 12(a): The facts are the same as in Example 2. S dies in 1996 when

$300,000 remains unpaid on the note. S leaves this note as a specific bequest to

B, the obligor on the note, who is also his son. At the date of death the value of

the note in S's gross estate is $280,000. S's basis in the note is zero. While alive

S already reported $500,000 of the $800,000 gain realized upon the sale.328 S's

estate is treated as having transferred the note for $300,000 under § 691(a)(2).

325Priv. Ltr. Rul. 85-52-007 (Sep. 18, 1985).

326Priv. Ltr. Rul. 88-06-048 (Nov. 17, 1987).

327§ 691(a)(5)(B).

328See Example 2 for 1989 through 1996.

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The estate must report the remaining $300,000 of capital gain on its fiduciary

income tax return. B's basis in the land purchased from his father should remain

at $2,500,000, on the ground the termination of the notes is a bequest, even

though S only pays $2,200,000.

Example 12(b): The facts are the same as in Example 12(a) except that B, the

obligor-buyer is S's son-in-law. S's estate must report $280,000 of capital gain

upon the effective cancellation of the note. B's $2,500,000 basis in the property

he purchased by issuing his own note is reduced by $20,000 under § 108(e)(5).329

When the fair market value of the installment obligation is more than its face

amount, the selling senior family member's estate recognizes gain measured by the value

of the note.330 The younger generation buyer should be able to increase his basis in the

property purchased by the excess of value over face amount.331 If the buyer whose note

cancelled by the selling senior family member's will is not a related party within the

statutory definition, for example, a son-in-law, the fair market value of the note is used to

determine the gain reported by the estate.332 The rule that the value of the note is not less

than its face amount only applies when the buyer is related to the selling senior family

member.333 The amount reported as income in respect of a decedent by the successor is

the excess of value over the decedent's basis in the note.334

329See ¶ 207.4 A.

330Read § 691(a)(5)(B) carefully.

331See LANE AND ZARITSKY, FEDERAL INCOME TAXATION OF ESTATES AND TRUSTS, ¶ 15.07[3][c] (1988).

332§ 691(a)(4)(A).

333§§ 691(a)(5)(B) and 453B(f)(2).

334§ 691(a)(4)(B).

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¶ 207.5 Interest Charged by the Government

If the sale price for the family business or other assets exceeds $5,000,000, or the

aggregate of different sales for the year exceed this $5,000,000 threshold, the selling

senior family member incurs an interest charge on the deferred portion of the taxes that

would have been incurred had the gain on the sale not been deferred.335 Interest is

required to be paid only if the aggregate sales price received by the senior family member

for the property exceeds $150,000 and the senior family member has total installment

obligations in excess of $5,000,000.336 Thus, whether interest is required depends on

both the amount realized by the selling senior family member (which only needs to

exceed $150,000), and whether the taxpayer has deferred gain on other installment sales

that brings his total outstanding installment obligations to more than $5,000,000. Interest

is charged only on tax allocable to the portion of the gain attributable to the excess of the

installment obligation over $5,000,000, but once an installment obligation becomes

subject to the interest charge, it remains subject, even after the taxpayer's balance of

installment receivables drops below $5,000,000.337 The interest on the tax, computed at

the top rate applicable to the year of computation,338 is nondeductible personal interest.339

¶ 207.6 Interest Deduction

Interest paid by individual family buyers for shares of a family C corporation is

investment interest deductible within the applicable limits.340 The character of interest

335§ 453A(a)(1) and (b)(2).

336§ 453A(a)(1), (b)(2) and (c).

337§ 453A(c)(4).

338§ 453A(c)(2).

339§ 163(h); Reg. § 1.163-9T(b)(2)(i) (interest on underpayments of income tax is nondeductible personal interest regardless of the source of income generating the underpayment).

340§ 163(d)(5); Reg. § 1.163-8T(b)(3); see Abbin, Interest Expense in Intrafamily Installment Sales, 74 J. TAX'N 389 (1991).

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paid by a noncorporate family buyer for shares in an S corporation or for an interest in a

partnership is determined by an allocation based on the nature of the entity's assets as

business assets, investment assets, etc.341 If a family C corporation is conducting a trade

or business, this rule may make it advisable to convert it to an S corporation prior to the

sale to avoid the investment interest limits.342 Interest paid by a family buyer that is a C

corporation under an sale or redemption agreement should be fully-deductible as business

interest.343

¶ 207.7 Original Issue Discount and Unstated Interest

The OID provisions relating to the time value of money were initially concerned

primarily with the potential for converting ordinary income into capital gain when the

principal amount was too high.344 The current concern has focused more sharply on the

distortions in the time of reporting income.345

341See Notice 89-35, Sec. IV.A, 1989-1 C.B. 675, 676.

342Reg. § 1.163-8T uses a tracing method to determine when interest is business interest, investment in-terest or personal interest.

343See § 163(d)(1) and (h) (investment interest and personal interest limits for taxpayers other than cor-porations). The 1986 Act added a provision to confirm that payments in connection with redemptions, including expenses, "greenmail" payments and the cost of standstill agreements, are not deductible. § 162(k) This provision does not deny deduction of interest on obligations issued in a redemption. The deduction may be subject to limits on interest on acquisition indebtedness and high-yield discount obli-gations. See §§ 163(e) and 279.

344See H.R. Rep. No. 1337, 83d Cong., 2d Sess. 83-84, A275-77 (1954) (original enactment of § 1232) (limiting capital gain on sale or retirement of debt obligation); H.R. Rep. No. 749, 88th Cong., 2d Sess. 72-74, A84-87 (1964) (original enactment of § 483 relating to prescribed interest on debt obligations issued for property limited capital gain and basis for the property).

345See H.R. Rep. No. 413, 91st Cong., 1st Sess. (Pt. 1) 109-10, (Pt. 2) 83-86 (1969) (amendment of § 1232 to provide ratable monthly inclusion of original issue discount); S. Rep. No. 494, 97th Cong., 2d Sess. 209-14 (1982) (amendment of § 1232 to provide for inclusion of original issue discount on a daily compound-interest basis); H.R. Rep. No. 432, 98th Cong., 2d Sess. (Pt. 2) 1241-51 (1984) (extension of the daily compound-interest inclusion to transactions in property and related changes; see §§ 163(e), 483, 1274 and 1974); S. Rep. No. 83, 99th Cong., 1st Sess. 1, 13-19, and 24 (1985) (on simplification of imputed interest rules, modifying interest inclusion on transfers of property).

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A. Issue Price of Obligations Issued for Family Corporation Shares

(or Other Property)

The first of the key concepts in measuring OID is the issue price of the family

buyer's debt obligations. In deferred payment sales of nonpublicly-traded family busi-

ness shares or other financial assets for debt obligations that are also not publicly traded,

the issue price is determined by the AFR.

The AFR for obligations of $2,800,000 or less issued in a sale of family business

shares (and other property) have a maximum prescribed rate of 9 per cent.346 Beginning

in 1990, the $2,800,000 threshold is adjusted for inflation.347 The $2,800,000 is based on

the total sale price in a transaction, not the price received by each selling senior family

member.348 In the highly unusual case when either the family business shares or the

family buyer's debt obligations are publicly traded (generally meaning that there is no

installment sale),349 the market prices determine the sale price of the shares and the

related issue price of the family buyer's debt obligation.350

B. Redemption Price

All payments, whether labelled principal or interest, become stated redemption

price. Similarly, because contingent payments cannot provide for steady interest, any

346§ 1274A(a) and (b); Prop. Reg. § 1.1274A-1(a) and (b). There is no longer any penalty for failing to provide explicit interest at the prescribed rate. All debt instruments that are part of the same transaction are aggregated in determining the $2,800,000 maximum amount. § 1274A(d)(1)(B); and Prop. Reg. § 1.1274A-1(d).

347§ 1274A(e); Prop. Reg. § 1.1274A-1(e). The limit for 1992 is $3,234,900. Rev. Rul. 92-6, 1992-6 I.R.B. 4.

348Prop. Reg. § 1.1274A-1(d)((2) Example (3) (aggregating sales pursuant to a tender offer for purposes of the $2,800,000 limitation).

349See ¶ 201.9.

350§ 1273(b)(3); Prop. Reg. § 1.1273-2(c)(1).

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contingent payments of purchase price more than one year after closing also inevitably

involve OID, whether or not there is public trading.351

Example 13: The facts are the same as in Example 2 except that the first in-

stallment payment is not due until 1992. The amount of the payment will

$226,000, which includes compound interest at 10% for two years as well as two

years' principal payments. Although the required interest exceeds the AFR, the

interest holiday means that none of the interest payments are qualified interest.

The total amount of the payments in the years 1992 through 2002 are redemption

price. Because interest is above the AFR, the stated principal of $600,000

determines the sale price. Interest at 10% accrues for both S and B during 1991

and 1992.

If the 1992 payment is only $215,000 including only simple interest for the two

years, the stated principal amount still determines the sale price, but the presence

of OID means that the true yield on the obligation must be computed and interest

at that rate accrued for 1991 and 1992 as well as all subsequent years. The true

yield is about 9.675%.

C. Effect of AFR

When the family acquisition agreement provides for interest at less than the AFR,

the amount of the family buyer's debt obligation, discounted at the AFR, and not the

principal amount of the obligation, determines both the selling price of the family

financial assets and the basis of property to the family buyer. If the family buyer's de-

ferred payment obligations (that are not traded) are issued for family business shares or

other financial assets (that are also not traded), and provide interest at a rate at least equal

to the AFR (whether or not annually), the amount of the debt and the basis of the

351See Prop. Reg. § 1.1275-4 (c) to (f); see ¶¶ 203.4 A and 203.4 B.

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property is face;352 if interest is payable at less than the AFR, the amount of the debt and

the basis of the property is determined by discounting, using the AFR.353

Example 14(a): The facts are the same as in Example 2 except the note

provides for interest at a compound annual rate of 8.5% on the unpaid balance of

principal. The interest is to be paid at the time of each principal payment. If the

annual AFR is 8.5 per cent or less, there is adequate stated interest because the

discounted present value of the payments, including the deferred payment of

interest at 8.5%, is at least $600,000. The nominal purchase price of $2,500,000

is the sale price. All parties treat the stated interest as interest for all tax purposes.

Example 14(b): If the AFR is more than 8.5 per cent, for example, 9 per

cent, the selling price is determined by discounting all payments of principal and

interest at 9 per cent. The $586,133 discounted value of the installment

obligation determines the selling price. See Example 15 infra, for a description of

the interplay of OID and the installment method on these facts.

D. Effect of OID

When the stated interest is at a rate below the AFR or there is any interest or

principal holiday, the OID rules may require reporting more interest than the amounts

paid. Thus, if there is OID the selling senior family member may have significant in-

terest income to report even though he does not receive cash to use to make payment.

This is, of course, a major advantage to the family buyer who receives a deduction

without payment of cash.

Example 15: The facts are the same as in Example 14(b). There is OID because

the stated interest rate is less than the AFR. The reallocation of the payments and

the reporting of OID and interest and of the adjusted principal is as follows:

352But see Prop. Reg. § 1.1274-1(d) (providing for possible adjustment for excessive interest); see ¶¶ 201.7 C and 207.7 C.

353See 1984 BLUE BOOK at 118-19.

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Total Stated Stated Interest Adjusted Year Payment Interest Principal and OID Principal 1991 -0- -0- -0- $ 52,752 -0- 1992 $206,335 $106,250 $100,000 57,500 $ 96,083 1993 92,500 42,500 50,000 44,104 48,396 1994 88,250 38,250 50,000 39,749 48,501 1995 84,000 34,000 50,000 35,384 48,616 1996 79,750 29,750 50,000 31,008 48,742 1997 75,500 25,500 50,000 26,621 48,879 1998 71,250 21,250 50,000 22,222 49,028 1999 67,000 17,000 50,000 17,810 49,190 2000 62,750 12,750 50,000 13,383 49,367 2001 58,500 8,500 50,000 8,940 49,560 2002 54,500 4,250 50,000 4,479 49,771 Totals $940,085 $340,085 $600,000 $353,392 $586,133

The selling price is $2,486,133 determined by valuing the deferred payments at

the AFR. Accordingly, the gross profit is $786,133. If the mortgage did not

absorb all of S's basis, the gross profit ratio would be computed using the

$2,486,133 selling price determined using the AFR not the nominal price of

$2,500,000. The gross profit ratio would then be applied to the adjusted principal

payments determined above.

In the calculation in Example 14(b), the issue price of the younger generation

buyer's debt obligation is determined derivatively by discounting the payments provided

in the sale agreement at the AFR. When the issue price is determined directly because

the property transferred is publicly traded, either shares in a family-controlled business

that is also publicly traded,354 or other financial assets that include publicly-traded

securities, the issue price is determined directly and the AFR does not apply to determine

the amount of OID.355 Under the proposed OID regulations, when a series of obligations

with OID is purchased for a single consideration, it is necessary to determine the yield to

maturity of the series of obligations, that is the interest rate that matches the issue price

354Shares of a family corporation are not publicly traded if the control premiums or blockage discounts are properly involved. Prop. Reg. § 1.1273-2(c)(1).

355§§ 1273(b) and 1274(c)(3)(D); Prop. Reg. §§ 1.1273-2(c)(c)(1) and 1.1274(b)(5).

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with the series of payments.356 When the terms of payment for the family business

provide for equal payments, standard compound-interest tables or formulas provide the

yield. The difficulty arises when there are irregular payments, as a result of an interest

holiday, a balloon payment or otherwise. For such cases, we have found that the IRR

(internal rate of return) function of Lotus 1-2-3 and, presumably, similar functions in

other spread sheet or financial programs, can provide the required yield.

Example 16: S sells family financial assets consisting of publicly-traded secu-

rities to B. The securities have a quoted market price of $750,000. The terms of

the sale provide for payments of $100,000 a year for 9 years and a final payment

of 500,000 for the tenth year. S cannot use the installment method because the

securities are publicly traded. Using the IRR function, the interest rate is

10.47062%. The components of the payments are as follows:

Total Year Received Principal Interest

1991 $ 100,000 $ 21,470 $ 78,530 1992 100,000 23,718 76,282 1993 100,000 26,202 73,798 1994 100,000 28,945 71,055 1995 100,000 31,976 68,024 1996 100,000 35,324 64,676 1997 100,000 39,023 60,977 1998 100,000 43,109 56,891 1999 100,000 47,623 52,377 2000 500,000 452,609 47,391

Totals $1,400,000 $750,000 $650,000

Gain or loss on the sale or exchange of a family buyer's debt obligation is capital

gain or loss.357 If an individual younger family member's debt obligation is retired for an

amount greater or less than its adjusted issue price, the gain or loss is ordinary income or

356Prop. Reg. § 1.1272-1(f).

357Prop. Reg. § 1.1271-1(b)(2).

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loss,358 but gain or loss on a corporate family buyer's debt obligations, to extent not

treated as ordinary income under the OID rules, is generally capital gain or loss.359 Thus,

if there is a change in interest rates, the selling senior family member realizes the change

in value of the family buyer's debt obligations as a investment gain or loss, not as an

adjustment in interest. A purchaser of a debt obligation, or the successor to deceased

holder who acquires the obligation with a date of death basis, on the other hand, has

market discount or premium for the difference between the price paid for the obligation

and its redemption price. Market discount is amortized over the life of the obligation on

a straight-line basis unless the holder elects to amortize it on a compound-interest

basis.360 It produces ordinary income on sale, exchange or retirement of the debt

obligation (including an exchange under § 351361) unless the holder elects to amortize it

while the bond is being held.362 This election may be useful because interest to carry

market discount bonds is deferred until the discount is taken into income.363 Market

premium is amortizable to reduce the interest income but only if an election is made.364

Example 17: The facts are the same as in Example 2 except that in 1993 when

the principal balance is $450,000, S sells the debt obligation for $420,000, re-

flecting an increase in interest rates to approximately 12%. S recognizes the

remaining gain on the installment sale of $450,000. As a result, S's basis for B's

note increases to $450,000, and S realizes an $30,000 capital loss on the sale.

358§ 1271(b)(1); Fairbanks v. United States, 306 U.S. 436 (1939) (no sale or exchange on retirement of debt obligations prior to enactment of predecessor of § 1271).

359§ 1271(a)(1).

360§ 1276(b).

361§ 1276(d)(1)(C).

362§ 1278(b).

363§ 1277.

364§ 171; see ¶¶ 201.7 H and 207.7 H.

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The purchaser's basis in the note is $420,000. The $30,000 difference between

the basis and the principal of the note is market discount. The market discount

can be amortized ratably at the rate of $3,333 for each $50,000 principal payment,

or it can be amortized on a compound-interest basis, in which case, the character

of each payment is as follows:

Total Stated Market Basis Year Payments Interest Discount Recovery

1994 $ 95,000 $ 45,000 $ 5,226 $ 44,774 1995 90,000 40,000 4,872 45,128 1996 85,000 35,000 4,475 45,525 1997 80,000 30,000 4,031 45.969 1998 75,000 25,000 3,534 46,466 1999 70,000 20,000 2,977 47,023 2000 65,000 15,000 2,354 47,646 2001 60,000 10,000 1,656 48,344 2002 55,000 5,000 875 49,125

Totals $675,000 $225,000 $30,000 $420,000

E. Small Transactions

The $250,000 and $2,000,000 small transaction amounts are determined by ag-

gregating debt instruments in the same transaction, and is adjusted for inflation beginning

in 1990.365

Example 18: S sells shares of a family corporation to B for $1,000,000. The

purchase price is payable in a lump sum at the end of five years with simple in-

terest at 8% payable annually. If the AFR is 9%, the discounted selling price at is

$961,103. Under the cash basis election, both parties report only the $80,000

interest paid in cash each year during the first four years and report the $38,898 of

OID in the year of final payment. If the election is not made, S reports OID

income and B deducts OID as follows:

365§ 1274A(d) and (e); Prop. Reg. § 1.1274A-1(d) and (e). The 1992 amount is $2,310,600. Rev. Rul. 92-6, supra note 347.

