Earlier this month, President Clinton signed into a law an extenders bill that provides, among other things, for the extension of certain expiring tax credit provisions. As usual, in order to pay for the cost of the tax benefits contained in the legislation, the bill contains revenue raising provisions. One of such provisions is the repeal of the installment method of accounting for accrual basis taxpayers.
As stated in my editor's column for the January-February issue of the Journal of Passthrough Entities, this provision stinks! Installment reporting, even for accrual basis taxpayers, has been a staple planning technique for as long as this author can remember. In many circumstances, the technique is what allows for the transfer of a business where the buyer is unable to provide the cash to pay the purchase price and, consequently, the seller does not have the cash to pay the tax generated by the sale of the business. Elimination of installment reporting for accrual basis taxpayers may very well prevent many non-abusive business transactions from being consummated. Sure, there may be circumstances where bank financing is available, but in many transactions it is not. In this author's opinion, Congress should have looked elsewhere for its revenue raising. Installment reporting is not abusive--in many circumstances it is an economic necessity. Hopefully, Congress will consider the repeal of this provision, so it can be remembered as having a one-year life, much like carryover basis at death had a one-year life in the late 70's.
However, as of now, the repeal of the installment method of accounting for accrual basis taxpayers is with us. This month's Partner's Perspective will examine certain, of what likely may be many, issues that may arise in connection with the sale of a business that is operated in the partnership format.
The new legislation does not apply to cash method taxpayers. Therefore, where it is necessary to sell a partnership's business on the installment basis (e.g., the buyer does not have the wherewithal to finance the entire purchase price or where there is a contingent purchase price), and the business is an accrual method taxpayer, it can be expected that many sellers will attempt to sell partnership interests, rather than the assets of the business. Needless to say, this form of transaction often is resisted by buyers, because of issues relating to undisclosed and contingent liabilities. However, in situations where the owner of a business operated in partnership format is himself on the cash method of accounting (which is generally the case where the owner is an individual), installment method reporting will be available for the sale of partnership interests.
One of the traps one will now have to sidestep, however, when attempting to utilize the installment method of reporting is encountered upon the sale of an interest in a single-member LLC. Let's examine one such transaction. Assume George has been operating a women's clothing store since 1980 and would like to slow down and partially cash out. For liability protection purposes, the store has been operated as a single-member LLC since 1997, after the check-the-box regulations became effective and confirmed that single-member LLCs should be treated as disregarded entities. George sells half his LLC interest to Mark on the installment basis at a time when the LLC has the following balance sheet:
- Basis
- Value
- Building
- Original cost
- $3,000,000
- Accumulated depreciation
- ( 2,000,000)
- 1,000,000
- $3,500,000
- Inventory
- 600,000
- 750,000
- Short-term capital assets
- 200,000
- 250,000
- Goodwill and going concern value
- - 0-
- 1,500,000
- $1,800,000
- $6,000,000
As of the beginning of the last year of the 20th century, many tax professionals would have maintained that George's sale of 50% of the interest in his single-member LLC would have yielded a gain of $2,100,000 ($3,000,000 purchase price less $900,000 basis), of which $75,000 would be ordinary with respect to the inventory (a Code Sec. 751 "hot asset") and the remainder would have been long-term capital gain. Not so fast! First, in Rev. Rul. 99-5, 1999-6 IRB 8, the IRS ruled that this transaction should be viewed as a sale of an undivided 50% interest in each asset, followed by a contribution of all the LLC's assets by George and Mark to a newly formed LLC. As a result, (1) $25,000 of what was thought to be long-term capital gain with respect to the sale of the LLC interest would be short-term capital gain with respect to a sale of a 50% interest in the short-term capital assets and (2) $1,000,00 of the $1,250,000 gain with respect to 50% of the underlying real estate would be taxed at the 25% Code Sec. 1250 capital gains rate.
Second, even if the sale of the LLC interest were respected, last August the IRS issued proposed regulations under Code Sec. 1(h), which provide that in determining the character of gain with respect to the sale of a partnership interest, it is necessary to determine the amount of gain that would be allocated to the selling partner and taxed at the 25% Code Sec. 1250 capital gains rate if the partnership were to sell all its assets. (Note--It was the position of Congress in the legislative history to the 1998 Tax Act that this look-through rule applied to the sale of a partnership interest, even without the issuance of regulations, although many tax professionals might disagree with this conclusion.)
