Oftentimes, buyers and sellers will include terms in the purchase agreement to allow for payment over time. This allows the buyer to manage cash flow and helps the seller to strategically spread the gain by not electing out of the installment sale treatment. However, care should be placed on the specific terms of these installment sales. Inclusion of stated interest, contingent payment terms, and debt considerations all can have a dramatic influence on how the transaction affects both parties.
For the seller, installment sales can result in gain recognition based on 1) the gross profit percentage and 2) the schedule of cash received. Both factors can be altered based on the terms of the agreement. The terms of any contingent payments can be high-impact as well. If a “maximum price” is built into the agreement, it will be used to calculate the gross profit percentage for each year until an event occurs that changes the total amount to be received. If there is no maximum price, then the traditional process of calculating a gross profit percentage is not used to determine gain recognition. Instead, a proportional calculation is performed over a fixed payment period. If no fixed payment period is defined, then a fifteen-year payment period is generally assumed.
Interest can often be one of the most unexpected components of an installment sale. It is important to include stated interest in contract terms. Otherwise, interest should be imputed, which in turn affects the gross profit percentage. The “price-interest recomputation rule” dictates the methodology for the gain calculation in this situation, and Internal Revenue Code (IRC) §483 and the accompanying regulations guide the calculation of the required interest. Even if interest is stated, it is prudent to ensure that the interest is sufficient or additional interest will be imputed.
Frequently, the biggest interest impact in installment sales stems from IRC §453(A)(a)(1). If the amount to be collected in the installment sale exceeds five million dollars after the first year, additional interest is calculated based off an “applicable percentage.” This applicable percentage remains unchanged following the year of sale, and therefore, a substantial amount of interest can be calculated under this section.
Special consideration should be placed on how debt is treated in the sale. “The term qualifying indebtedness means a mortgage or other indebtedness encumbering the property [sold] and indebtedness, not secured by the property but incurred or assumed by the purchaser incident to the purchaser's acquisition, holding, or operation in the ordinary course of business or investment, of the property” (regulation §15A.453-1(b)(2)(iv)). If debt meets the criteria for qualifying indebtedness, then as long as it does not exceed the basis of the property, it can be excluded from the amount deemed received as payment for the year. To the extent that it exceeds basis, there is an additional “deemed payment” to be included in the gain calculation.
Overall, installment sales are often desirable or even the only realistic option for buyers. However, the terms of the installment sale within sale agreements can make a big difference in the ultimate tax and interest due.
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