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Stated Year Interest OID Total

1 $ 80,000 $ 6,500 $ 86,500 2 80,000 7,085 87,085 3 80,000 7,722 87,722 4 80,000 8,417 88,417 5 80,000 9,174 89,174 Total $400,000 $38,898 $438,898

F. Liability Transfers

The OID rules generally do not apply to liability transfers.366 This can create

exactly the type of distortion the OID rules are designed to prevent. If the transferred

liability was originally issued with OID, the amount of the transferred liability is the

original issue price as modified for any amortized discount.367 The same principle should

apply if the obligation was originally issued at a premium.368

Example 19: The facts are the same as in Example 1. The $1,750,000 mortgage

was taken out several years ago when interest rates were only 8%. At present

interest rates of 10% the mortgage has a present value of approximately

$1,525,0000. Accordingly, the true economic purchase price is only $2,375,000.

Nevertheless, under the OID and unstated interest rules, the mortgage is valued at

$1,750,000 so that there is no OID. The sale price used in determining S's gain

and B's basis is $2,500,000.

The basic justifications for tolerating this distortion appear to be administrative

convenience, the lack of an offsetting deduction for any OID for the mortgage lender or

other creditor, and the absence of the potential for the extreme distortions because the

changes in value are limited by changes in market rates of interest.369 If the terms of the

366§ 1274(c)(4); Prop. Reg. § 1.1274-7; see ¶ 201.7 F.

367Prop. Reg. § 1.1274-7(d).

368See Commissioner v. Tufts, supra note 26.

369See Lokken, supra note 47, at 155-58.

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mortgage or other liability are changed as part of the sale transaction, perhaps as a result

of a negotiation required to obtain creditor consent, OID can result.370

G. Unintended Gift for Gift Tax Purposes

A family seller (and buyer) avoids the OID and unstated interest rules, as long as

the terms of the sale provide stated interest at least equal to the AFR.371 A stated interest

rate of, for example, 10% avoids imputed interest whenever the AFR is 10% or less.

Indeed, for small transactions, a stated interest rate of 9% avoids imputed interest even

when the AFR is higher.372

This may not, however, guarantee that there has not been a transfer for inadequate

consideration for gift tax purposes, because § 7520(a)(2) requires that a discount rate

equal to 120% of the midterm AFR (apparently without the 9% maximum) be used in

valuing annuities and term interests. Thus, if the mid-term rate is 10%, a discount rate of

12% is used in valuing the family buyer's obligation if it is determined to be an "annuity"

or "term interest." Although these terms are not defined in the Code, it is possible that

even a fixed installment obligation is a term interest. As discussed in ¶ 201.7 G, the

better argument is that it is not. If the note is a term interest, there probably is no gift

when the transaction satisfies the bona fide business transaction exception, an intent

test.373 If neither argument is accepted, and it well may not be in family situation, the

adequacy of the consideration may be measured under § 7520.

Example 20: The facts are the same as in Example 3 in which S financed a

$600,000 balance for 12 years at 10% interest, providing level annual payments

of $88,058. Under the AFR of 10%, the discounted value of the payments is the

370§ 1274(c)(4); Prop. Reg. § 1.1274-7.

371See ¶¶ 201.7 C and 207.7 C

372See ¶¶ 201.7 E and 207.7 E.

373Reg. §§ 25.2511-1(g)(1) and 25.2512-8.

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same as the $600,000 stated principal. If gift tax valuation requires use of a 12%

rate (120% of the AFR (ignoring any differences between the mid-term and long-

term AFR)), the factor is 6.1944,374 and the gift tax value of the obligation is only

$545,466 (6.1944 x 88,058). This in turn means that there is a taxable transfer of

$54,534 ($600,000, value of the property, - $545,466, discounted value of the

payments). If the S wishes to avoid the gift tax risk, he must use a 12% stated

interest rate. As applied to a level payment arrangement, this increases the annual

payment to $96,862 ($600,000/6.1944). The additional annual payment of $8,804

is taxed as additional interest. On the other hand, discounting the annual

payments of $96,862 at 10% gives a present value of $659,896 ($96,862 x

6.8132, the discount factor used in Example 3). Thus, in one sense, B has been

forced to pay $59,896 more than the property is worth, if 10% is an appropriate

borrowing rate.

This potential distortion is inevitable as long as § 7520 uses 120% of the AFR to

value future payments. An issue not adequately addressed is when it is appropriate to use

the AFR (income tax discount rates) to determine whether a gift has been made for

purposes of the gift tax. In other words, under what circumstances can the valuation

rules under § § 1274 and 483 override the valuation rules mandated by § 7520?375 When

the ordinary business transaction approach applies, as G.C.M. 39503 indicates is

appropriate for transactions taxed as installment sales, the AFR governs.376 On the other

hand, the G.C.M. insists the transfer tax tables apply when the transaction is taxed as an

annuity. Even so, the IRS indicated in G.C.M. 39503 that factors other than the actuarial

tables may be considered in appropriate cases.

374See ALPHA VOLUME, supra note 162, Table B, 12.0%, page 3-25.

375Cohen v. Commissioner, 92 T.C. 1039 (1989); Ballard v. Commissioner, supra note 301. See discussion of the Ballard and Cohen cases, infra at notes 378 and 379, indicating that for installment sales the interest rate applied in § 483 is used to value the installment note for gift tax purposes.)

376G.C.M. 39503, Issue (2)(B), supra note 4.

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Two recent cases involving intrafamily sales that occurred in 1981, when the then

version of § 483 provided that there was no imputed interest if stated interest was at least

6%. Actual market interest rates in 1981 were significantly higher, a factor that is partly

responsible for the present versions of §§ 483 and 1274. The IRS argued that it was not

bound by the § 483 rate for gift tax purposes, and used an 11% rate in the Krabbenhoft

case,377 and an 18% rate in the Ballard case.378 Although it is possible that the parties

used the lower § 483 rate to convert ordinary income into capital gain, it is apparent that

they also intended to use obligations with a value less than their face amount. The court

of appeals in Ballard held that the § 483 rate applied for all purposes of the Code and

refused to find a gift, but the appellate court in Krabbenhoft upheld the IRS. More

significantly, in the Cohen case,379 the court upheld use of realistic interest rates and

disregarded the transfer tax tables in valuing an interest-free loan. At one level, the IRS

position, upheld in Krabbenhoft and Cohen, although rejected in Ballard, is that it is not

bound by use of unrealistic specified rates, particularly income tax rates, in determining

gift tax values. In a broader sense, however, the cases may stand for the proposition that

economic reality, not prescribed rates, should determine the gift tax consequences. The

question is whether the AFR rates or the § 7520 rates more closely reflects that reality. A

substantial argument can be made that to the extent that a transaction is taxed as a sale,

the AFR, which is now based on current interest rates, albeit ones that are consciously

less than most taxpayers could obtain, should nevertheless control. Interestingly, the IRS

has recently argued, in a case arising before the enactment of § 2702, that it could

377Krabbenhoft v. Commissioner, 939 F.2d 529 (8th Cir. 1991), aff'g 94 T.C. 887, cert. den. Jan. 27, 1992..

378Ballard v. Commissioner, 53 T.C.M. (CCH) 325 (1987), rev'd, 854 F.2d 185 (7th Cir. 1988).

379Cohen v. Commissioner, 910 F.2d 422, aff'g 94 T.C. 887 (1990); see also Estate of Arbury v. Com-missioner, 93 T.C. 136 (1989) (interest rate on noninterest bearing loans not limited by state's usury rate); Tech. Adv. Mem. 87-01-002 (Sep. 19, 1986).

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disregard the transfer tax valuation tables in valuing a retained income interest.380

Although it lost, it has appealed to the same circuit that decided Krabbenhoft.

H. Premium

Although there is apparently no authority relating to whether premium can arise

in the sale of a family business. Before the current express provisions relating to OID

were adopted, there was a split of authority whether OID could arise when debt obliga-

tions were issued for property.381 To add to the confusion, the IRS has ruled that an

accrual method senior family member must take the face amount of the family buyer's

obligation into income, implying that a cash basis taxpayer can use the fair market value

of the obligation.382 Although taxpayers have frequently claimed that obligations have a

fair market value below the face amount, no case has been found in which the taxpayer or

the IRS has claimed a value above face. Finally, the OID proposed regulations contain a

provision permitting the IRS to recharacterize as purchase price, a portion of the interest

if the IRS determines that the interest rate is excessive.383 These regulations indicate that

380O'Reilly v. Commissioner, 95 T.C. 646 (1990), appeal filed, Mar. 2, 1991, 8th Cir. see also Tech. Adv. Mem. 91-33-001, (Jan. 31, 1990) (since death was imminent and would most likely occur within one year, the IRS ignored the transfer tax actuarial tables in valuing the younger generation buyer's private annuity obligation and used the facts and circumstances to value it).

381Discount was permitted in American Smelting and Refining Co. v. United States, 130 F.2d 883 (3d Cir. 1942) (debt obligations issued for issuer's own stock; before Commissioner v. National Alfalfa De-hydrating & Milling Co., 417 U.S. 139 (1974) (finding no OID in exchange of the issuers $50 debt obli-gations for the issuer's outstanding preferred shares initially issued for $50); and Nassau Lens Co. v. Commissioner, 308 F.2d 39 (2d Cir. 1962) (debt obligations issued in transaction under § 351; remanded for determination of values; transferred basis), but rejected in Montana Power Co. v. United States, 332 F.2d 541 (3d Cir. 1956) and 159 F. Supp 593 (Ct. Cl. 1958) (debt obligations issued in tax-free reorga-nization; discount claimed using transferred basis; no evidence that value of assets less than face of debt) and Southern Natural Gas Co. v. United States, 412 F.2d 1222 (Ct. Cl 1969) (debt obligations issued for property; IRS conceded that face of debt governed basis of property until Code amended to require trans-ferred basis); cf. § 171(b)(4) (limiting amortizable premium on debt obligations received in exchanges where there is a substituted basis in whole or part to the fair market value of the debt obligation; this prevents conversion of an unrecognized, possibly capital loss, into a currently deductible item).

382Rev. Rul. 79-292, 1979-2 C.B. 287. See Mieves, Revenue Ruling 79-292 and Deferred Reporting, 36 U. MIAMI L. REV. 175 (1981); Goldberg, Open Transaction Treatment for Deferred Payment After the Installment Act of 1980, 34 TAX LAWYER 605 (1981). The ruling does not address the buyer's basis.

383Prop. Reg. § 1.1274-1(d).

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the excess may be determined on the basis of the fair market value of the property or an

arm's-length interest rate, and, further, indicates that the relative tax effect to the parties

from the overstatement is a major factor. If the regulation provision applies, the effect is

to treat the recharacterized portion as premium, but the regulations do not state this, or

refer to the possible amortization. The regulation is an anti-tax-avoidance provision, and

does not provide general authority on premium in sales of shares under family sale

agreements (or otherwise). The 1986 Act placed premium amortization on a compound-

interest basis, by express cross reference to the accrual methods under § 1272.384 When

the premium provisions apply, they make no distinction between original issue and

market premium.385

Example 21: S sells family financial assets consisting of publicly-traded secu-

rities to B. The securities have a quoted market price of $650,000. The terms of

the sale provide for principal payments of $50,000 a year for ten years plus

interest at 12%. Because market interest rates are only 10%, B's obligation is

worth $650,000 even though the stated principal amount is only $600,000. It is

not clear if the excess of the value of the financial assets over the principal

amount of the debt obligation gives rise to amortizable premium. If it does not,

S's amount realized and B's basis for the property is probably determined by the

$600,000 face of the notes. Even if S is a cash basis taxpayer generally required

to use the fair market value of debt obligations, valuing the B note at $650,000 is

inconsistent with a determination that there is no amortizable premium. S must

report gain in the year of sale and not under the installment method, because the

family financial assets are publicly-traded securities.

384§ 171(b)(3). The legislative history, which treats this as a technical correction, gives no indication why the other concepts relating to issue price and redemption price are not adopted.

385§ 171; Reg. § 1.61-2(c). Compare ¶ 207.7 D.

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If the legal conclusion is that there can be amortizable premium, the amount re-

alized by S for the assets is $650,000. If B is an accrual basis taxpayer, he

routinely amortizes the discount as a reduction of his interest deduction. S has an

election to amortize the premium. If she does not, she has a capital losses

aggregating $50,000 when the debt obligations are paid. If she does, the prin-

cipal, interest and amortized premium are as follows:

Total Payments Stated Amortized Year Received Principal Interest Premium

1991 $ 122,000 $ 50,000 $ 72,000 $ 6,563 1992 116,000 50,000 66,000 6,257 1993 110,000 50,000 60,000 5,921 1994 104,000 50,000 54,000 5.551 1995 98,000 50,000 48,000 5,143 1996 92,000 50,000 42,000 4,694 1997 86,000 50,000 36,000 4,201 1998 80,000 50,000 30,000 3,657 1999 74,000 50,000 24,000 3,059 2000 68,000 50,000 18,000 2,400 2001 62,000 50,000 12,000 1,676 2002 56,000 50,000 6,000 878 Total $1,068,000 $600,000 $468,000 $50,000

The amortized premium is a reduction in the interest taxable to S, and deductible,

within applicable limits, by B.

If neither the family financial assets, nor the B debt obligations, are publicly

traded, but the parties can establish the fair market value, the results relating to

premium should be the same. The premium provisions make no distinction based

on the presence or absence of public trading. If there is no public trading, the sale

should qualify for reporting under the installment method. If there is premium,

the selling price should be $$650,000. S's higher gain is offset by the

amortization of the premium that reduces her interest income on the B debt

obligations.

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¶ 207.8 Convertible Obligations

Debt obligations convertible into shares of a family corporate buyer can qualify

for installment sale treatment in the same manner as straight debt obligations. Con-

vertible obligations convertible into shares that are readily tradeable on an established

securities market can qualify under the installment method as long as the obligations are

not themselves so traded. The regulations provide a safe harbor for obligations that are

not convertible for one year from date of issue.386 They also provide a more general

exception for obligations convertible at a substantial discount.387 Although conversion of

a convertible security is normally not a recognition event,388 the IRS has ruled that the

entire value of shares received on conversion is a taxable disposition of an installment

obligation.389 Unlike the OID rules, when a corporate family buyer's debt obligation is

convertible, the value of the conversion privilege is excluded from any amortizable

premium.390

Example 22: S sells to B, a family corporation, shares worth $1,000,000 that

have a basis of $100,000 and receives a B convertible debenture with a principal

amount and value of $1,000,000. S subsequently converts the debenture into B

shares with a value of $2,500,000. Under the IRS view, the entire $2,500,000

value of the B shares, not the $1,000,000 principal amount and selling price is the

amount S receives on disposition of the installment obligation so that he reports

gain of $2,400,000, not $900,000 (or zero) at the time of the conversion. S's gain

386Temp. Reg. § 15A.453-1(e)(5)(ii).

387Id. A substantial discount exists if the value of the shares is less that 80% of the value (not the principal amount) of the obligation. Apparently the value of the obligation does include the value of the conversion privilege.

388Rev. Rul. 72-265, 1972-1 C.B. 222; see Fleischer and Cary, The Taxation of Convertible Bonds and Stock, 74 HARV. L. REV. 473, 476-88 (1961).

389Rev. Rul. 72-264, 1972-1 C.B. 131; G.C.M. 34595 (Aug. 25, 1971).

390§ 171(b)(1); Reg. § 1.171-2(c). See ¶¶ 201.8 and 207.8.

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does not affect B's basis in the family corporation shares (if the sale is not a

redemption by B of its own shares). S's basis in the shares received on conversion

is $2,500,000.

The full market price or AFR issue price of convertible debt obligations of a

family corporate buyer is the issue price for OID purposes; the conversion privilege is not

separately valued to give rise to OID.391 If, on the other hand, the family buyer's debt

obligation is part of bond and warrant or bond and stock package, value is separately

assigned to the stock or warrants issued as part of a package, even if the debt obligation

may be used to pay the exercise price for the warrant.392 This may cause OID or unstated

interest if the remaining consideration allocated to the family buyer's debt obligation is

less than the stated redemption price.

¶ 207.9 Exclusions

There is no installment recognition of loss.393 Inventory assets, depreciation re-

capture and marketable securities do not qualify for installment sale treatment,394 as are

dispositions by dealers in personal property or real property (with an exception for dis-

positions of farm property, unimproved residential lots and time shares).395 Although not

expressly excluded, it is likely that tax benefit items are also not eligible because the sale

is "fundamentally inconsistent" with the prior deduction that gives rise to the tax benefit

problem.396

391Prop. Reg. § 1.1273-2(e); Lokken, supra note 47 at 30.

392Prop. Reg. § 1.1273-2(d); Lokken, supra note 47 at 29-30.

393See Rev. Rul. 68-13, supra note 87.

394§ 453(b)(2), (i) and (k)(2). Similarly, unamortized market discount is recognized. § 1276(a)(2).

395§ 453(l).

396See Hillsboro National Bank v. Commissioner, supra note 274; Manning, supra note 274.

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Reporting the recapture income increases the selling senior family member's basis

in the younger generation buyer's debt obligation for purposes of determining the gross

profit ratio under the installment method for the remainder of the gain. When the

younger generation buyer takes over the selling senior family member's liabilities in a

deferred payment sale of an asset with potential depreciation recapture income, the in-

crease in the seller's basis resulting from the immediate reporting of the recapture income

may reduce or even eliminating the "deemed" payment of cash that occurs when the

liability transferred exceeds the seller's basis in the property sold.

Example 23: The facts are the same as in Example 2 except that the asset sold is

improved real estate depreciated using an accelerated method. (The building was

acquired by S prior to 1987.) The real estate has $125,000 of depreciation

recapture.

S must report as gain on the sale $125,000 of ordinary income in 1989, the year of

the sale. For purposes of determining the gross profit ratio applied to "all"

payments received under the sales contract, S's basis in the asset is increased by

the $125,000 of recapture income that was not eligible to be deferred under the

installment method. With a redetermined basis of $1,825,000, the gross profit is

now $675,000. The entire $1,750,000 mortgage reduces the $2,500,000 sales

price to arrive at a $750,000 contract price. Since the mortgage does not exceed

S's basis, as redetermined, no fictional payment of cash occurs. The resulting

90% gross profit ratio ($675,000/$750,000) is applied to the $150,000 down

payment and $600,000 of principal payments on the note so that the $675,000 of

the § 1231 or capital gain realized on the sale is reported under the installment

method. The total gain on the sale remains at $800,000. The timing of this gain

has changed because $125,000 of the gain is not eligible for the installment

method.