Let's now examine the impact on this transaction of the revocation of the installment method of reporting for accrual method taxpayers. Prior to the new legislation, the portion of the gain attributable to the inventory was not eligible for installment reporting, but the remaining gain would be so eligible. (Note, it may have been possible to allocate any cash received at closing as payment for inventory (to the extent of the value of the inventory) and, consequently, increase the timing benefits of the installment method. See Rev. Rul. 68-13, 1968-1 CB 195.)
After the legislation, a sale of an LLC interest by a cash method taxpayer, such as George, still would be eligible for installment reporting. However, Rev. Rul. 99-5 provides that George is not deemed to sell an LLC interest, but is deemed to sell assets. Unfortunately, the assets are being sold by an accrual basis business. And one would expect that the IRS will take the position that, notwithstanding that the LLC is not recognized for federal tax purposes prior to the sale and is deemed to be owned by George directly, George is an accrual basis taxpayer with respect to the LLC's business. (Note--a taxpayer that operates a sole proprietorship having inventory is required to utilize the accrual method of accounting with respect to such business, even though he is likely to be on the cash method with respect to his other income and deductions.)
Therefore, if installment reporting is desired, one would have to assert that the IRS's position in Rev. Rul. 99-5 is in error and the sale of the membership interest should be respected, or find a method of planning around the IRS's position. The latter approach probably makes more sense. The key is to make sure there is a recognized sale of an LLC interest. For example, let's suppose that George decides to do some estate planning prior to the sale of the 50% LLC interest to Mark and transfers a 1% LLC interest to a child or a trust for a child's benefit. Now, a sale of a membership interest to Mark should be regarded as such, and installment reporting should be available (other than with respect to the inventory portion of the LLC interest).
Note that a recognized sale of an LLC interest, rather than an asset sale, has other side benefits besides the availability of installment reporting. Under the asset purchase scenario, because of George's continuing interest in 50% of each and every asset of the "newly formed LLC," the IRS takes the position in the proposed regulations under Code Sec. 197 that the anti-churning rules apply and Mark is not eligible for amortization with respect to the goodwill he purchased. On the other hand, if there is a recognized purchase of an LLC interest, Mark's basis in the purchased goodwill would come via a Code Sec. 743(b) basis step-up, which is an exception to the application of the anti-churning rules.
The second additional benefit of the transaction being characterized as a purchase of an LLC interest is elimination of the applicability of the Code Sec. 704(c) rules. As discussed in detail in this Partnership Tax Planning and Practice Guide at 63180, whenever there is a contribution of appreciated property to a partnership, the partnership must account for the unrealized gain in the contributed property (the "Sec. 704(c) variation") by means of certain (1) special allocations of depreciation away from the property-contributing partner to the non-property contributing partner and (2) special allocations of gain to the property-contributing partner on an eventual sale of the contributed property to the extent of the remaining Sec. 704(c) variation at the time of sale. In the case of George and Mark, these rules would raise their head under the Rev. Rul. 99-5 depiction of the transaction, because there is a deemed property contribution to a newly formed partnership. In this situation, there would be a Sec. 704(c) variation of $1,250,000 in the portion of the building deemed contributed by Mark (50% of $1,000,000 basis vs. 50% of $3,500,000 fair market value).
Without discussing the Code Sec. 704(c) rules in great detail, very generally, the analysis would be George has contributed a building with a basis of $500,000 and a fair market value of $1,750,000 and Mark would expect to be allocated $875,000 of depreciation deductions with respect to his 50% share of such property. The Code Sec. 704(c) rules would attempt to allocate tax depreciation to Mark equal to his share of book depreciation (i.e., $875,000). However, because there is only $500,000 of tax depreciation to allocate there is what is known as a "ceiling rule" problem. Where such a problem exists, the Code Sec. 704(c) regulations set forth three acceptable methods of addressing the Code Sec. 704(c) variation--(1) the traditional method; (2) the curative method; and (3) the remedial method. (Note--there may be other acceptable methods; however, the three noted methods are safe harbors under the regulations.)
Under the traditional method, no adjustment is made for the ceiling rule problem and Mark is "short" of the depreciation he would expect to be allocated (and could end up being allocated tax gain on sale in excess of economic gain). The curative method requires special allocations of other LLC depreciation deductions (or other deductions or income) to be made to the extent of the ceiling rule problem over the remaining tax life of the contributed property. The remedial method is similar to the curative method in eliminating the ceiling rule problem, but does so over the remaining book life of the contributed property.
