REFUND OF INTEREST ON DEFERRED TAX ON INSTALLMENT SALE DENIED.

Index Number: 453A.03-01

(1) In the case of a contingent installment obligation, whether Taxpayer is entitled to a refund of interest paid in an earlier year under section 453A of the Internal Revenue Code where Taxpayer later estimates that the selling price used to compute the deferred tax liability with respect to that installment obligation will not be received.

(2) Whether Taxpayer and his spouse, who each separately own shares in X, an S corporation, are considered a single taxpayer for the purpose of applying the $5,000,000 limitation of section 453A.

[2] CONCLUSIONS

(1) Taxpayer is not entitled to a refund of interest paid in an earlier year under section 453A where Taxpayer later estimates that the selling price used to compute the deferred tax liability with respect to that installment obligation will not be received.

(2) Taxpayer and his spouse are not treated as a single taxpayer for the purpose of applying the $5,000,000 limitation of section 453A.

FACTS

[3] Before date 1, Taxpayer owned aa% of the stock of X, an S corporation whose principal business was conceiving, researching, developing, marketing, and producing a variety of x for presentation to the public. At that time, the remainder of X's stock was owned by Taxpayer's minor children, his brother, his brother's wife, his sister, his mother and a residuary trust established under his father's estate.

[4] On date 1, X sold most of its assets to Y for $a. Prior to the sale, X had an appraisal prepared by an independent third party that listed the value of X's business enterprise as $b. The appraisal also listed revenues from X for the year prior to the sale as $c and projected that revenues would increase by bb% per year. Taxpayer was the executive director of X before the sale and became an employee of Y thereafter.

[5] Under the sales agreement, Y assumed X's liabilities of $d and issued an installment note to X for $e in payment for the balance of the purchase price. No cash was received in the year of sale. The installment note required payment to be made to X on a contingent basis. The amount to be paid by Y under the note was limited to the lesser of $e or cc% of the "available excess cash flow" as defined in the installment note and in the sale agreement. The amounts payable to X under the note were calculated and due quarterly, and applied first to interest and then to the principal of the installment note. The installment note was for a term of 10 years, beginning on date 1 and expiring on date 2, whereupon no further payments would be made to X even if the maximum principal amount had not been paid. X reported the sale of its assets under the installment method of accounting.

[6] Simultaneous with the sale of X's assets to Y, Taxpayer transferred dd% of X's stock to A, his spouse, leaving himself with ee% of X's stock and, therefore, a ee% interest in X's installment obligation. Taxpayer and A do not reside in a community property state and have filed separate tax returns for all tax years involved.

[7] As a result of the transfer of Taxpayer's X stock to his spouse, Taxpayer calculated that, for purposes of figuring his federal income tax liability, his share of the installment note was $f, or ee% of the $e maximum amount payable to X under the sale agreement. Because this amount exceeded $5,000,000, Taxpayer included interest on his deferred tax liability with respect to his share of the installment note as additional tax on his year 2 tax return in accordance with section 453A. In computing his unrecognized gain for purposes of figuring his deferred tax liability under section 453A, Taxpayer estimated that he would receive $f, his share of the maximum $e sale proceeds that could be received by X under the sale agreement. Thus, Taxpayer's calculation of his section 453A interest for his year 2 return was based on an estimated receipt of the maximum that X could have received on the installment sale.

[8] In accordance with the contingent terms of the installment obligation, Y did not make any principal payments to X under the note in year 1 or year 2. In year 3, Y paid principal to X equaling $g. In year 4 and year 5, Y paid principal of $h and $i, respectively. In year 6, no principal was paid under the note.

[9] In year 5, Taxpayer estimated that X would not receive the $e sales price as determined under the installment agreement because, according to Taxpayer, there was a change in market conditions. Based on Taxpayer's personal knowledge of the business and the industry, Taxpayer then calculated revised projections of the profits and working capital of Y until the end of the 10-year installment note, and estimated that X would receive only $j of the $e maximum payable under the note. Thus, Taxpayer estimated that he would receive only $k (i.e., ee% of $j) on the installment sale.