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¶ 207.10 Part-Sale, Part Gift

When a transaction is part-sale, part gift, the senior family member can apply her

entire basis against the sale price,397 but usually cannot recognize a loss if the basis

exceeds the consideration received.398 The younger generation buyer can, however,

reduce any subsequent gain by the loss denied the senior family member.399 Similarly,

the younger generation buyer's basis in the property generally is the greater of the price

paid or the transferor's basis limited by the fair market value of the property.400 When the

selling senior family member has a basis greater than the value of the property and the

purchase price, the younger generation buyer's basis in the property is split, with the

selling senior family member's basis for purposes of determining gain but the fair market

value for purposes of determining loss.401 When there is a split basis, the gain basis is

used to determine depreciation,402 although this appears inconsistent with using the split

basis to determine loss for the younger generation buyer. Any gift tax paid can increase

the buyer's basis up to, but not beyond, the fair market value of the property.403 The

senior family member's gift tax should not increase the buyer's basis if it is determined by

the purchase price even when the purchase price is less than the fair market value of the

property, because the adjustment is treated as an increase in the transferor's basis.404

397§ 1011(a); Reg. § 1.1001-1(e).

398§ 267(a)(1); Reg. § 1.100-1(e) Examples (2) and (4).

399§ 267(d); Reg. § 1.267-1(a).

400§ 1015(a); Reg. § 1.1015-4

401Reg. § 1.1015-4(b) Example (4).

402§ 167(g); Reg. § 1.167(g)-1.

403§ 1015(d); Reg. § 1.1015-5

404§§ 1015(d) and 1016(b); Reg. § 1.1015-5(c).

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Example 24(a): The facts are the same as in Example 2 except that B's notes are

only for $350,000. S has made a gift of $250,000. Her gain is only $550,000, (amount

realized of $2,250,000 ($1,750,000 mortgage, $150,000 cash and $350,000 notes) -

$1,700,000 basis. S does not allocate any of her basis to the gift. B's basis in the

property is $2,250,000.

Example 24(b): The facts are the same as in Example 24(a) except that S's basis

in the property is $2,400,000 and the fair market value of the property is $2,300,000. S

does not realize a loss on the sale and has made a gift of $50,000. B's basis in the

property is $2,400,000 for purposes of determining gain and depreciation. It is only

$2,300,000 for purposes of determining loss on a subsequent sale so that if B sells the

property for $2,350,000 he realizes neither gain nor loss.

Example 24(c): The facts are the same as in Example 24(b) except that the fair

market value of the property is $2,250,000. S cannot deduct any loss. There is no

gift and B's basis in the property is the purchase price of $2,250,000 for purposes

of determining gain, loss and depreciation. If B subsequently sells the property

for $2,350,000, he can offset S's nondeductible loss and report no gain. If the

property is depreciable, B is worse off having paid full value for the property than

if he had received a part gift.

When a transaction is a part-sale, part-gift, it is difficult to find that it satisfies the

bona fide business transaction rule for gift tax purposes. Nevertheless, the note given in

the sale portion of the transaction should be valued under the OID and unstated interest

principles, not under § 7520.405

405See ¶ 201.7 G.

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¶ 208 Private Annuity Sale Obligations

¶ 208.1 Tax Treatment of Annuities in General

An individual who saves by depositing money in a bank savings account must

report the interest earned each year under the doctrine of constructive receipt even if no

withdrawals are made. Even an individual who buys a long-term certificate of deposit

where early withdrawal incurs a penalty must report interest as earned under the OID

rules.406

Example 25: A deposits $2,460.80 in a bank savings account on January 1,

1990. The bank pays 10.6% annual interest. A intends to withdraw $1,000 an-

nually for the next three years beginning on December 31, 1990. The following

illustrates the interest income earned each year:

Deposit on January 1, 1990 $2,461 Interest at 10.6% for 1990 + 261 Withdrawal on December 31, 1990 -1,000 Balance on January 1, 1991 $1,722 Interest at 10.6% for 1991 + 182 Withdrawal on December 31, 1991 - 1,000 Balance on January 1, 1992 $ 904 Interest at 10.6% for 1992 + 96 Withdrawal on December 31, 1992 -1,000 Balance -0-

When the individual saves by purchasing an annuity, the implicit interest in the

internal buildup in the policy is not taxed currently.407 The doctrine of constructive re-

ceipt does not apply because the annuitant does not have a right to withdraw as the in-

terest is earned.

406Prop. Reg. § 1.1275-1(b).

407See ¶ 202.1. Cf. § 56(g)(4)(B)(ii) including such internal buildup in determining the adjusted current earnings adjustment for purposes of the corporate alternative minimum tax.

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The basic mechanism for taxing annuities is to allocate each payment between

basis recovery and income on a straight line basis by use of the "exclusion ratio,"408 the

fraction determined by dividing the annuitant's "investment in the contract"409 by the

"expected return,"410 that is, the total of the undiscounted payments to be made.411 If all

payments to be made are not subject to any contingencies, then the guaranteed number of

payments is used to determine the expected return.412 If there is a contingency, such as

payments to be made for the rest of the annuitant's life, then the life expectancy of the

annuitant at the "annuity starting date" is the multiple used to determine the expected

return.413 The annuity starting date is the date in the future the annuity payments are to

commence.414 The life expectancy multiples to be used in determining the expected

return are prescribed in the Regulations under § 72.415

Example 26: B purchases an annuity on January 1, 1990, for $2,461, the present

value of $1,000 a year for three years at 10.6%, the § 7520 rate. This annuity

contract provides that B will receive $1,000 annually for three years, the first

payment to be made on December 31, 1990.

The "investment in the contract" is $2,461. The "expected return" is $3,000. The

"exclusion ratio" is 82.03%. Therefore, B must report $179 as income every time

he receives a $1,000 annuity payment.

408§ 72(b)(1).

409§ 72(c)(1).

410§ 72(c)(3).

411See ¶ 202.1.

412§ 72(c)(3)(B).

413§ 72(c)(3)(A).

414§ 72(c)(4).

415Reg. § 1.72-9, Table V.

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As Example 26 indicates, the annuity reporting rules do not change the aggregate

amount of interest income reported. But, the timing rules for annuities have a deferral

advantage.

Table A

Annuity Interest Year Income Income

1990 $180 $261 1991 180 183 1992 180 96

Total $540 $540

¶ 208.2 Private Annuity Sales

The traditional tax treatment of private annuity sales developed before the In-

stallment Sales Revision Act of 1980 extended installment sale treatment to contingent

payment sales,416 presumably including those with payments in the form of an annuity.417

The following facts will be used to illustrate the tax consequences of the private

annuity sale and SCIN examples in the balance of Part II.

Example 27: S is 70 years old. On April 1, 1990, S sells the stock in a family

business corporation to B for $1,000,000. S's basis for the stock is $200,000 and

it is worth $1,000,000.

Under Reg. § 1.72-9, Table V, a 70-year old has a life expectancy of 16.0 years.

However, the estate and gift tax valuation tables in Reg. § 20.2031-7(f) and the

tables in the Alpha Volume use 10.8 years as the life expectancy of a 70-year old.

As announced in Rev. Rul. 90-28,418 the AFR annual interest rates for April, 1990

are:

416See H.R. Rep. No. 1042, 96th Cong., 2d Sess. 10, note 12; S. Rep. No. 1000, 96th Cong., 2d Sess. 12, note 22; Manning and Hesch, supra note 2, at 20-21, 23-27; see also ¶ 203.

417See G.C.M. 39503, supra note 4; see also ¶ 205.

4181990-14 I.R.B. 10.

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Mid-term AFR 8.75% Long-term AFR 8.75% 120% AFR, the § 7520 rate 10.60%

The present value of $1 annually is:

For life for a 70-year old under income tax tables (16 years) at 8.8%, the AFR, (rounding 8.75%) $8.4161 For life for a 70-year old under income tax tables (16 years) at 10.6%, the § 7520 rate $7.5520 For life for a 70-year old under transfer tax tables (10.8 years) at 8.8%, the AFR $6.8745 For life for a 70-year old under transfer tax tables (10.8 years) at 10.6%, the § 7520 rate $6.1972

Accordingly, the annual level payment needed to pay the price of $1,000,000 is:

For life for a 70-year old under income tax tables (16 years) at 8.8%, the AFR, (rounding 8.75%) $118,820 For life for a 70-year old under income tax tables (16 years) at 10.6%, the § 7520 rate $132,415 For life for a 70-year old under transfer tax tables (10.8 years) at 8.8%, the AFR $145,465 For life for a 70-year old under transfer tax tables (10.8 years) at 10.6%, the § 7520 rate $161,363

A. Installment Sale

For comparison purposes, we will first illustrate an installment sale in which the

younger generation buyer makes a level annual payment over a fixed term. When all

payments are fixed, the deferred payment arrangement is an installment sale governed by

the installment reporting rules under § 453. The 16-year term for the payments cor-

responds to the selling senior family member's 16-year life expectancy used in the in-

come tax tables.419

As discussed in ¶ 202.7 G, the higher interest rate required under § 7520 (120% x

AFR), if applicable, can result in a deferred payment obligation having a lower value for

419Reg. § 1.72-9, Table V.

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gift tax purposes than the principal amount of the debt obligation determined under the

OID and unstated interest rules under § 1274(d)(1) (the AFR) .

Example 28: The facts are the same as in Example 27. On April 1, 1990, S sells

his family business shares, with a basis of $200,000, to B for $1,000,000. S

agrees to finance the entire $1,000,000 purchase price over 16 years. In order to

avoid any imputed interest issues, B will pay interest at 8.8%. A gross profit ratio

of 80% is applied to each principal payment to determine the amount of capital

gain reported under the installment method.

(a) Decreasing Payment Obligation. One form of installment sale requires B

to pay $62,500 annually for 16 years, plus 8.8% interest on the unpaid balance.

The first annual payment (principal and interest) is $150,000 ($62,500 principal

and $87,500 interest). The annual payment decreases each year, and finally is

only $67,969 ($62,500 principal and $5,469 interest) at the end of the 16-year

term.

(b) Level Payment Obligation. An alternative is a level annual payment over

the entire 16-year term of the loan. Using the actuarial tables for 8.8% interest,

the present value of $1.00 annually for 16 years is 8.4161. Therefore, the annual

payment is $118,820 ($1,000,000 divided by 8.4161).

For gift tax purposes, the present value of an obligation to pay $118,820 annually

for 16 years would be discounted at 10.6% under § 7520, if it is applicable.

Therefore, the value of B's obligation would be only $897,327 ($118,820 x

7.5520), resulting in a potential gift of $102,673.420

420If S uses 10.6% interest to determine the annual installment payment, it would be $132,415 ($1,000,000 divided by 7.5520), and under § 7250 the value of the buyer's obligation is $1,000,000, and no gift arises because the consideration is adequate. However, for income tax purposes, using 8.8% interest, the principal amount of this obligation is $1,114,420.

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For income tax purposes, B's basis is $1,000,000 because § 1274 using the AFR,

treats $1,000,000 as both the imputed and the stated principal amount of B's

obligation.

The amount, character and timing of S's income upon receipt of each annual

payment, using an 80% gross profit ratio for each principal payment, is:

Capital Year Payment Basis Gain Interest

4-1-91 $ 118,820 $ 6,164 $ 24,656 $ 88,000 4-1-92 118,820 6,707 26,826 85,287 4-1-93 118,820 7,297 29,186 82,337 4-1-94 118,820 7,939 31,755 79,126 4-1-95 118,820 8,632 34,528 75,660 4-1-96 118,820 9,392 37,566 71,862 4-1-97 118,820 10,218 40,872 67,730 4-1-98 118,820 11,117 44,469 63,234 4-1-99 118,820 12,096 48,382 58,342 4-1-00 118,820 13,160 52,640 53,020 4-1-01 118,820 14,318 57,272 47,230 4-1-02 118,820 15,578 62,312 40,930 4-1-03 118,820 16,949 67,796 34,075 4-1-04 118,820 18,441 73,762 26,617 4-1-05 118,820 20,063 80,253 18,504 4-1-06 118,820 21,829 87,315 9,676

$1,901,120 $200,000 $800,000 $901,120

As the above table indicates, the 80% gross profit ratio is applied each year to an

increasing principal payment. And, as the outstanding principal balance is reduced each

year, the interest portion of each succeeding payment decreases. If any of the seller-

provided financing is later cancelled, the amount of the cancellation is a purchase price

adjustment that reduces the buyer's basis.421

B. Traditional Treatment

When contingent payment sales did not qualify as installment sales, the IRS

permitted deferred reporting of certain contingent sales under the annuity rules.422

421§ 108(e)(5); see ¶ 207.4 A.

422Rev. Rul. 55-119, supra note 103; Rev. Rul. 69-74, supra note 103; see ¶ 202.2. At the time Rev. Rul. 69-74 was issued, the annuity rules under § 72 permitted the indefinite use of the exclusion ratio, thereby permitting an annuitant to continue to exclude from taxation a portion of all annuity payments as the

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If a private annuity sale is governed by the annuity rules, the younger generation

buyer's basis initially equals the value of the private annuity obligation, but changes

depending upon the amount the buyer pays under the annuity arrangement.423

This "tentative basis" is finally determined only after the selling senior family

member dies, and all payments are finally fixed. The younger generation buyer's "final"

basis is equal to the aggregate of all annuity payments made to the seller. Once the total

of all payments made exceeds the tentative basis amount, each additional payment is

added to the buyer's basis. The basis only becomes final when the payments cease. If the

selling senior family member dies before the total of the annuity payments made equals

the tentative basis amount, then the final basis is an amount equal to the payments

actually made. If the younger generation buyer sells the family business or other

financial assets before the selling senior family member's death, there is a split basis, with

gain determined using the tentative basis, but loss allowed only to the extent the sale

price is less than payments made.424 All subsequent payments are loss, whether gain or

loss was realized on the interim sale of the family business or other financial assets.

No interest is imputed for any annuity payment made by the younger generation

buyer.425 The effect is that the entire amount of each annuity payment made by the buyer

is treated as a principal payment. The inability of the buyer to treat any portion of an

investment in the contract even though he had previously recovered his entire investment in the contract. Effective for annuities starting after December 31, 1986, § 72(b)(2) eliminated this so-called mortality gain. The discrepancy between Rev. Rul. 69-74, treating the seller's basis in the property sold as his investment in the contract, and Reg. § 1.1011-1(b) Example (8), treating the value of the property sold as the investment in the contract, no longer has any tax significance because of § 72(b)(2) which precludes the use of the exclusion ratio once the entire basis is recovered.

423Rev. Rul. 55-119, supra note 103.

424Id.

425Dix v. Commissioner, supra note 115; Bell v. Commissioner, 76 T.C. 232 (1981). Under § 1275(a)(1)(B)(i), the OID and unstated interest rules do not apply. For the seller, the annuity rules under § 72 accomplish the same objective as the imputed interest rules under § 1274. Under § 72 the seller treats a portion of each payment as "annuity income." This is in effect the interest component.

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annuity payment as interest expense requires the buyer to capitalize, as part of his basis,

what is realistically an interest expense. Because the younger generation buyer cannot

treat any portion of the annuity payment as interest expense, the total of the actual

payments will exceed the tentative basis amount well before the selling senior family

member reaches his actuarial life expectancy. Therefore, a younger generation buyer

using a private annuity sale arrangement can expect to have a basis for an asset far

greater than the amount he paid for it (i.e., greater than its value).

Another distortion is caused when the higher interest rates (120% of the AFR as

mandated by § 7520) and shorter mortality assumptions found in the gift tax valuation

tables under Reg. § 20.2031-7(f) and the Alpha Volume are used to calculate the annuity

payments. The amount of each annuity payment will be larger than if the lower income

tax interest rate and longer income tax mortality assumptions were used. Since Rev. Rul.

55-119 requires the use of the gift tax valuation tables,426 the younger generation buyer

can end up undertaking an obligation that has a value greater than the value of the

property purchased as determined under the OID and unstated interest rules.

Consequently, if the buyer lives to the longer actuarial life expectancy used in Reg. §

1.72-9, Table V, the buyer will end up paying far more for the property than it may be

worth, with a resultant basis greater than its value.

Example 29: The facts are the same as in Example 27. B, the buyer, agrees to

pay S an annual annuity payment for the rest of the S's life. If the annual annuity

payment is computed using the transfer tax tables in the Alpha Volume at 10.6%,

the § 7520 rate, it is $161,363 ($1,000,000 divided by 6.1972).

426In Estate of Bell v. Commissioner, supra note 425, the court sanctioned the use of the estate and gift tax tables in valuing an annuity obligation under Rev. Rul. 55-119 for determining the buyer's tentative basis.

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The investment in the contract is $200,000. The expected return is $2,581,811

($161,363 x 16.0 year life expectancy of the income tax annuity tables). There-

fore, the exclusion ratio is 7.75%.427

Assume that S dies in the year 2009. Under the § 72 annuity rules the amount,

character and timing of S's income is:

Capital Annuity Date Payment Basis Gain Income

4-1-91 $ 161,363 $ 12,500 $ 50,000 $ 98,863 4-1-92 161,363 12,500 50,000 98,863 4-1-93 161,363 12,500 50,000 98,863 4-1-94 161,363 12,500 50,000 98,863 4-1-95 161,364 12,500 50,000 98,864 4-1-96 161,363 12,500 50,000 98,863 4-1-97 161,363 12,500 50,000 98,863 4-1-98 161,363 12,500 50,000 98,863 4-1-99 161,363 12,500 50,000 98,863 4-1-00 161,364 12,500 50,000 98,864 4-1-01 161,363 12,500 50,000 98,863 4-1-02 161,363 12,500 50,000 98,863 4-1-03 161,363 12,500 50,000 98,863 4-1-04 161,363 12,500 50,000 98,863 4-1-05 161,364 12,500 50,000 98,864 4-1-06.428 161,363 12,500 50,000 98,863 4-1-07 161,363 -0- -0- 161,363 4-1-08 161,363 -0- -0- 161,363 4-1-09 161,363 -0- -0- 161,363

Total $3,065,900 $200,000 $800,000 $2,065,900

As illustrated in Example 30, the younger generation buyer's basis in a private

annuity sale reported under the annuity rules exceeds the value of the property purchased

far before the selling senior family member reaches the end of his actuarial life

expectancy. This is because the buyer cannot deduct any portion of his annuity payments

as interest expense and because the transfer tax tables used in determining the annual

427By using a 16.0 year life expectancy under § 72, the seller will end up recovering his basis over a longer term than the 10.8 year life expectancy used to compute the amount of the annual annuity payment. In other words, the recovery of basis is over a 16-year period instead of over 10.8 years.