The timing differences between the three methods can be substantial. Depending on whose "ox is being gored," it may be necessary to negotiate the Code Sec. 704(c) method to be used as part of the partnership agreement. For example, if the property-contributing partner does not control tax decisions, it is necessary for such a partner to negotiate the Code Sec. 704(c) method as part of the partnership agreement, otherwise it is likely that the non-property contributing partner will select the curative method (which generally provides the non-property contributing partner with the maximum amount of deductions over the shortest period of time).
Also note that the IRS takes the position that curative and remedial allocations cannot be made with respect to goodwill. Prop. Reg. §1.197-2(g)(2)(vi). Accordingly, while Mark would be able to obtain substantial deductions with respect to the portion of the real estate deemed contributed by George (the amount of which would be determined based on the Code Sec. 704(c) method selected), he would not be able to obtain any deductions with respect to the goodwill deemed contributed by George. (As noted above, the anti-churning rules would also be a bar to goodwill amortization in this case. However, the anti-churning rules would be inapplicable, if the business had been formed after August 10, 1993.)
The complexity of the Code Sec. 704(c) rules becomes irrelevant, however, where there is a recognized purchase and sale of a partnership interest. In such a case, the purchasing partner obtains his deductions via a Code Sec. 743(b) adjustment, i.e., for building depreciation, goodwill amortization and the like. Ceiling rules and anti-churning rules do not raise their heads.
In this situation, a small third benefit of a recognized purchase and sale of an LLC interest would be that George's share of the unrealized gain in the short-term capital assets would be long-term (because he has a long-term holding period for his membership interest), to the extent that such assets are not Code Sec. 751 "hot assets" (e.g., depreciation recapture).
As the 21st century progresses, there likely will be significant impact of the repeal of the installment method in ways that tax professionals have not yet contemplated. At present, three other issues immediately come to mind.
First, the receipt of a contingent payment obligation may raise serious tax risks. For example, assume that Mark purchased George's entire business and agreed to pay George a sum certain of cash and, in addition, issued his installment note providing for the payment of a percentage of the business's profits over the next five years. The current Code Sec. 453 regulations are bad enough in the manner in which a taxpayer's basis is allocated between the cash payment and the contingent installment payments. Now, installment reporting is not even available for the accrual basis taxpayer. Instead, it will be necessary to value the installment note. How will this be done? And if the note is overvalued, the taxpayer will ultimately end up with a capital loss, which often is unutilizable. Will the open transaction doctrine have a rebirth?
Second, the repeal of installment reporting for accrual basis taxpayers will likely cause tax professionals to take a longer and harder look at the concept of allocating purchase price to "personal goodwill." As discussed in detail in the Partner's Perspective at 69617, the mid-1998 cases of Martin Ice Cream and Norwalk address situations where taxpayers were able to successfully assert that some of the value inherent in a business was attributable to the personal goodwill of its owners. So, for example, to the extent George's sale of his accrual-basis business to Mark could not be structured as a sale of an LLC interest, but installment reporting was desired, to the extent the goodwill of the business was properly allocable to George, it may be able to be purchased from him on an installment basis.
Third, one must be especially careful to consider the "syndicate" rules regarding whether an LLC or partnership must report its income on the accrual basis. Code Sec. 448(a)(3) in conjunction with Code Secs. 461(i)(3) and 1256(e)(3)(B) provide that a syndicate must report on the accrual basis, and an LLC or a partnership that has more than 35% of its losses allocable to limited partners or limited entrepreneurs is a syndicate. The regulations (Reg. Sec. 1.448-1T(b)(3)) help somewhat by referring to losses allocated, rather than allocable, so that if the LLC or partnership has not generated losses, it should not be classified as a syndicate by reason of Code Sec. 1256(e)(3)(B). In addition, an interest in an entity generally will not be considered as held by a limited entrepreneur, if its owner actively participates in management. See Code Sec. 464(e)(2). Needless to say, there could be some surprises as to whether an LLC or a partnership can really utilize the cash method of accounting.
A complete discussion of these and other issues raised by the repeal of installment sale reporting for accrual basis taxpayers is beyond the space limitations of this column. In any event, tax practitioners will have to be very wary of all the collateral effects of this ill-conceived legislation.