[10] Because Taxpayer anticipated that a much lower consideration eventually would be paid by Y for X's assets, in year 5 he amended his tax return for year 2, his earliest open year, to request a refund of part of the interest paid in that year on his deferred tax liability under section 453A. On his amended return, Taxpayer recomputed the interest payable under section 453A using anticipated receipts of $k for his share of the installment note proceeds, rather than the $f figure originally used to determine the amount of his deferred tax liability at the close of year 2. Based on these calculations, Taxpayer requested a refund of $l to reflect the difference between his original calculation of interest payable under section 453A and his revised calculation.

LAW AND ANALYSIS

[11] Section 453(a) provides that, except as otherwise provided, income from an installment sale shall be taken into account under the installment method.

[12] Section 453(b)(1) defines the term "installment sale" as a disposition of property where at least one payment is to be received after the close of the taxable year in which the disposition occurs.

[13] Section 453(c) defines the term "installment method" as a method under which the income recognized for any taxable year from a disposition is that proportion of the payments received in that year which the gross profit (realized or to be realized when payment is completed) bears to the total contract price.

[14] Section 453A(a)(1) provides that in the case of an installment obligation to which section 453A applies, interest shall be paid on the deferred tax liability with respect to such obligation in the manner provided under section 453A(c).

[15] Section 453A(b) provides, in part, that section 453A applies to any obligation which arises from the disposition of any property under the installment method, but only if the sales price of such property exceeds $150,000, such obligation is outstanding as of the close of such taxable year, and the face amount of all such obligations held by the taxpayer which arose during, and are outstanding as of the close of, such taxable year exceeds $5,000,000. Except as provided in regulations, all persons treated as a single employer under subsection (a) or (b) of section 52 shall be treated as one person for purposes of this paragraph and subsection (c)(4).

[16] Section 453A(c)(1) provides that if an obligation to which section 453A applies is outstanding as of the close of any taxable year, the tax imposed for such taxable year shall be increased by the amount of interest determined in the manner provided in section 453A(c)(2).

[17] Section 453A(c)(2) provides that the interest for any taxable year shall be an amount equal to the product of the applicable percentage of the deferred tax liability with respect to such obligation multiplied by the underpayment rate in effect under section 6621(a)(2) for the month with or within which the taxable year ends.

[18] Section 453A(c)(3) defines "deferred tax liability" as the product of the amount of gain with respect to an obligation which has not been recognized as of the close of such taxable year, multiplied by the maximum rate of tax in effect under section 1 or 11, whichever is appropriate, for such taxable year.

[19] Section 453A(c)(4) defines "applicable percentage" as the percentage determined by dividing the portion of the aggregate face amount of obligations outstanding as of the close of such taxable year in excess of $5,000,000, by the aggregate face amount of such obligations outstanding as of the close of such taxable year.

[20] Section 453A(c)(6) provides that the Secretary shall prescribe such regulations as may be necessary to carry out the provisions of section 453A(c) including regulations providing for the application of this subsection in the case of contingent payments, short taxable years, and passthrough entities.

Issue (1) -- In the case of a contingent installment obligation, whether Taxpayer is entitled to a refund of interest paid in an earlier year under section 453A where Taxpayer later estimates that the selling price used to compute the deferred tax liability with respect to that installment obligation will not be received.

[21] In year 5, Taxpayer filed an amended return for his year 2 tax year requesting a refund of a portion of the section 453A interest reported on that return with respect to his share of X's installment obligation. Taxpayer contends that, because he determined that X would most likely receive less than the maximum $e selling price set forth in the installment agreement, the amount of section 453A interest reported on his year 2 tax return was overstated. More specifically, Taxpayer takes the position that the amount of section 453A interest that Taxpayer reported in his year 2 return should be adjusted to reflect Taxpayer's year 5 estimate of the amount that he would eventually receive under installment sale obligation.