428Once basis fully recovered; all subsequent payments are annuity income. § 72(b)(2).

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annuity payments use shorter life expectancies and higher interest rates, thereby

increasing the amount of the annual annuity payment that is required to avoid gift tax.

Example 30: B's tentative basis for the private annuity sale in Example 29 is

$1,000,000, the present value of the annuity obligation using the transfer tax ta-

bles at 10.6%, the § 7520 rate. As the annuity payments are made B's tentative

and final basis is as follows:

Annual Payments Tentative Date Payment to Date Basis429

4-1-91 $161,363 $ 161,363 $1,000,000 4-1-92 161,363 322,726 1,000,000 4-1-93 161,363 484,089 1,000,000 4-1-94 161,363 645,452 1,000,000 4-1-95 161,364 806,816 1,000,000 4-1-96 161,363 968,179 1,000,000 4-1-97430 161,363 1,129,542 1,129,542 4-1-98 161,363 1,290,905 1,290,905 4-1-99 161,363 1,452,268 1,452,268 4-1-00 161,364 1,613,632 1,613,632 4-1-01 161,363 1,774,995 1,774,995 4-1-02 161,363 1,936,358 1,936,358 4-1-03 161,363 2,097,731 2,097,731 4-1-04 161,363 2,259,084 2,259,082 4-1-05 161,364 2,420,448 2,420,448 4-1-06 161,363 2,581,821 2,581,821 4-1-07 161,363 2,743,174 2,743,174 4-1-08 161,363 2,904,537 2,904,537 4-1-09 161,363 3,065,900 3,065,907

Example 31: The facts are the same as in Example 30. The annual private an-

nuity payment, using an 8.8% interest rate and a 16.0 year life expectancy, is

$118,820. This is the same annual amount as when B's obligation is a fixed 16-

year installment obligation.431

429Had an interest deduction been allowed consistent with the interest income reported by the seller, then only $62,500 of each annual annuity payment would have been applied towards basis so that the $1,000,000 tentative basis would not have been adjusted upward until the end of the 16th year.

430The buyer's basis in the shares purchased begins to exceed the $1,000,000 value of the shares by the seventh annual payment.


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If the selling senior family member in a private annuity sale reported under the §

72 annuity rules dies before reaching his actuarial life expectancy, there is an unre-

covered "investment in the contract." Presumably, the seller may deduct any unrecov-

ered basis on his final income tax return under § 72(b)(3)(A). The character of the loss

for unrecovered basis should be determined by reference to the character of the property

sold rather than being viewed as a loss in an independent annuity transaction.432 Where

the asset sold is a capital asset, the loss is a capital loss. Nevertheless, when the buyer in

a private annuity sale is related to the seller, the loss provided an annuitant for

unrecovered basis on premature death should not be disallowed under the related party

rule of § 267(a)(1) because it is not part of the sale, but of the annuity transaction.433

Example 32: The facts are the same as in Example 30. If S dies at the end of the

year 2000 at age 80, having received only 10 of the expected 16 annual payments.

The remaining, unrecovered basis is $75,000. S is permitted to deduct $75,000 on

his final income tax return. B's basis is finally determined to be $1,613,630, the

aggregate of all payments made.

C. Part-Sale, Part-Gift

When a private annuity sale is a portion of a part-sale, part-gift transaction, the

only significant difference from a part-sale, part-gift in a fixed payment installment sale

is that, under the IRS view, the gift portion is determined using the transfer tax tables

including the higher discount rates under § 7520.

Example 33: The facts are the same as in Example 29 except that B's annual

payments are only $50,000. S's gift is $ under the transfer tax tables of Reg.

§ 2031-7(f). S's basis in the property should be applied first to the mortgage and

then to B's payments. B's initial basis for the property is $ , the sum of the

432See Arrowsmith v. Commissioner, supra note 221; see also ¶ 209.

433§ 72(b)(3)(A).

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mortgage and the actuarial value of the payments as further increased for any gift

tax paid by S. If S's basis is more than $ , B's initial basis for the property

is the same as S's basis (adjusted for gift tax paid) in determining gain and

depreciation, but is limited by the fair market value in determining loss.

¶ 208.3 Impact of Chapter 14

When a deferred payment obligation is a bona fide debt, even if a private annuity,

it should not be subject to the special valuation rules of § 2701.434 Such a bona fide

arrangement should also avoid § 2702 because there is no "retained" interest.435 The

deferred payment obligation is not an interest in the business purchased even though the

payment terms resemble those of a guaranteed retained annuity trust ("GRAT"). As long

as the younger generation buyer's obligation is an independent one, that is, not a

nonrecourse obligation secured solely by the business purchased,436 it is not a retained

interest.437 If this is so, the selling senior family member does not have to survive the

term of the retained interest to remove the transferred property from the gross estate as is

required for a GRAT.438 For similar reasons a private annuity obligation or SCIN should

not be considered a lapsing right under § 2704.439 It is not a voting or liquidation right.

Although cancellation of the obligation to make payments may save the younger

generation buyer of the family business money, that possibility of early termination is

434See ¶ 202.3.

435Covey, Recent Developments Concerning Estate, Gift and Income Taxation--1990, 25th ANN. PHILIP E. HECKERLING INST. ON EST. PLAN., Ch. 1, ¶ 101.4 F (1991).

436See, e.g., LaFargue v. Commissioner, 689 F.2d 846 (9th Cir. 1982) (private annuity transaction with a trust is sale, not retention of income interest where annuity amount not related to income of trust, had a value substantially less than value of trust and taxpayer lacked control of trust); Stern v. Commissioner, 747 F.2d 555 (9th Cir. 1984) same even though value of annuity close to value of transferred property).

437See Estate of Moss v. Commissioner, supra note 158.

438See Covey, supra note 435.

439See Manning, supra note 16, at ¶ 708.061 (1991).

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properly taken into account in fixing the value of the payments.440 Nevertheless, since

the IRS has always had, at best, an ambivalent approach to private annuity sales and

SCINs, there remains a possibility that future proposed regulations under § 2701 or §

2702 will seek to apply Chapter 14 to private annuity sales.441 The regulations should not

do so for the reasons stated above.

A private annuity obligation or SCIN should not be used in determining price in a

buy-sell agreement effective at death. Because such arrangements are rarely used in

arm's-length agreements among unrelated parties, their use will probably prevent the

agreement's satisfying the requirements of § 2703(b)(4).442

¶ 209 Contingent Payment Installment Sales

When contingent payments are part of an installment sale, providing for the re-

covery of basis, and application of the OID and unstated interest rules, adds significant

additional complexity to a transaction that is not simple to begin with.

¶ 209.1 Recovery of Basis

The temporary installment method regulations approach to the complex problem

of basis recovery, by classifying contingent price sales as those providing a maximum

price, a maximum payment period or neither, and establishing different basis recovery

approaches depending on the classification, leaves a significant risk that there will be

unrecovered basis after the last payment is made.443 Based on the Arrowsmith case, the

loss should be characterized by the initial sale transaction.444 The loss is presumably a

440See ¶¶ 200, 208.2 and 210.2.

441It took a similar position in Notice 89-99, Part V(C), 1989-2 C.B. 422, 430 under former § 2036(c). Cf. Priv. Ltr. Rul. 91-13-009 (Dec. 21, 1990) (senior family member's guarantee of loan to junior family member is taxable transfer of the entire amount of the loan).

442See Manning, supra note 16, at ¶ 708.061.

443Temp. Reg. § 15A.453-1(c); see ¶ 203.1.

444Arrowsmith v. Commissioner, supra note 221 (loss to shareholders on payment of corporate liabilities after liquidation is capital because gain on liquidation was capital gain); see Rev. Rul. 78-25, supra note

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capital loss, with limited deducibility, unless for the family financial assets sold were not

capital assets.445 The selling senior family member may be able to take advantage of §

1341(a)(5), but this is far from clear.446 Section 1341(a)(5) allows a taxpayer who

restores a significant amount which he was required to include in income in an earlier

year to avoid the disadvantage of lower tax rates or limited deducibility by computing the

tax effect of the deduction in the current year by reference to what the results would have

been in the earlier year if the amount had not been received.

A. Stated Maximum Selling Price

When less than the maximum price is received, there may be unrecovered basis

deducted in the year in which the claim becomes worthless.447

Example 34: The facts are the same as in Example 2 except that S's basis for the

property is $1,925,000 and all payments after the initial $150,000 payment in

1990 are to be equal to 25% of the income from the property for the first 20 years

after the sale, with maximum additional payments of $900,000. Each payment is

to be accompanied by an interest payment at an annual rate of 10% from the date

of sale to the date of payment. The gross profit is $875,000 determined by

assuming that the maximum of $900,000 contingent payments will be made

($2,800,000 amount realized ($900,000 maximum contingent payments +

$150,000 down payment + $1,750,000 mortgage) - $1,925,000 basis). The gross

profit percentage is 83-1/3% ($875,000 gross proft/$1,050,000 contract price).

444 (loss in case like Arrowsmith case eligible for § 1341); Rev. Rul. 67-331, 1976-2 C.B. 290 (similar result for repayment of part of § 1231 conversion gain).

445§ 453B(a). It is possible that the loss is eligible for the special treatment provided by § 1341. See Ar-rowsmith v. Commissioner, supra note 221.

446See Rev. Rul. 78-25, supra note 444; Rev. Rul. 67-331, supra note 444; see also Reg. § 1.483-1(e)(3) Example (4), (under the former provisions of § 483), which provides a "loss in accordance with the other applicable provisions of the Code" without stating what they are or the time or character of the loss.

447Temp. Reg. § 15A.453-1(c) Example (5).

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Thus, only $25,000 basis is recovered from the initial $150,000 payment.

Similarly, only 16-2/3% of each additional principal payment is basis recovery. If

less than $900,000 is received so that basis remains at the end of the 20-year

payment period, the unrecoverd basis may be deducted as a loss. It is not clear

whether the loss is a capital loss or worthlessness of the debt obligation or

whether its character is determined by the nature of the property sold.

B Maximum Payment Period

The maximum payment period approach allocates the basis over time somewhat

like straight-line depreciation, without regard to the actual pattern of contingent pay-

ments, with adjustment for any component of the term, for example, a changing per-

centage of profits, that is not uniform throughout the term.448 When basis is allocated

ratably over the maximum payment period, and the principal payments received for any

year are less than the basis recovery allocable to the year, the excess of the basis nor-

mally allocated for that year is not allowed as a loss.449 The excess is carried to the next

year in which there is an excess of a principal payment over the basis otherwise allocated

to that subsequent year.450

Example 35: S sells family financial assets worth $1,000,000, in which her basis

is $500,000, to B for payments over a 10-year period equal to 10% of the value of

the assets at the beginning of the year. Although the assets are pledged to secure

payment of the obligation, B is personally liable for the payments without regard

to income from the assets. Each payment is to be accompanied by an interest

payment equal to 10% from the date of sale to the date of payment. S treats

$50,000 of each payment as a return of basis, whether the payment is $75,000 or

448Temp. Reg. § 15A.453-1(c)(3).

449Temp. Reg. § 15A.453-1(c)(3)(i).

450Temp. Reg. § 15A.453-1(c)(3)(i) Example (2).

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$200,000. If the payment for the third year is only $45,000 because of a sharp

decline in the value of the assets, S does not deduct any loss. Instead, she carries

the $5,000 excess forward to the fourth year and recovers basis of $55,000 then if

the fourth year payment is at least $55,000

The formula does not work well if there is a substantial fixed payment as well as a

contingent component.

Example 36: The facts are the same as in Example 35 except that B makes a

lump sum payment of $400,000 at the time of sale and the subsequent payments

are only 6% of the value of the property. The family can demonstrate that the 6%

payments are expected to provide payments of $60,000 a year for the ten-year

period, but that amount is neither guaranteed nor is it a limit on the payments.

Nevertheless, only $50,000 of the initial payment is recovery of basis with a

similar $50,000 basis recovery for each subsequent payment.

There is a complex special basis recovery procedure to deal with this problem.451

C. Neither Stated Maximum Selling Price Nor Maximum Payment

Period

When there is neither a maximum price nor term, the regulations first query

whether a sale has occurred.452 If, not, the transaction is not a sale, it is taxed, pre-

sumably, as a lease or license or some similar transaction that may not properly be called

a disposition of a family business and is therefore beyond the scope of this paper.453

451See ¶ 209.1 D.

452Reg. § 1.453-1(c)(4).

453See, e.g., Commissioner v. Brown, 380 U.S. 563 (1965) (sale of business to tax-exempt charity for contingent price and lease back is a sale); Rev. Rul. 66-153, 1966-1 C.B. 187 (Brown not applicable when amount payable by charity is in excess fair market value of stock); Restland Memorial Park v. United States, 509 F.2d 187 (5th Cir. 1975) (transaction was contribution to equity and not a sale to a new corporation; not at arm's length and no fixed price nor payment period); Portermain v. Commissioner, 58 T.C.M. (CCH) 293 (1989) (purported contingent price sale was a sham where price for sale to nonresident alien employee based on management agreement between acquired corporation and selling shareholder's controlled corporation).

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Although the regulations do not so state, there should be no significant issue

whether a sale of family business has occurred when there is a substantial fixed payment

as well as a contingent payment.454 Other indicia of sale, such a transfer of control and of

other benefits and burdens of ownership should also be relevant.455

When a sale has occurred, basis is recovered on a straight line basis over a 15

year (or other) period,456 and the rules are a basically the same as for a maximum pay-

ment period. If the payment for any year is less than the basis recovery allocable to that

year, the unused basis is carried forward to the next year.457 If payments cease before the

end of the 15-year term, any unrecovered basis can be deducted at the time it is

determined that no further payments will be made.458

Example 37: S sell shares of the family corporation worth $1,000,000, in which

her basis is $150,000, to B for a fixed payment of $300,000 plus contingent

payments equal to 5% of the pre-tax net profits of the corporation without limit as

to time or amount. Any annual loss offset against future net profits in

determining the amount of the payment. The earnings prospects of the corpora-

tion are such that the fair market value of B's obligation is $1,000,000. Despite

the unlimited nature of the payment, the transaction should still be a sale because

of the significant fixed payment, because the contingent payment is not measured

by the amounts B receives from the corporation but by the income of the

corporation itself, and because the transfer passes control and other benefits and

454Cf. Rev. Proc. 77-37, Secs. 3.03 and 3.06, 1977-2 C.B. 568, (providing as a guideline for rulings in reorganizations that 50% of maximum amount of purchaser shares are to be delivered at closing).

455See, e.g., Commissioner v. Brown, supra note 453; Frank Lyon Co. v. United States, 435 U.S. 561 (1978) (sale and lease-back is sale when purchaser-lessor undertook substantial liability).

456See ¶ 203.1 C.

457Temp. Reg. § 15A.453-1(c)(4).

458Id.

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burdens of share ownership to B. S treats $10,000 of each payment for fifteen

years as recovery of basis.

D. Special Basis Recovery

When the rules above result in a substantial and inappropriate deferral or accel-

eration of basis recovery, a more reasonable, alternative allocation of basis may be

used.459 The IRS has been relatively liberal in allowing adjustments, freely accepting

reasonable taxpayer representations as a basis for such rulings.460 However, an advance

private letter ruling is required to accelerate basis recovery and the ruling request must

show that under the alternative method the selling senior family member will ap-

propriately recover basis at twice the rate under the prescribed 15-year approach.461 This

would be almost impossible to demonstrate in most annuity sales.462

Example 38: The facts are the same as in Example 36. The family can

demonstrate that the expectation that the 6% payments are expected to provide

payments of $60,000 a year for the ten-year period is reasonable. Under these

facts, basis recovery should be 50% of each payment or $200,000 for the first

payment and $30,000 for each subsequent payment. After five years $350,000 of

basis is recovered under this approach as compared with only $250,000 under the

regulations' approach. Despite the distortion, it is not clear that the alternate

method will be approved.

459See ¶ 203.1 D

460Priv. Ltr. Rul. 90-13-014 (Dec. 21, 1989) (allows use of estimated contingent payments in computing basis recovery when there are both fixed and contingent payments); Priv. Ltr. Rul. 89-46-028 (Aug. 21, 1989) (same where estimate that two-thirds of price received in year of sale).

461See Temp. Reg. § 15A.453-1(c)(2)(i), (c)(3)(i), (c)(4) and (c)(7) (allow use of other methods to prevent substantial acceleration or deferral of basis recovery).

462For example, a 70-year old has a 16-year life expectancy. In a private annuity sale, the seller would need to have more than a 30-year life expectancy. A 53-year old has a life expectancy of 30.4 years. See Reg. § 1.72-9 Table V. Therefore, the seller would need to be younger than age 54 to satisfy Temp. Reg. § 15A.453-1(c)(7)(ii).

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Another unfortunate aspect of the regulations is that in every case that can qual-

ify, the family must undertake the trouble and expense of obtaining a private letter ruling.

It would be much better if the regulations made provision for using reasonable estimates

of contingent payments when there are significant fixed payments.463 There is also a

limited provision for use of an income forecast method without the necessity for

obtaining a private letter ruling.464

Under the maximum selling price approach, the same gross profit ratio is applied

to each principal payment. Under the maximum term and 15-year basis recovery

approach, the basis recovery is a level amount that does not bear any specified ratio to the

principal payment so that the gain portion of each principal payment is not a constant

percentage of each principal payment.

¶ 209.2 Determining the Buyer's Basis

The contingent payment provisions of the proposed OID and unstated interest

regulations take the approach that the younger generation buyer's initial basis is deter-

mined on the assumption that only fixed or minimum payments will be made, thus

minimizing the younger generation buyer's basis.465 In other words, a buyer cannot

obtain basis for undertaking a contingent payment obligation.466 The younger generation

buyer's basis for the family assets is adjusted if fixed or minimum payments are paid

earlier than assumed,467 and when contingent payments are made.468 As a corollary,

463Cf. Rev. Proc. 77-37, secs. 3.03 and 3.06, supra note 454.

464Temp. Reg. § 15A.453-1(c)(6).

465Prop. Reg. § 1.1275-4(d)(1)(i)(B) and (c)(3)(i) and (4) Examples (1) and (2). For payments the buyer is obligated to make, but with the timing not known, Prop. Reg. § 1.1275-4(d)(2) takes the position that the amount he is obligated to pay will be paid at the last possible date. This has the effect of allocating a greater portion of each obligated payment to interest, thereby minimizing the buyer's initial basis.

466Prop. Reg. §§ 1.483-5(b)(3)(iv) and (d) Example (3)(i) and 1.1275-4(d)(2). See Albany Car Wheel v. Commissioner, supra note 279.

467Prop. Reg. § 1.1275-4(d)(2)((ii)(B).

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under the contingent payment provisions of the OID and unstated interest regulations, the

selling senior family member seller treats the receipt of a contingent payment as an

additional amount realized in reporting gain on the sale under the installment method.469

This approach may be appropriate for contingent payments that occur as a result of

payment of contingent liabilities,470 but it is not consistent with the approach of the

maximum price provisions of the contingent payment installment sale regulations that

take the maximum price into account in allocating basis.471 The inconsistency between

the approach of the contingent installment sale regulations and the contingent OID

regulations is difficult to justify and may be unworkable.472 This is discussed further in ¶

209.4 B.

Example 39: The facts are the same as in Example 34. Although S determines

gain on each payment except the last by assuming that all contingent payments

will be made, B's basis for the property does not include any of the contingent

payments until they are made.

If the property is disposed of before the payments are completed and the obliga-

tion to make the payments is not transferred, the principal portion of subsequent pay-

ments is a loss.473 Although there is no express authority, the taxpayer may be able to

468Prop. Reg. §§ 1.483-5(b)(3)(iv) and 1.1275-4(c)(4) Example (1)(iii). This position is supported by the case law. See David R. Webb Co. v. Commissioner, supra note 178; Commercial Security Bank v. Commissioner, supra note 179; Crane, supra note 181.

469Prop. Reg. § 1.1274-4(c)(4) Example (1)(iii), last sentence. See also David R. Webb Co. v. Commis-sioner, supra note 178.

470See Albany Car Wheel v. Commissioner, supra note 143; David R. Webb Co. v. Commissioner, supra note 280.

471See ¶¶ 203.1 A and 209.1 A.

472The proposed regulations recognize the inconsistency, but do not explain or justify it. Prop. Reg. § 1.1275-4(d)(2).

473Cf. Rev. Rul. 55-119, supra note 103 (private annuity sale); Rev. Proc. 77-37, secs. 3.03 and 3.06, supra note 454 (contingent shares in a reorganization).

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elect to compute the tax effect of the loss as if realized in the year of sale under §

1341(a)(5).474

¶ 209.3 Electing Out of Installment Method

A selling family member who elects not to report a contingent payment sale on

the installment basis is allowed to use the basis-first method of reporting payments only

in rare and extraordinary circumstances.475 The regulations indicate that the contingent

amount realized is at least equal to the fair market value of the family business or the fair

market value of the contingent payment obligation itself.476

These regulatory provisions ignore the practical reality that bona fide contingent

payment obligations reflect uncertainty about those values, but may be justified as cre-

ating a strong incentive to stay with the installment method and, in particular, a disin-

centive to attempt to use the basis-first method. The regulations indicate further that in

those rare circumstances in which neither the property, nor the contingent payment

obligation, has a measurable fair market value, the transaction will be examined to de-

termine whether a sale has occurred.477

When the contingent payment obligation is valued in the year of sale, subsequent

collections in excess of the value assigned are apparently ordinary income, either as

OID478 or as receipts that are not part of a sale or exchange.479 It may be possible to

474See Rev. Rul. 78-25, supra note 444; Rev. Rul. 67-331, supra note 444. The payment of additional purchase price does not fit the traditional picture of repayment of a receipt, but should be so characterized because gross income only includes "gains derived from dealings in property" § 61(a)(3) [emphasis added]. Cf. § 280E (disallowing expenses but not costs of drug dealers).

475Temp. Reg. 15A.453-1(d)(2)(iii); S. Rep. No. 1000, 96th Cong., 2d Sess. at 23 (disapproving use of cost-recovery method of Burnet v. Logan, 283 U.S. 404 (1931)).

476Id. The validity of this regulation for cash basis taxpayers has been questioned. See Goldberg, supra note 382 at 648-49 (1981). Some aspects of the application to accrual basis taxpayers have also been questioned. See Mieves, supra note 382.

477Temp. Reg. 15A.453-1(d)(2)(iii). Cf. Temp. Reg. § 15A.453-1(c)(4) (similar issue when there is neither a maximum price nor maximum term); ¶ 209.1 C.

478See ¶ 201.7 G.

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argue, based on the Arrowsmith case, that the tax consequences of the subsequent col-

lections should be considered part of the original sale transaction.480 If basis is not fully

recovered, the selling senior family member is entitled to deduct any unrecovered basis

when the final payment is made.481

¶ 209.4 OID and Unstated Interest

The proposed OID and unstated interest regulations take radically different ap-

proaches to interest determinations depending on whether the family financial assets (or

the buyer's obligations) are publicly traded or not. If there is public trading, interest is

front-loaded. If there is no public trading, interest is back-loaded.

A. Publicly-Traded Property

When there is public trading, the amount of the younger generation buyer's

contingent payment obligation is treated as equal to the value of the publicly-traded

family financial assets or family corporation securities.482 The proposed regulations bi-

furcate the instrument.483 If fixed payments (whether labelled principal or interest) equal

or exceed the issue price, the fixed payments are a separate instrument with issue price

determined under the general principles including those relating to qualified interest.484

Under the proposed regulations, fixed payments up to the issue price are principal,

remaining fixed payments are OID, and all contingent payments are interest.485

479See Bittker, Capital Gains and Losses--The "Sale or Exchange" Requirement, 32 Hastings L.J. 743, 762-63 (1981).

480Arrowsmith v. Commissioner, supra note 221; Rev. Rul. 67-331, supra note 444; see ¶ 209.1.

481§ 453(b)(f); Temp. Reg. § 15A.453-1(c)(2) Example (5) and (c)(3)(i); see ¶ 209.1.

482§ 1273(b)(3). Since the value of a publicly-traded security is known, it is logical to conclude that it was sold for its value. Therefore, it is presumed that the value of the obligation (issue price of the debt instrument) equals the value of the property received in an arm's length exchange.

483Prop. Reg. § 1.1275-4(e)(1) and (f)(1).

484Prop. Reg. § 1.1275-4(e)(4) Examples (1) to (4).

485Prop. Reg. § 1.1275-4(e)(2) and (3).

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If the fixed payments are not sufficient to cover the issue price, all fixed payments

are principal and contingent payments are split between interest and principal, applied

first to interest accrued at the AFR to the date of payment on the issue price as adjusted

for prior payments of principal from fixed or contingent payments.486 When fixed

payments do not cover the issue price, and the final contingent payment does not cover

the remaining principal, the selling senior family member has a loss for the remaining

principal.487 The buyer presumably adjusts the basis of the family corporation shares for

the deficiency.488 If the contingent principal payments would otherwise exceed the issue

price, the excess is all interest.489

The effect of this is a front-loading of interest in the contingent payments.490 In

determining the interest portion of each contingent payment, an interest rate at least equal

to the AFR is applied to the outstanding principal balance at the time the payment is

received.491 The amount of any contingent payment in excess of the amount treated as a

payment of the interest accrued on the outstanding principal is treated as a principal

payment,492 which in turn reduces the outstanding principal balance used to accrue

interest for the next contingent payment.493 Once the aggregate of the amounts treated as

principal payments exceed the value of the publicly-traded securities, any additional

contingent payment is treated as entirely interest.494 The assumption supporting this

486Prop. Reg. § 1.1275-4(f).

487Prop. Reg. § 1.1275-4(f)(3) and (4) Example (1)(iii).

488See § 108(e)(5); ¶ 207.4 A.

489Prop. Reg. § 1.1275-4(f)(3) and (4) Example (1)(ii).

490Prop. Reg. § 1.1275-4(f); see ¶ 209.4 B for the back-loading of interest when there is no public trading.

491Prop. Reg. § 1.1275-4(f)(2)(iii).

492Prop. Reg. § 1.1275-4(f)(2)(ii)(B).

493Prop. Reg. § 1.1275-4(f)(2)(iv).

494Prop. Reg. § 1.1275-4(f)(2)(ii), last sentence.

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front-loading approach is that the issue price of the obligation issued by the buyer for

publicly-traded family financial assets or family corporation shares is equal to the value

of the publicly-traded family corporation securities.495 In other words, the contingent

nature of the payment is not a factor in determining the principal amount of the younger

generation buyer's obligation, but only in determining the timing of the payment of

interest and, possibly, whether the obligation is in fact paid in full.

The proposed regulations do not directly address the buyer's basis for the pub-

licly-traded securities. When fixed payments equal or exceed the issue price, the younger

generation buyer's basis should equal the issue price. When fixed payments are not equal

to the issue price, the choices are:

i. The younger generation buyer's initial basis is equal to the issue price of

his obligation, with an adjustment in basis if payments differ from this amount, or

ii. The younger generation buyer's initial basis does not include contingent

payments and is adjusted as contingent principal payments become fixed.

Since the publicly-traded regulations view the buyer as undertaking an obligation having

an ascertainable principal amount at the time of the sale, the better view is to recognize

an initial basis equal to the issue price. However, given that the publicly-traded

regulation is an exception to the contingent payment regulation for purposes of deter-

mining the interest component inherent in each payment, the rules denying the buyer a

basis until a contingent payment is fixed may prevail.

Example 40(a): S sells shares of a family-controlled corporation that is publicly

traded, which have a basis of $100,000, to B for fixed principal payments of

$800,000 and contingent payments over the next five years based on 20% of the

pre-tax profits of family corporation, up to additional payments of $400,000. The

495Cf. Philadelphia Park Amusement Corp. v. Commissioner, supra note 53; United States v. Davis, 370 U.S. 65 (1962) (value of property rights surrendered by wife in divorce in exchange for marketable secu-rities presumed to be equal to value of securities).

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fixed principal payments are to be made $400,000 at closing and $400,000 five

years later. In addition, B is to make annual interest payments of $40,000 at 10%

on the deferred principal payment of $400,000. On the date of the sale, the family

corporation shares have a quoted market price of $900,000. Because the fixed

payments are $1,000,000 ($800,000 principal + $200,000 (5 x $40,000) interest),

the fixed deferred payments constitute a separate debt instrument with an issue

price of $500,000 ($900,000 - $400,000 initial payment). Disregarding the

qualified interest provisions, the yield of the fixed obligation is only 3.5%. The

determination of principal and interest for the fixed payments is made as

described in 207.7 D and Example 16. Any contingent payments are interest.

B's basis in the shares should be $900,000, the issue price, with no adjustment

when contingent payments become fixed. Because of the public trading, there is

no installment sale. Accordingly, S must report gain in the year of sale, pre-

sumably measured by the issue price.

Example 40(b): The facts are the same as in Example 40(a) except that the

quoted market price of the family corporation shares on the date of sale is

$1,100,000. All fixed payments are principal. Thus, each $40,000 payment,

labelled interest by the parties, is principal for tax purposes. Although the quoted

market price should allow B to claim an initial basis for the property of

$1,100,000, his initial basis may be limited to the fixed payments of $1,000,000.

If a contingent payment of $70,000 is made at the end of the first year and the

AFR is 9%, the payment is interest to the extent of $63,000 (9% of $700,000

($1,100,000 - $400,000 initial payment) and the remaining $10,000 is principal.

An additional $80,000 payment at the end of the second year is interest to the

extent of $58,770 (9% of $653,000 ($700,000 - $47,000 ($40,000 fixed payment

+ $7,000 principal component of first contingent payment).

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If B's initial basis is limited to $1,000,000, the principal portion of both payments

increases the basis. If the initial basis is $1,100,000, there should be no

subsequent adjustments. Even if contingent payments would otherwise increase

principal, under the proposed regulations, all excess is interest. Because of the

public trading, there is no installment sale. Accordingly, S must report gain in the

year of sale, presumably measured by the quoted market price.

B. Property That Is Not Publicly Traded

When there is no public trading to fix an issue price, there is no fixed principal

that can be used to compute OID. The amount of interest inherent in each contingent

payment can only be calculated as payments are actually received.496 In other words, it

must first be determined how much of each periodic payment is principal and how much

is interest. Both the temporary installment sale and the proposed contingent payment

OID and unstated interest regulations adopt a back-loading of interest approach.497

Recognizing the impracticality of determining in advance how many principal payments

will be made, each payment is a separate original issue discount debt instrument that

includes all of the interest accrued on the outstanding principal inherent in each

payment.498 Therefore, the principal inherent in each payment is equal to the present

496The temporary installment sale regulations indicate that qualified interest can be provided, at least for maximum price sales, by providing for payment of interest at the prescribed rate in addition to all payments of the price under the contract. Temp. Reg. § 15A.453-1(c)(2)(ii). This regulation provision, however, was promulgated before the extension of the OID rules to sales of property and applies only for purposes of determining the maximum selling price. It does not determine what portion of subsequent payments is, in fact, treated as interest under the OID rules.

497Temp. Reg. § 15A.453-1(c)(2)(ii) and Prop. Reg. §§ 1.483- 5(b)(3) and 1.1275-4(c)(3)(ii). The back-loading of interest approach used by the temporary installment sale regulation dealing with a contingent payment sale having a maximum selling price, Temp. Reg. § 15A.453-1(c)(2)(ii), is used only to determine the maximum selling price so that a gross profit ratio can be calculated. Since this temporary regulation was promulgated before the extension of the OID rules to sales of property, it appears that this temporary regulation can only apply for purposes of determining the gross profit ratio. Once the gross profit ratio is calculated, this temporary regulation should defer to the proposed regulations under §§ 483 and 1275 for purposes of determining what portion of each payment received is, in fact, treated as interest.

498Prop. Reg. §§ 1.483-5(b)(3) and 1.1275-4(c)(3)(ii).

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value of the payment, determined by discounting the payment from the date the payment

is received to the date of the sale.499

Example 41: The facts are the same as in Example 34 and 39 except that there is

no additional interest paid with each contingent payment. The transaction is a

contingent payment installment sale. If payments are made as shown below, the

discount factor at the 8.8% AFR, the principal and the interest are as follows:

Discount Date Payment Factor.500 Principal Interest

4-1-91 $ 70,000 .919118 $64,338 $ 5,662 4-1-92 80,000 .844777 67,582 12,418 4-1-93 90,000 .776450 69,880 20,120 4-1-94 80,000 .713649 57,092 22,908 4-1-95 60,000 .655927 39,356 20,644 4-1-96 50,000 .602874 30,144 19,856 4-1-97 90,000 .554112 49,870 40,130 4-1-98 120,000 .509294 61,115 58,885 4-1-99 160,000 .468101 74,896 85,104 4-1-00 100,000 .430240 43,024 56,976

Total $900,000 $557,297 $342,703

The back-loading of interest approach used in the contingent payment regulations

results in treating an increasing portion of each payment as interest and a decreasing

portion as principal. This back-loading approach should be contrasted with the constant

level of principal and interest reported under traditional annuity treatment,501 and with the

front-loading of interest in a guaranteed deferred payment sale502 and when there is

public trading.503

499Prop. Reg. §§ 1.483-5(b)(3)(i)(A) and 1.1275-4(c)(3)(ii)(A). See Prop. Reg. § 1.483-5(d) Example (3).

500See ALPHA VOLUME, supra note 162, at p. 3-17.

501See ¶ 208.2.

502See ¶ 207.1.

503See ¶ 209.4 A.

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Under the equivalent provisions in the maximum price installment sale regula-

tions, the calculation is adjusted annually on the basis of facts as they appear at the end of

the year (and which are subject to prompt verification, presumably in time for filing of

the return). This has the effect of minimizing the anticipated interest, maximizing the

anticipated principal and therefore deferring the recovery of basis.

Example 42: The facts are the same as in Example 40 except that the shares of

the family corporation are not publicly traded. Under the temporary installment

sale regulations, the initial maximum price is $1,166,972 ($800,000 fixed pay-

ments + $366,972 discounted value of the contingent payment on the assumption

that earnings could be sufficient to pay that amount at the end of the first year).

This amount is used to compute the initial gross profit ratio of 91.4%

($1,066,972/$1,166,972) so that $365,600 of the $400,000 initial payment is gain

under the installment method.

A contingent payment of $70,000 is made at the end of the first year. The tem-

porary installment sale regulations assume that this payment is interest of $5,780

and principal of $64,220. The maximum price is reduced to $1,141,974

($800,000 fixed payments + $64,220 principal portion of the contingent payment

+ $277,754 discounted value of the remaining $330,000 maximum contingent

payment on the assumption that it will be made at the end of the second year).

The new gross profit ratio is 94.1% ($698,036 remaining gain ($1,141,974 -

$100,000 basis - $365,6000 gain reported)/$741,974 remaining payments

($400,000 fixed payment + $64,220 + $277,754)). Thus, $60,417 of the $64,220

principal portion of the $70,000 contingent payment is gain. On the other hand,

as set forth in Example 40(b), the principal portion of the first year payments is

$47,000 ($40,000 fixed payment labelled interest + $7,000 of the contingent

payment). These results seem impossible to reconcile.

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¶ 210 Self-Cancelling Installment Notes

¶ 210.1 When Used?

The major nontax difference between an installment sale, a private annuity sale

and a SCIN is the payment period. In an installment sale, the payment period is fixed.

The specified payments continue even if the selling senior family member dies before the

end of the payment term. The payments cease at the end of the specified period, even if

the seller is still alive. Thus the payment period may be more or less than needed to fund

the selling senior family member's retirement. A private annuity sale shifts this actuarial

risk to the younger family member buyer, but at the cost of an obligation to make

payments that may exceed the value of the property. A SCIN seeks to split the difference

in part, but leaves the selling senior family member at risk if the capital value

accumulated during the maximum period does not provide adequate funds for the rest of

his or her life. The higher payments needed for a SCIN to have an initial value equal to

the value of the property may help make up for this.504

¶ 210.2 Valuation of a SCIN

The difference in payment terms between a SCIN and a fixed period installment

sale on the one hand, and a private annuity sale on the other, requires use of different

discount factors that take into account not only the maximum term and the life ex-

pectancy but the actuarial relation between them. The determination is complicated by

the different life expectancy and discount rates used for income tax purposes under § 72

and the AFR than those used for transfer tax purposes and § 7520. The IRS has pub-

lished a simplified method for determining the relevant divisor to be used in determining

the annual payment for a SCIN.505

504See ¶ 210.2.

505See ALPHA VOLUME, supra note 162, at page 5, Example (9), illustrating the determination of factors involving one life and a term of years and Factors at 10 Percent Involving One and Two Lives (Actuarial Values II), IRS Publication 723E (12-83).

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Example 43: The facts are the same as in Example 27. Several additional factors

must be added to take into account the mixed nature of a SCIN.

The present value of a payment of $1 annually for the life of a 70-year old or 16

years, whichever is less is:

Under the income tax annuity tables and at 8.8%, the AFR $7.4899 Under the income tax annuity tables and at 10.6%, the § 7520 rate$6.3981 Under the transfer tax tables and at 8.8%, the AFR $6.5083 Under the transfer tax tables and at 10.6%, the § 7520 rate $5.9331

Accordingly, the annual level payment needed to pay the price of $1,000,000 is:

Under the income tax annuity tables and at 8.8%, the AFR $133,512 Under the income tax annuity tables and at 10.6%, the § 7520 rate$156,297 Under the transfer tax tables and at 8.8%, the AFR $153,649 Under the transfer tax tables and at 10.6%, the § 7520 rate $168,546

If a SCIN, computed using the transfer tax tables, is taxed under the annuity rules,

the expected return is $2,140,533.62 ($168,545.95 x 12.7 years).506

¶ 210.3 Income Tax Treatment of a SCIN

The income tax treatment of a SCIN depends on whether it is classified as an in-

stallment sale or as a private annuity sale. Under G.C.M. 39503, this in turn depends on

whether the maximum term exceeds the selling senior family member's life expectancy

under the income tax annuity tables of § 72. If it does not, it is an installment sale; but if

it does, it is a private annuity sale. Thus, major consequences can depend on relatively

minor differences in payment periods.

Example 44: A selling senior family member who is 70 years old has an actu-

arial life expectancy of 16 years under the § 72 annuity tables. Accordingly, a

506The 12.7 year life expectancy multiple used to determine the expected return is obtained from Reg. § 1.72-9, Table VIII.

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SCIN that provides a maximum period of 15 years and 11 months is an install-

ment sale, while one that provides a term of 16 years and 1 month is a private

annuity sale under the IRS view.

G.C.M. 39503 indicates that gain on a secured sale that is classified as a private

annuity sale under these rules is taxed in the year of sale, but this is questionable.507 If

being secured means that a private annuity sale does not qualify for traditional private

annuity sale treatment, with the result that the transaction is an installment sale, the

anomaly becomes greater because a secured sale may be classified as an installment sale

if secured or while an unsecured sale with identical payment terms may be treated as a

private annuity sale.

A. Under the Annuity Rules

The effect of the minor modifications of the annuity rules to deal with a SCIN

classified as a private annuity sale are set forth in the examples that follow:

1. The seller. The only difference for the senior family member seller

between a straight private annuity sale and a SCIN classified as a private annuity sale is

the amount of the annual payment required to achieve a value equal to the desired sale

price.

Example 45: The facts are the same as in Example 43. S agrees to sell the

$1,000,000 worth of shares in the family corporation to B for $168,546 a year

over the next 16 years or until S's death, whichever occurs first. The payment

provided has a present value of $1,000,000 under the transfer tax tables using the

¶ 7520 rate. The sale occurs on 4-1-90, and the first annual payment is due on 4-

1-91.

The $1,000,000 value of the property divided by the expected return of

$2,140,534 gives an exclusion ratio of 46.72%, so that $78,740 of each annual

507G.C.M. 39503, Issue (2)(C)(1)(a), supra note 4.; see ¶ 202.2.

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payment, is the principal and $89,806 is annuity income. The $78,740 principal is

further broken down into $15,748 recovery of basis and $62,992 capital gain.

After $1,000,000 of principal has been received (occurring after 12.7 years), the

entire payment is treated as annuity income because the exclusion ratio is no

longer be applied once the annuitant has recovered his entire investment in the

contract.508 The expected return is $2,140,534 (12.7 years x $168,546).

The amount, character and timing of the income reported by S if he receives all

16 annual payments are as follows:

Capital Annuity Date Payment Basis Gain Income

4-1-91 $ 168,546 $ 15,748 $ 62,992 $ 89,806 4-1-92 168,546 15,748 62,992 89,806 4-1-93 168,546 15,748 62,992 89,806 4-1-94 168,546 15,748 62,992 89,806 4-1-95 168,546 15,748 62,992 89,806 4-1-96 168,546 15,748 62,992 89,806 4-1-97 168,546 15,748 62,992 89,806 4-1-98 168,546 15,748 62,992 89,806 4-1-99 168,546 15,748 62,992 89,806 4-1-00 168,546 15,748 62,992 89,806 4-1-01 168,546 15,748 62,992 89,806 4-1-02 168,546 15,748 62,992 89,806 4-1-03509 117,982 11,024 44,096 62,862 4-1-03 50,564 -0- -0- 50,564 4-1-04 168,546 -0- -0- 168,546 4-1-05 168,546 -0- -0- 168,546 4-1-06 168,546 -0- -0- 168,546

Total $2,696,736 $200,000 $800,000 $1,696,736

2. The buyer. Similarly, the younger generation buyer's only significant

difference is in computing the initial tentative basis.

Example 46: At the § 7520 rate 10.6%, the present worth of the right to receive

$168,546 annually for 16 years or until the death of the person age 70, whichever

508§ 72(b)(2).

509The payment for the 13th year must be bifurcated because the exclusion ratio cannot be applied once the annuitant has recovered his entire investment in the contract. § 72(b)(2).

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is earlier, is $1,000,000 ($168,546 x 5.9331) under the transfer tax tables.510

Therefore, B's tentative basis in the shares purchased from S is $1,000,000.

Since the younger generation buyer under a private annuity purchase is not per-

mitted to deduct the interest component inherent in each annuity payment, the aggregate

of the payments made will exceed the tentative basis amount well before the senior

family member seller achieves the actuarial life expectancy used to determine the annual

SCIN payment. Moreover, if the seller does survive to that age, the payments will

exceed the value of the property by more than would be the case for a straight private

annuity sale.

Example 47: The facts are the same as in Example 46. The annual and cumu-

lative payments and B's tentative basis are as follows:

Annual Cumulative Tentative Date Payment Payments Basis

4-1-91 $168,546 $ 168,546 $1,000,000 4-1-92 168,546 337,092 1,000,000 4-1-93 168,546 505,638 1,000,000 4-1-94 168,546 674,184 1,000,000 4-1-95 168,546 842,730 1,000,000 4-1-96 168,546 1,011,276 1,011,276 4-1-97 168,546 1,179,822 1,179,822 4-1-98 168,546 1,348,368 1,348,368 4-1-99 168,546 1,516,914 1,516,914 4-1-00 168,546 1,685,460 1,685,460 4-1-01 168,546 1,854,006 1,854,006 4-1-02 168,546 2,022,552 2,022,552 4-1-03 168,546 2,191,098 2,191,098 4-1-04 168,546 2,359,644 2,359,644 4-1-05 168,546 2,528,190 2,528,190 4-1-06 168,546 2,696,736 2,696,736

If S collects all 16 payments, B's final basis will be the total of all payments

made, or $2,696,7356, an amount far in excess of the value of the property

purchased and, because of the larger annual payment, more than the $2,581,821

tentative basis at the end of 16 years in a standard private annuity sale. See Ex-

510See ALPHA VOLUME, supra note 162, Example (9) at page 6.

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ample 30 in ¶ 208.2 B. There is, of course, the possibility that payments in a

standard private annuity sale may continue for more than 16 years.

3. When SCIN is cancelled. Under the annuity rules the final younger

generation buyer's final basis is fixed when payments cease.

Example 48: The facts are the same as in Example 45, but S dies on June 1,

2000, at age 80, having received only 10 payments under the SCIN. B's final

basis is $1,685,460. This is more than the $1,613,632 tentative basis if S had died

on the same date in a standard private annuity sale. See Example 30 in ¶ 208.2 B.

The cancellation rules that apply upon the cancellation of a installment obligation

at the death of the seller do not apply to a private annuity sale. Therefore, neither the

selling senior family member nor the estate is required to report any of the capital gain

that would have been reported upon receipt of the remaining payments. There no longer

is a "right" to a payment because the obligation is cancelled by its own terms.511 The

selling senior family member should be able to deduct any unrecovered basis on the final

income tax return.512

Example 49: The facts are the same as in Example 48. The $42,520 of unre-

covered basis can be deducted on S's final income tax return. Although six

payments were cancelled, only three contained unrecovered basis.

B. Under the Installment Method

When a SCIN is taxed under the installment method, the gross profit ratio de-

termines the allocation of each principal payment between return of basis and capital

gain. Even though the installment method regulations classify it as a maximum price

sale, the contingent payment OID regulations may back-load the interest.

511See § 691(a)(2), (4) and (5).

512§ 72(b)(3)(A).

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The following examples will illustrate the income tax consequences of a SCIN

treated as an installment sale by taking into account the two variables:

(i) whether the risk premium is to be treated as additional principal ("SCIN-

PRIN") or as additional interest ("SCIN-INT"), and

(ii) whether the income tax mortality assumptions of the annuity tables and

the AFR or the transfer tax mortality assumptions and § 7520 rates apply .

The intermediate cases involving use of income tax mortality assumptions and the § 7520

rate or using the transfer tax mortality assumptions and the AFR are not illustrated.

The mortality assumptions create the major portion of the difference so that the results of

the former case are closer to those also using the AFR and the latter case closer to those

using the § 7520 rate.

If the premium required because of the risk that the selling senior family member

will die before the end of the maximum term of the obligation is characterized as an

additional principal amount, then the maximum sales price of the property is greater than

for a fixed payment sale. This may result in additional capital gain and a larger basis for

the younger generation buyer. If the risk premium is characterized as a higher interest

rate, the principal, gain and basis are the same as for a fixed payment sale, but the interest

is significantly more. The discounted value of the series of payments is the same no

matter how the payments are split between principal and interest is characterized as long

as the same discount rate and actuarial assumptions apply.

1. The seller

The literature on SCINs written during the last decade assumes that the gift and

estate tax tables are used to determine the periodic SCIN payments. As previously dis-

cussed, this assumption is not appropriate in all situations. Therefore, the examples that

follow will illustrate the tax treatment for

(i) a SCIN using the higher interest rates and shorter life expectancy multi-

ples found in the Alpha Volume, and

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(ii) a SCIN using the lower AFR interest rates and the longer life expectancy

multiples found in Reg. § 1.72-9.

Examples 50 through 54 assume that the interest portion of each payment is based

on the outstanding principal during each payment period. Therefore, the amount of

principal inherent in each payment is arrived at by reducing the payment by the interest

that has accrued on the outstanding principal balance. This approach front-loads the

interest to the earlier years as occurs in the amortization of principal for a fixed payment

obligation such as a mortgage loan. However, as illustrated in Example 55, the

contingent payment installment sale regulations back-load the interest by assuming that

each payment is a separate debt obligation with its own interest.513 .

Example 50: SCIN-PRIN at 8.8%.

Using the AFR of 8.8% and the 12.7-year actuarial period for a temporary life

annuity, based on the lesser of 16 years of the life of a 70-year old, found in the

income tax annuity tables, the annual payment for the purchase of $1,000,000

worth of shares is $133,512. See Example 43.

At 8.8%, the present value of $133,512 annually for 16 years is $1,127,150.

Therefore, the risk premium of $127,160 is additional principal, increasing the

seller's gain and the buyer's basis by an equal amount. With a sales price of

$1,127,150 and a basis of $200,000.00, the gross profit ratio under the installment

method is 82.26%.

513See Temp. Reg. § 15A.453-1(c)(2)(ii)

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The amount, character and timing of the income reported by S is:

Capital Date Payment Interest Basis Gain

4-1-91 $ 133,512 $ 98,627 $ 6,190 $ 28,695 4-1-92 133,512 95,575 6,732 31,205 4-1-93 133,512 92,254 7,321 33,937 4-1-94 133,512 88,645 7,961 36,906 4-1-95 133,512 84,714 8,658 40,140 4-1-96 133,512 80,448 9,416 43,648 4-1-97 133,512 75,805 10,239 47,468 4-1-98 133,512 70,756 11,135 51,621 4-1-99 133,512 65,265 12,110 56,137 4-1-00 133,512 59,293 13,169 61,050 4-1-01 133,512 52,799 14,322 66,391 4-1-02 133,512 45,736 15,575 72,201 4-1-03 133,512 38,056 16,937 78,519 4-1-04 133,512 29,704 18,420 85,388 4-1-05 133,512 20,620 20,031 92,861 4-1-06 133,512 10,742 21,784 100,986

Total $2,136,192 $1,009,039 $200,000 $927,153

Example 51: SCIN-INT at 8.8%.

Payments of $133,512 annually for the 16 year maximum term have a present

value of $1,000,000 if the discount rate is 10.7% instead of the 8.8% AFR. With

a $1,000,000 sales price and a $200,000 basis, the gross profit ratio under the

installment method is 80%

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The amount, character and timing of the income reported by S is:


4-1-91 $ 133,512 $ 107,418 $ 5,218 $ 20,875 4-1-92 133,512 104,615 5,779 23,117 4-1-93 133,512 101,511 6,400 25,600 4-1-94 133,512 98,074 7,088 28,350 4-1-95 133,512 94,267 7,849 31,396 4-1-96 133,512 90,051 8,692 34,768 4-1-97 133,512 85,383 9,626 38,503 4-1-98 133,512 80,213 10,660 42,639 4-1-99 133,512 74,488 11,805 47,219 4-1-00 133,512 68,148 13,073 52,291 4-1-01 133,512 61,126 14,477 57,908 4-1-02 133,512 53,351 16,032 64,128 4-1-03 133,512 44,740 17,754 71,017 4-1-04 133,512 35,205 19,662 78,646 4-1-05 133,512 24,645 21,773 87,094 4-1-06 133,512 12,950 24,112 96,449

Totals $2,136,192 $1,136,192 $200,000 $800,000

If all payments are made, the total gain is $127,153 less and the total interest is

$127,153 more than in Example 50.

Example 52: SCIN-PRIN at 10.6%.

Using the transfer tax tables in the Alpha Volume at the § 7520 rate of 10.6%, the

annual payment for a 16-year maximum term is $168,548. See Example 43. This

is $35,036 more than when the income tax annuity tables and the AFR are used.

At 10.6%, the present value of $168,546 annually for 16 years is $1,272,865.

With a basis of $200,000 and a sales price of $1,272,865, S's gross profit ratio

under the installment method is 84.29%. The entire $272,865 premium is ad-

ditional principal that increases S's potential capital gain and B's potential basis

by an equal amount. If all payments are made, this is $145,712 more than in

Example 50.

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4-1-91 $ 168,547 $ 134,924 $ 5,283 $ 28,340 4-1-92 168,547 131,360 5,843 31,344 4-1-93 168,547 127,418 6,463 34,666 4-1-94 168,547 123,058 7,148 38,341 4-1-95 168,547 118,237 7,905 42,405 4-1-96 168,547 112,904 8,743 46,900 4-1-97 168,547 107,005 9,670 51,872 4-1-98 168,547 100,482 10,695 57,370 4-1-99 168,547 93,267 11,828 63,452 4-1-00 168,547 85,288 13,082 70,177 4-1-01 168,547 76,462 14,469 77,616 4-1-02 168,547 66,701 16,002 85,844 4-1-03 168,547 55,905 17,699 94,943 4-1-04 168,547 43,965 19,575 105,007 4-1-05 168,547 30,758 21,650 116,139 4-1-06 168,547 16,153 23,945 128,449

Totals $2,696,752 $1,423,887 $200,000 $1,072,865

Example 53: SCIN-INT at 10.6%.

Payments of $168,547.20 for the 16 year maximum term have a present value of

$1,000,000 if the discount rate is 15.1% instead of the 10.6% § 7520 rate..

Assuming that 15.1% is not an excessive interest rate, with a $1,000,000 sales

price and a $200,000 basis, S's gross profit ratio under the installment method is

80%.

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Date Payment Interest Basis Gain

4-1-91 $ 168,547 $ 150,713 $ 3,567 $ 14,267 4-1-92 168,547 147,025 4,104 16,417 4-1-93 168,547 144,933 4,723 18,892 4-1-94 168,547 141,373 5,435 21,739 4-1-95 168,547 137,278 6,254 25,015 4-1-96 168,547 132,565 7,196 28,785 4-1-97 168,547 127,142 8,281 33,124 4-1-98 168,547 120,902 9,529 38,116 4-1-99 168,547 113,721 10,965 43,861 4-1-00 168,547 105,458 12,618 50,470 4-1-01 168,547 95,950 14,519 58,078 4-1-02 168,547 72,418 19,226 76,903 4-1-04 168,547 57,931 22,123 88,493 4-1-05 168,547 41,259 25,458 101,830 4-1-06 168,547 22,075 29,294 117,178

Totals $2,696,752 $1,696,752 $200,000 $800,000

If all payments are made, the total gain is $145,712 less and the total interest is

$145,712 more than in Example 52.

2. The buyer. As previously discussed, under the contingent payment reg-

ulations, a younger generation buyer does not obtain any initial basis for undertaking a

contingent payment obligation.514 Basis is obtained only as payments become fixed or

are made. The buyer is permitted to deduct the interest component inherent in each

payment. The interest and basis increase of each payment vary depending upon the

treatment of the risk premium.

Example 54: B's basis.

Using the transfer tax tables and the § 7520 rate: .

(a) If the risk premium is characterized as an additional principal payment, then

the amount of B's obligation and B's potential basis is $1,272,865. B's initial

basis in the property purchased is zero. B's interest deductions will total

$1,423,887 if all 16 payments are made.

(b) If the risk premium is characterized as additional interest, then the amount of

B's obligation and B's potential basis is $1,000,000. B's initial basis in the shares

514§ 1.275-4(d)(2); see ¶¶ 203.2 and 209.2.

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is zero. B's interest deductions will total $1,696,755.20 if all 16 annual payments

are made.

Using the income tax annuity tables and the AFR: .

(a) If the risk premium is characterized as an additional principal payment, then

the amount of B's obligation and B's potential basis is $1,1,127,153. B's initial

basis in the property purchased is zero. B's interest deductions will total

$1,009,039 if all 16 payments are made.

(b) If the risk premium is characterized as additional interest, then the amount of

B's obligation and B's potential basis is $1,000,000. B's initial basis in the shares

is zero. B's interest deductions will total $1,696,755.20 if all 16 annual payments

are made.

3. When SCIN is cancelled. Under the contingent payment OID and un-

stated interest regulations, the younger generation buyer's basis may be limited to pay-

ments made. This is an anomalous result when the senior family member seller dies

before the end of the maximum SCIN term in a related party sale in that the younger

generation buyer's basis can be less than the aggregate of the capital gain and return of

basis reported by the seller or the estate. Whatever the merits of the position of G.C.M.

39503 in giving the buyer an initial basis measured by the contingent payment obligation,

the logic of Rev. Rul. 86-74, requiring the decedent's estate to report the entire inherent

gain, supports the view that the cancellation is a bequest to the younger generation buyer

that should support a basis at least equal to fair market value at death.515 A counter

argument is that although the gain is reported by the selling senior family member, the

value of the remaining payments is not included in the gross estate.516 Nevertheless, the

income tax result should prevail.

515See Rev. Rul. 67-96, 1967-1 C.B. 195 (basis of stock acquired through exercise of option provided in will is date of death value plus any consideration paid for option).

516See ¶ 204.1.

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By similar logic, if the cancellation is during the selling senior family member's

lifetime and thus, a gift, the younger generation buyer's basis should be the fair market

value, although there is some chance that the gift rule of the higher of the donor's basis or

purchase price applies.517

The effect of differences in the amount of principal depending on whether the risk

premium is treated as interest or principal carries through to the consequences of

termination of the SCIN upon the premature death of the selling senior family member.

When the buyer and the seller are related parties, the value of the cancelled installment

obligation is deemed to be equal to its face amount.518 Since a SCIN-PRIN treats the risk

premium as additional loan principal, there is more capital gain potential than in a SCIN-

INT and a greater basis for the younger generation buyer. Again, when the gain is

reported by the senior family member seller's estate, the full basis should be allowed the

younger generation buyer.

Example 55: The facts are the same as in Example 54 except that S dies on June

1, 2000, having received only 10 annual payments. B's obligation to make the

remaining six annual payments is cancelled. B and S are related parties.

Therefore, the value of the cancelled payments is treated as equal to its face

amount.

(a) SCIN-PRIN. The outstanding principal amount for the remaining payments is

$721,340, and the unrecovered basis is $113,340. The estate reports $608,000 of

capital gain upon cancellation of the obligation. B's basis in the shares should be

$1,272,865, but, under the contingent price OID and unstated interest regulations,

may be limited to $551,528, the principal payments actually made.

517See Reg. § 1.1015-4.

518§ 691(a)(2), (a)(4)(B) and (5)(B).

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(b) SCIN-INT. The outstanding principal amount is $636,641, and the unre-

covered basis is $127,328. The estate reports $509,313 of capital gain. B's basis

in the shares should be $1,000,000, but, under the contingent price OID and

unstated interest regulations, may be limited to $ 363,359, the principal payments

actually made.

As illustrated in Example 55, all of the capital gain inherent in the annual pay-

ments is eventually reported by the seller and the seller's estate. The only difference is

that for a SCIN-PRIN there is an additional $272,865 of capital gain. Therefore, an

advantage of a SCIN-INT is the potential for less aggregate income being reported in the

event of the selling senior family member's premature death.

The irrebutable presumption that the value of the cancelled payments equals the

principal amount does not apply if the buyer is not a related party, such as a son-in-law.

The built-in termination reduces the amount received upon the disposition to zero,

permitting the unreported realized gain on a sale to an unrelated party to escape income

taxation. And, the tax savings are further increased because the selling senior family

member should receive a deduction for any unrecovered basis.519 Since the unrelated

buyer's initial basis cannot include his initial obligation, the cancellation of the unrelated

buyer's remaining obligation has a symmetrical effect with the capital gain reported by

the seller.

Example 56: The facts are the same as in Example 55, except that B is S's son-

in-law.

(a) SCIN-PRIN. B's initial basis in the shares is zero, even though B undertakes a

contingent $1,272,865 obligation to make 16 annual payments of $168,547 each.

Upon the death of S, the remaining $721,340 of principal payments becomes

519Temp. Reg. § 15A.453-1(3)(i) and (4). There is some argument for denying a deduction on the ground that the loss is not part of a transaction entered into for profit, see Rev. Rul. 72-193, 1972-1 C.B. 58, or that the loss did not occur until death so that it is essentially a reduction in value of the property at death.

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worthless. Therefore, none of the remaining capital gain is reported as income,

and S can deduct the $113,340 of unrecovered basis on the final income tax

return. B's basis in the shares is $551,528, the principal payments B made.

(b) SCIN-INT. B's initial basis in the shares is zero even though B undertakes a

contingent $1,000,000 obligation to make 16 annual payments. Upon S's death,

the remaining $636,641 principal obligation becomes worthless. None of the

remaining capital gain is reported as income, and S can deduct the $127,328 of

unrecovered basis on his final income tax return. B's basis in the shares is

$363,359, the principal payments B made.

4. Treatment as contingent payment sale with a maximum selling price.

The treatment illustrated in Examples 50 through 56 does not reflect the back-loading of

interest approach apparently required in the contingent payment regulations. In the

examples, the interest was front-loaded to the early years because it was assumed that the

principal portion of each annual payment reduced the outstanding principal for the

subsequent year. In effect, Examples 50 through 56 illustrate the results when a SCIN is

treated as a maximum selling price installment sale, the result we consider proper.520 The

contingent payment OID and unstated interest regulations back-load the interest to the

later years on the assumption that there is no principal amount so that each payment

contains its own interest on the principal inherent in that payment from the date of sale to

the date of payment.521 In other words, each payment is treated as a separate OID

obligation.

Example 57: The facts are the same as in Example 52. SCIN-PRIN at 10.6%.

Treating the first annual payment of $168,547 as a separate OID obligation means

that the amount of the interest inherent in it is $16,154. The present value of $1

520¶ 206.1 F.

521Temp. Reg. § 15A.453-1(c)(2)(ii).

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to be received in one year at a 10.6% discount rate is .904159. Therefore, the

principal amount in the first payment is $152,393 ($168,547 x .904159).

The present value at 10.6% of $1 received in two years is .817504. Therefore, the

principal amount in the second payment received on 4-1-92 is $137,788

($168,547 x .817504), and the interest portion is $30,759.

By treating each annual payment as a separate debt obligation, the amount of the

discount (the interest element) increases with each subsequent payment. By the

time the last payment is received on 4-1-06, the present value of $1 in 16 years is

.199489 so that the principal portion of the payment is $33,623 ($168,5470 x

.199489) and the interest portion is $134,924. The amount, character and timing

of each payment, using an 84.29% gross profit ratio for each principal payment,

is:

Date Payment Interest Gain Basis

4-1-91 $ 168,547 $ 16,153 $ 128,449 $ 23,945 4-1-92 168,547 30,759 116,138 21,650 4-1-93 168,547 43,965 105,007 19,575 4-1-94 168,547 55,905 94,943 17,699 4-1-95 168,547 66,700 85,844 16,003 4-1-96 168,547 76,462 77,616 14,469 4-1-97 168,547 85,288 70,178 13,081 4-1-98 168,547 93,267 63,452 11,828 4-1-99 168,547 100,481 47,371 10,695 4-1-00 168,547 107,006 51,871 9,670 4-1-01 168,547 112,903 46,901 8,743 4-1-02 168,547 118,234 42,407 7,906 4-1-03 168,547 123,059 38,340 7,148 4-1-04 168,547 127,418 34,667 6,462 4-1-05 168,547 131,360 31,344 5,843 4-1-06 168,547 134,924 28,340 5,283

Totals $2,696,752 $1,423,884 $1,072,868 $200,000

A comparison of Examples 52 through 57 shows that the aggregate amount of

capital gain, return of basis and interest income reported does not change if the maximum

payments are made. The approach of in the contingent payment OID and unstated

interest regulations accelerates capital gain and defers interest income and deduction, an

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advantageous result for the seller when there is a significant rate preference for capital

gains, although not advantageous for the younger generation buyer. More importantly,

the OID approach permits deferral of the aggregate annual income reported. In Example

51 the total income reported upon the receipt of the first payment is $163,264. In

Example 57, first year income totals only $144,602, the difference attributable to the

greater portion treated as principal and a resultant return of basis.

Another consequence of back-loading the interest is that when the younger gen-

eration buyer's obligation is cancelled upon the selling senior family member's premature

death, less capital gain is reported upon a cancellation because more capital gain and less

interest income was reported in the earlier years. Back-loading of interest means that the

younger generation buyer's basis greater, but at the cost of reduced interest deductions.

Example 58: The facts are the same as in Example 52 except that interest is

computed under the approach of the contingent payment OID and unstated in-

terest regulations as illustrated in Example 56. S dies after receiving only 10

annual payments.

SCIN-PRIN at 10.6%.

For a SCIN-PRIN, the potential capital gain inherent in all 16 annual payments is

$1,072,865 and the potential interest is $1,423,885.

In Example 52, the interest is front-loaded to the earlier years. The remaining

capital gain inherent in the cancelled payments is $608,000, and that amount must

be reported by S's estate on its first fiduciary income tax return. See also

Example 55(a).

In Example 57, the interest is back-loaded to the later years. The remaining

capital gain inherent in the cancelled payments is $221,999, and that amount must

be reported by S's estate.

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Front-loading Back-loading

Capital Capital Gain Interest Gain Interest

First 10 Payments $ 464,865 $1,133,939 $ 850,870 $675,986 At death 608,000 -0- 221,998 -0-

Totals $1,072,865 $1,133,939 $1,072,868 $675,986

B's final basis $1,272,865.522 $1,272,865.523 B's interest deductions 1,113,939 675,986

Totals $2,386,804 $1,948,851

In Example 51, where interest is front-loaded, the unreported interest inherent in

the six cancelled payments is $289,947. In Example 57 where interest is back-

loaded, the unreported interest inherent in the six cancelled payments is $747,900.

¶ 210.4. Comparing SCINS as Installment Sales and Private Annuity Sales

The differences between taxing a SCIN under the installment method or as a

private annuity sale shows that the cumulative effects of the differences in timing of the

selling senior family member's gain and ordinary income and the younger generation

buyer's basis and deduction creates a crazy quilt pattern that may display a certain

symmetry, but no real sense.

Example 59: A comparison of the results set forth in the SCIN taxed as a private

annuity sale as described in Examples 45 to 49 with the result when it is taxed

under the installment as shown in Examples 51 to 58 is shown below:

522This amount represents the total principal payments that measure the gain required to be reported by the seller of the estate on termination, but the buyer's basis may be limited to $551,558 payments made.

523May be limited to $1,009,485 payments made.

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Private Installment Annuity Sale S's potential amount realized 1,000,000 1,127,153 Annual payments $168,546 168,546.524 B's initial basis $1,000,000 -0- Final capital gain if all payments made 800,000 927,153.525 Ordinary income if all payments made1,696,736 1,423,887 Final basis if all payments made 2,696,736 1,127,153 Final gain if S dies after 10 years526: Related party sale 629,920. 1,127,153 Unrelated party sale 629,920 464,865 Ordinary income if S seller dies after 10 years898,060 1,133,912 Final basis if S dies after 10 years Related party sale 1,686,460 1,127,153.527 Unrelated party sale 1,686,460 551,528

In a private annuity sale, S may deduct the any unrecovered basis on his final

income tax return. In an installment sale, the remaining basis offsets the amount

of principal reported as capital gain upon cancellation.528

As Example 59 illustrates for both situations, basis cannot be obtained unless

there is a corresponding income recognition on the selling senior family member's side of

the transaction.

524SCIN-PRIN at 10.6%

525Under § 691(a)(2), the cancellation accelerates the remaining $ of capital gain and it is reported on the estate's first income tax return.

526$42,540 of unrecovered basis can be deducted on S's final return.

527For illustrative purposes, if the interest portion of each annuity payment is factored out, B is treated as having made 10 principal payments of $62,500 each and the final basis would be $625,000. Under Rev. Rul. 55-119, supra note 103 , the buyer must capitalize the interest component inherent in each payment.

528§ 691(a)(4)(A).

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When the buyer and the seller are related parties, the installment reporting rules

mandate that the entire gain initially deferred under the installment method will be re-

ported by the seller or the seller's estate in all events.529 Therefore, the younger gener-

ation buyer should be permitted to use the entire obligation as part of his final basis.530

Since the annuity rules do not require the remaining capital gain to be reported if the

selling senior family member dies prematurely, the buyer cannot obtain basis for any

payment obligation that is cancelled. The seller deducts any unrecovered basis in the

annuity sale so that the buyer should obtain no benefit for it..

¶ 211 Private Annuity Sales and SCINs as Installment Sales

This part of the paper illustrates how the installment method, using the approach

for contingent payment sales, would be applied to a private annuity sale.

¶ 211.1 In General

The temporary regulations applying the installment method to contingent payment

sales531 and the proposed regulations determining allocations between interest and

principal for payments received under contingent payment sales for purposes of deter-

mining OID and unstated interest532 contain the rules that must be applied concurrently

when a private annuity sale is treated as a contingent payment installment sale.

529If the value of the cancelled obligation is less than its face amount and the buyer and the seller are not related parties, than no gain is reported with respect to that decline in value. However, a corresponding reduction in basis is mandated by § 108(e)(5). See ¶ 207.4 A.

530In G.C.M. 39503, Issue (2)(C)(2)(b), the IRS indicated that the buyer can include the full value of the contingent payment obligation in basis because the seller reports the remaining capital gain under the in-stallment sale early disposition rules. This is inconsistent with Prop. Reg. §§ 1.483-5(b)(3)(iv) and 1.1275-4(c)(4) providing basis only as payments become fixed or are made, but the regulations do not expressly refer to the effect of the installment sale provisions.

531Temp. Reg. § 15A.453-1(c).

532Prop. Reg. §§ 1.483-5 and 1.1275-4.

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¶ 211.2 Application of the Contingent Payment Regulations to Private

Annuity Sales

A. Treatment as an Installment Sale with Neither Maximum Price nor

Fixed Period

When a private annuity sale is treated as a contingent payment sale, it may be

viewed as one with neither a maximum price nor a maximum payment period.533 As

such, under the temporary installment sale regulations, basis is allocated over an arbitrary

15-year period. Under the proposed contingent payment regulations, the interest

component of each payment is determined as if that payment was the only one made.534

Even after the selling senior family member survives beyond his actuarial life ex-

pectancy, each subsequent payment will continue to contain a principal component and a

back-loaded interest component. Once the entire basis is recovered, however, the selling

senior family member treats all of the principal portion of each subsequent payment as

additional capital gain.535 The aggregate of the capital gains reported by the seller will

exceed the capital gain inherent in the asset sold well before the selling senior family

member reaches the end of his actuarial life expectancy. This is caused by the back-

loading of interest, which has the effect of front-loading the principal payments.

Similarly, under the temporary contingent payment OID and unstated interest regulations,

the younger generation buyer's initial basis for the property is zero,536 adjusted for the

principal portion of each payment as it becomes fixed.537 In addition, the buyer continues

533Temp. Reg. § 15A.453-1(c)(4); see ¶¶ 203.1 C and 208.1 C.

534Prop. Reg. §§ 1.483-5(b)(3)(i) and 1.1275-4(c)(3)(ii); see ¶¶ 203.4 B B and 208.5 B.

535See Prop. Reg. § 1.1275-4(c)(4) Example (1)(iii).

536Prop. Reg. §§ 1.483-5(b)(3)(iv) and -5(d) Example (3)(i), and 1.1275-4(c)(4) Example (1)(iii); see also ¶¶ 203.2 and 209.2.

537Id.

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to increase the basis of the asset for each principal payment made after the selling senior

family member reaches his actuarial life expectancy.

Example 60: S, age 70, has a 16-year life expectancy. S owns stock with a basis

of $200,000 and a value of $1,000,000. S sells the stock to B in exchange for B's

promise538 to pay S $161,363 annually for life. S dies in the year 2009 having

received 19 annual payments. At 10.6%, the amount, character and timing of S's

income is:

Capital Date Payment Basis Gain Interest

4-1-91 $ 161,363 $ 13,333 $ 132,565 $ 15,465 4-1-92 161,363 13,333 118,582 29,448 4-1-93 161,363 13,334 105,938 42,091 4-1-94 161,363 13,333 94,508 53,522 4-1-95 161,364 13,333 84,173 63,858 4-1-96 161,363 13,334 74,827 73,202 4-1-97 161,363 13,333 66,378 81,652 4-1-98 161,363 13,333 58,738 89,292 4-1-99 161,363 13,334 51,830 96,199 4-1-00 161,364 13,333 45,585 102,446 4-1-01 161,363 13,333 39,939 108,091 4-1-02 161,363 13,334 34,832 113,197 4-1-03 161,363 13,333 30,217 117,813 4-1-04 161,363 13,333 26,043 121,987 4-1-05 161,364 13,334 22,269 125,761 4-1-06 161,363 -0- 32,190 129,173 4-1-07 161,363 -0- 29,105 132,258 4-1-08 161,363 -0- 26,316 135,047 4-1-09 161,363 -0- 23,793 137,570

$3,065,900 $200,000 $1,097,828 $1,768,072

B's initial basis in the stock is zero. Upon payment of the first annuity payment

on 4-1-91, B's basis is increased by the $145,898 principal payment he has made.

Upon the termination of B's obligation in the year 2009, B's final basis is

$1,297,828. At the end of 10 years, B's basis will have reached $966,457 and the

S's gain $833,124. See Example 59.

538It does not matter whether or not B's promise is secured because installment reporting is available for both secured and unsecured obligations.

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Under the § 72 annuity reporting rules, as illustrated in Example 29, S's allocation

of the $161,363 annual payment between principal and interest is constant for

each year at $62,500 of principal and $98,863 of interest. Thus, S reports

$625,000 of principal and $988,630 of annuity income over a ten-year period

under the annuity reporting rules.

B. Treatment as an Installment Sale with a Maximum Selling Price

If the actuarial value of the annuity is treated as if it is a fixed maximum price, the

interest is front-loaded. The entire principal obligation would be fully paid at by the time

the selling senior family member reaches his actuarial life expectancy; any subsequent

payments are entirely interest.539 If the value of the younger generation buyer's

obligation is treated as a maximum principal amount, then this value would be used to

determine the seller's capital gain on the sale and the resultant gross profit ratio.

Example 61: The facts are the same as in Example 60. If treated as a maximum

price sale, S has sold the stock for $1,000,000, the value of B's annuity obligation,

thereby realizing an $800,000 capital gain. The gross profit ratio is 80%. S dies

after receiving 19 annual payments. The amount, character and timing of the S's

income is:

539Prop. Reg. §§ 1.1275-4(c)(3)(ii) and 1.483-5(b)(3)(iii); see § 203.4 B..

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Capital Date Payment Interest.540 Basis Gain

4-1-91 $ 161,363 $ 106,000 $ 11,073 $ 44,290 4-1-92 161,363 100,132 12,246 48,985 4-1-93 161,363 93,641 13,544 54,178 4-1-94 161,363 86,462 14,980 59,921 4-1-95 161,364 78,523 16,568 66,273 4-1-96 161,363 69,742 18,324 73,297 4-1-97 161,363 60,030 20,267 81,066 4-1-98 161,363 49,288 22,415 89,660 4-1-99 161,363 37,409 24,791 99,163 4-1-00 161,364 24,270 27,419 109,675 4-1-01.541 101,602 9,737 18,373 73,492 4-1-01 59,761 59,761 -0- -0- 4-1-02 161,363 161,363 -0- -0- 4-1-03 161,363 161,363 -0- -0- 4-1-04 161,363 161,363 -0- -0- 4-1-05 161,364 161,364 -0- -0- 4-1-06 161,363 161,363 -0- -0- 4-1-07 161,363 161,363 -0- -0- 4-1-08 161,363 161,363 -0- -0- 4-1-09 161,363 161,363 -0- -0-

Total $3,065,900 $2,065,900 $200,000 $800,000

540The interest for each year is 10.6% of the principal outstanding for the preceding 12 months, determined as follows:

Principal Principal Date Balance Payment 4-1-90 $1,000,000 -0- 4-1-91 944,637 $ 55,363 4-1-92 883,405 61,232 4-1-93 815,683 67,722 4-1-94 740,782 74,901 4-1-95 657,942 82,840 4-1-96 566,320 91,621 4-1-97 464,987 101,333 4-1-98 352,913 112,074 4-1-99 228,958 123,954 4-1-00 91,865 137,094 4-1-01 -0- 91,865 Total $1,000,000

541The entire $1,000,000 of principal is amortized over 10.8 years instead of 16.0 years because the tables in the ALPHA VOLUME, supra note 162, used in computing the annual annuity payment incorporate this shorter life expectancy.

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B's basis is finally determined to be $1,000,000 because a maximum price limits

the amount of principal and potential basis.

If the private annuity sale is treated as a contingent price sale with a fixed period,

the only significant difference is that the selling senior family member's basis is allocated

ratably over the life expectancy on a straight-line basis instead of as a fixed portion of

each principal payment. This is likely to result in larger basis recovery and lower gain in

the early years when interest is front-loaded and the reverse when it is back-loaded.

Another approach uses the temporary contingent payment, installment sale

maximum selling price regulation only for purposes of treating the private annuity sale as

having a maximum selling price, and then uses the proposed contingent payment OID

regulations for purposes of determining the interest inherent in each payment. Under this

approach, the interest is back-loaded, but the selling senior family member's actuarial life

expectancy542 determines the maximum principal amount by totalling the principal

portion of only those payments that can be received before the seller reaches the actuarial

life expectancy. Again, by treating the private annuity sale as having a maximum selling

price, once the total treated as principal exceeds this maximum, any additional contingent

payments are interest.543

Example 62: The facts are the same as in Example 61, except that the alternate

approach is applied. Under this approach, S is treated as having sold his stock for

$1,218,614.02, the aggregate of the principal portion inherent in the first 16

annual payments. S realizes a $1,018,614.02 capital gain on the sale and the

gross profit ratio is 83.59%. If S dies after having received 19 annual payments.

The amount, character and timing of S's income is:

542The longer life expectancy multiples used in Reg. § 1.72-9 Table V are used for this purpose.

543Prop. Reg. §§ 1.483-5(b)(3)(iii) and 1.1275-4(a)(3)(ii).

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Interest Basis Capital Date Payment (10.6%) (16.41%) Gain (83.59%)

4-1-91 $ 161,363 $ 15,465 $ 23,9459 $ 121,953 4-1-92 161,363 29,448 21,650 110,265 4-1-93 161,363 42,091 19,575 99,697 4-1-94 161,363 53,522 17,699 90,142 4-1-95 161,364 63,858 16,003 81,503 4-1-96 161,363 73,203 14,469 73,691 4-1-97 161,363 81,652 13,082 66,629 4-1-98 161,363 89,292 11,828 60,243 4-1-99 161,363 96,199 10,695 54,469 4-1-00 161,364 102,444 29,670 49,249 4-1-01 161,363 108,091 8,743 44,529 4-1-02 161,363 113,197 7,905 40,261 4-1-03 161,363 117,813 7,147 36,403 4-1-04 161,363 121,987 6,462 32,914 4-1-05 161,364 125,761 5,844 29,759 4-1-06 161,363 129,173 5,283 26,907 4-1-07544 161,363 161,363 -0- -0- 4-1-08 161,363 161,363 -0- -0- 4-1-09 161,363 161,363 -0- -0-

Total $3,065,900 $1,847,286 $200,000 $1,018,614

C. Private Annuity Sale of Publicly-Traded Property

A private annuity sale of publicly-traded property cannot qualify as an installment

sale, but there is no reason that it cannot be a contingent payment sale under the

contingent payment OID and unstated interest regulations.545 If so, the issue price is

fixed and the interest rate should be determined using the AFR, not the § 7520 rate. The

proposed regulations require that the interest be front-loaded.

Example 63: The facts are the same as in Example 29 except that the property

sold was publicly-traded securities worth $1,000,000 on the date of the sale. The

544If principal payments received in excess of the initial principal amount are not treated as interest, the breakdown between principal and interest for the last three annual pay-ments is:

Date Interest Principal 4-1-07 $132,258 $29,105 4-1-08 135,048 26,315 4-1-09 137,570 23,793

545See ¶ 209.4 A.

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principal amount of B's obligation on the 4-1-90 sale date is $1,000,000. The

8.75% (unrounded) AFR is used to determine the amount of interest accrued each

year. Assume that S dies after receiving 19 annual payments of $161,363 each.

The amount, character and timing of S's income is:

Date Payment Interest Principal

4-1-91 $ 161,363 $ 87,500 $ 73,863 4-1-92 161,363 81,037 80,326 4-1-93 161,363 74,008 87,355 4-1-94 161,363 66,365 94,998 4-1-95 161,364 58,053 103,310 4-1-96 161,363 49,013 112,350 4-1-97 161,363 39,182 122,181 4-1-98 161,363 28,491 132,872 4-1-99 161,363 16,865 144,498 4-1-00546 52,467 4,221 48,246 4-1-00 108,897 108,897 -0- 4-1-01 161,363 161,363 -0- 4-1-02 161,363 161,363 -0- 4-1-03 161,363 161,363 -0- 4-1-04 161,363 161,363 -0- 4-1-05 161,364 161,364 -0- 4-1-06 161,363 161,363 -0- 4-1-07 161,363 161,363 -0- 4-1-08 161,363 161,363 -0- 4-1-09 161,363 161,363 -0-

Total $3,065,900 $2,065,900 $1,000,000

¶ 211.3 Comparison of Installment Method and Private Annuity Sales

As the foregoing shows, the differences between the tax treatment of standard

installment sales, SCINs and private annuity sales makes the choice among them

ridiculously complex.

The following list details the large number of differences between them that

makes the choice a true challenge to the tax professional.

(i) The younger generation buyer's basis is finally determined at the initial

time of purchase using the value of the buyer's obligation for a fixed payment

546The payment for the year 2000 must be bifurcated once the entire $1,000,000 principal amount has been received.

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installment sale, tentatively determined at the actuarial value of the annuity in a

private annuity sale and may be determined only as payments become fixed for

contingent installment sales.547

(ii) The younger generation buyer is permitted an interest deduction in fixed

or contingent payment installment sales, but not in private annuity sales.

(iii) The selling senior family member reports interest income as it financially

accrues, back- or front-loaded for installment sales, but a uniform annual amount

for private annuity sales.

(iv) If the younger generation buyer's obligation for a fixed or contingent in-

stallment obligation is terminated prior to maturity, the selling senior family

member or the estate must report the remaining capital gain if the buyer and seller

are related parties, under the installment method,548 but not for a private annuity

sale. Consequently, the seller does not have unrecovered basis in an installment

sale, but may in a private annuity sale.

(v) Depreciation recapture cannot be deferred under the installment

method,549 but there is no similar limitation for private annuity sales.

(vi) The anti-Rushing rule of § 453(e) for a subsequent sale by a related pur-

chaser applies to installment sales but not to private annuity sales.

(vii) The installment method is not available for sales of depreciable property

to related parties,550 but there is no similar limitation for private annuity sales.

(viii) The installment method is not available for dealer or inventory sales, but

may be for private annuity sales.551

547There may be a purchase price adjustment under § 108(e)(5) if the value of the obligation at death is less than its face amount and the buyer is unrelated to the seller. See ¶ 207.4 A.

548§ 691(a)(5)(B).

549§ 453(i).

550§ 453(g).

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(ix) The selling senior family member in a large installment sale may be re-

quired to pay interest under § 453A on taxes deferred under the installment

method, but there is no similar requirement for private annuity sales.

(x) Pledging of an installment obligation as collateral for a loan results in

reporting of the gain otherwise deferred,552 with no similar provision for private

annuity sales.

(xi) The installment method is not available if the younger generation buyer's

obligation is readily tradeable,553 but such trading may not prevent qualification

as a private annuity sale.

(xii) The installment method is available even if the younger generation buyer's

obligation is secured, but not the private annuity sale approach.

(xiii) The installment method is not available for deferred payment sales of

publicly-traded securities,554 but the private annuity sale approach may be.

(xiv) The OID and imputed interest rules apparently determine the transfer tax

value of obligations taxed under the installment method, but do not apply to pri-

vate annuity sales,555 so that the value is determined by discounting under the §

7520 rate.

(xv) The status of a selling senior family member's health and other factors

may be considered in an installment sale, but the actuarial tables are more likely

to control private annuity sales.

551§ 453(b)(2) and (l).

552§ 453A(d).

553§ 453(f)(4).

554§ 453(k)(2).

555§§ 483(c)(3) and 1275(a)(1)(B).

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(xvi) Specific rules control when the selling senior family member elects out of

the installment method that generally prohibit use of the basis-first method;

similar, but different, rules avoid basis-first recovery for private annuity sales.

(xvii) The installment method can be used by shareholders for obligations re-

sulting from a corporate sale of property,556 but there is no similar express pro-

vision for private annuity sales.

(xviii) An S corporation can distribute an installment obligation without imme-

diate gain recognition,557 but there is no similar provision for private annuity

sales.

The following example provides a further comparison and shows additional

complexities of a transaction that is part-sale and part gift.

Example 64: S, who is 70 years old, has finally decided to enter into a buy-sell

arrangement to turn the family widget manufacturing corporation over to his son,

B. Since he continues to need funds to live on, he is not prepared to make a gift

of the entire business, but does want to reduce his estate to a degree. S's basis in

the 10,000 shares of stock is $500,000 for 9,000 shares and $200,000 for the

remaining 1,000 shares (inherited from his deceased wife, Wilma, in early 1989).

The business is estimated to be worth $2,000,000.

S wants about $150,000 a year to live on. He is adamantly opposed to any ar-

rangement that gives him preferred stock of the corporation, since he insists on an

absolute legal right to his payments. He has heard about private annuity sales,

straight installment sales and self-cancelling installment notes as possible means

of accomplishing his goals and asks for your advice concerning which he should

use.

556§ 453(h).

557§ 453B(h).

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Under the unisex income tax annuity tables, he has a life expectancy of 16 years.

An annuity of $150,000 a year for a person of his age has a value of ap-

proximately $950,000 under the estate and gift tax tables, using the March, 1990,

rate under § 7520 of 10.2%. If viewed as an installment sale, contrary to the IRS

position in G.C.M. 39503, it is a contingent installment sale with no maximum

price or term. As a result, basis is presumably spread over 15 years and an

increasing portion of each payment is treated as interest and a decreasing portion

as principal.

A payment of $150,000 per year for the lesser of 20 years or life has an expected

return of 14.4 years, and on that basis, incorporating compound interest of 8.59%

(long-term AFR for March, 1990), represents an installment sale principal of

approximately $1,200,000 but has an estate and gift tax table value of about

$950,000. The difference is attributable to a combination of a higher interest rate

and to different actuarial assumptions. G.C.M. 39503 indicates there may be

some room to argue against use of the tables.

An installment sale with 20 level annual payments of $150,000, incorporating the

March, 1990 long-term AFR of 8.59% interest, represents a principal of

approximately $1,400,000 but has an estate and gift tax table value of about

$1,250,000, all attributable to the different interest rate assumptions.

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Self-Cancelling Private Annuity Installment Note Sale

Contin- Install- Install- gent In- ment ment Private Tradi- stallment Sale Sale Annuity tional Sale

(in thousands)

Initial Sale Transaction

S--Gift: Value Shares 2,000 2,000 2,000 2,000 2,000 Value Payments 1,250 950.558 950 950 950.558 Gift 750 1,050 1,050 1,050 1,050 S--Gain--Own Shares: Amount Realized (90%) 1,125 1,080.559 855 855 ??? Basis 500 500 500 500 500 Gain 625 580 355 355 ??? S--Gain (Loss)--Inherited Shares: Amount Realized (10%) 125 120 95 95 ??? Basis 200 200 200 200 200 Gain (Loss560) (75.) (80.) (105.) (105.) ??? B--Initial Basis: S's Shares561 1,125 1,080 855 855 500.562 Inherited Shares563 200 200 200 200 200 Total 1,325 1,280 1,055 1,055 700

558May be able to argue for installment sale value $1,200,000 under G.C.M. 39503, reducing gift to about $800,000.

559Effect of maximum price approach not clear; may be same as column 1.

560Nondeductible under § 267 or basis limited under Reg. § 1.1015-4.

561In part-sale, part-gift, greater of S's basis or purchase price. Reg. § 1.1015-4. Where transferred basis is greater; also includes any gift tax up to FMV.

562Presumably, transferred basis is a minimum.

563Gain basis; loss basis is presumably amount paid.

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(in thousands)

Annual Payments

S: Amount Received-- Own Shares: 135 135 135 135 135 OID or Ordinary Income: 115.564 110.564 75.565 82.566 12.5567 Gain 55.6% 53.7% 25.565 22.566 109.2568 Basis Recovery 44.4% 46.3% 35.565 31.566 13.3569 Amount Received-- Inherited Shares: 15 15 15 15 15 OID or Ordinary Income: 12.564 11.564 7.5565 8.566 1.3567 Gain None None None None None Basis Recovery Balance Balance Balance Balance Balance

564First year; decreasing amounts each year thereafter.

565For 14.4 years; thereafter entire payment is ordinary annuity income.

566For 16 years; thereafter entire payment is ordinary annuity income.

567First year; increasing amounts thereafter to 95.8 in fifteenth year and 109.0 twentieth year. After fifteenth year, all amounts may be interest under Prop. Reg. §§ 1.1275-4(c)(3)(ii) and 1.483-5(b)(3)(iii).

568First year; decreasing amounts thereafter to 25.9 in fifteenth year. In sixteenth and subsequent years all amounts that are not interest are gain since basis has been recovered.

56915 years.

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B: Investment Interest Deduction570 Yes Yes None None Yes Basis Increase-- Pay- Pay- Princi- S's Shares None None ments ments pal Pay- after after ments Year 6 Year 6 after year 3 Basis Increase-- Inherited Shares None None Payments Payments None571 after after Year 14 Year 14



(in thousands)

S's Death

Gross Estate Value Inclusion Remaining None572 None572 None572 None572 Payments Gain or Loss As Unre- Unre- Recognition Payments ported None None ported Received Gain Gain B's Basis Limited Limited Unre- Adjustment None None to Pay- to Pay- ported ments ments Gain

570Where available, same amount as S's income.

571Principal payments never will total $200,000.

572Assumes no inclusion under Chapter 14.

Private Annuity SSRN-Id1503462

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Transcript of Private Annuity SSRN-Id1503462