[22] Taxpayer argues that such an adjustment is consistent with the purpose of section 453A. In general, the purpose of section 453A is to charge a taxpayer interest on the tax liability that is being deferred as a result of taxpayer's use of the installment method to report their gain on the sale. By computing his section 453A interest for year 2 based on his share of the maximum amount that X could receive on the obligation, Taxpayer claims that he paid interest on amounts in excess of the tax liability that will actually be deferred. For additional support, Taxpayer cites to the special rules set out in section 15A.453-1(c)(7) of the Income Tax Regulations, which allows a taxpayer using the installment method to use an alternative method of basis recovery for contingent payment sales where the taxpayer can show that the normal basis recovery rules will substantially and inappropriately distort the recovery of basis. Taxpayer argues that these rules can be extended to the interest computation under section 453A to allow a recomputation of the deferred tax liability. The agent takes the position that, while Taxpayer's approach seems reasonable, neither the Code nor the regulations under section 453 provide specific authority for a recomputation and refund of section 453A interest.

[23] We believe that Taxpayer in this case is not entitled to a refund of its section 453A interest. First, section 15A.453-1(c)(7) does not apply to Taxpayer's situation. In general, section 15A.453- 1(c)(7) allows a taxpayer to use an alternative method for reporting payments received on a contingent installment sale if the required reporting method would substantially and inappropriately distort the taxpayer's recovery of basis. Under this regulation, a taxpayer may request a letter ruling from the Service allowing it to apply an alternative allocation of basis to the payments received by the taxpayer on the installment sale. While the use of an alternative method will affect the rate at which taxpayer recovers its basis and recognizes gain from the sale, it generally will not affect the amount of gain that is ultimately recognized by the taxpayer. Moreover, the taxpayer must receive a letter ruling from the Service before using an alternative method of basis recovery. See section 15A.453-1(c)(7)(ii).

[24] In the present case, Taxpayer had not requested a letter ruling from the Service permitting him to use an alternative method of basis recovery for reporting amounts received under the installment method. In fact, for installment reporting purposes, Taxpayer continued to report income under the basis recovery rule normally applicable to a maximum contingent selling price agreement. In addition, the alternative basis recovery rules set out in section 15A.453-1(c)(7) were designed to adjust the time at which a taxpayer recovers its basis and recognizes gain, not the amount of gain that is ultimately recognized by the taxpayer. In contrast, section 453A concerns itself with the amount of gain, and consequently, the tax liability, that a taxpayer will ultimately defer as a result of its use of the installment method. Thus, section 453A serves a purpose independent of the general installment reporting rules and the regulations thereunder. Moreover, the alternative basis recovery rules under section 15A.453-1(c)(7) clearly envision a prospective adjustment in the taxpayer's basis recovery. In contrast, in the present case, Taxpayer has requested a retroactive adjustment, for its earliest open year, on the basis of projections that were not made until year 5. Section 15A.453-1(c)(7) provides no authority for such a retroactive adjustment. Accordingly, these regulations provide little support for Taxpayer's refund claim.

[25] More significantly, if Taxpayer were allowed to obtain a refund in this situation, Taxpayer would be given more favorable treatment than a taxpayer in an identical situation who elected out of the installment method. If a taxpayer elects out of the installment method, then the taxpayer must report, as the amount realized in the year of sale, the fair market value of the contingent payment obligation. See section 15A.453-1(d)(2)(iii). Pursuant to the regulations, this amount may be ascertained from, but in no event shall be considered to be less than, the fair market value of the property sold. Id. Thus, under the facts provided, including the appraisal received by Taxpayer prior to the sale, if Taxpayer elected out of the installment method, Taxpayer would have reported an amount realized on the sale comparable to the amount that Taxpayer used to compute unrecognized gain for purposes of calculating interest under section 453A. In this situation, Taxpayer would have paid taxes on all the anticipated gain from the installment sale in the year of sale, and would have lost the time value on the amount denominated as taxes. If Taxpayer, having reported the gain and paid the tax thereon, had not thereafter received the full amount previously reported under the terms of the sales agreement, Taxpayer would not be able to recover any of the time value on the taxes previously paid.

[26] However, in the present case, Taxpayer used the installment method to account for its share of X's installment obligation. As a result, under section 453A, Taxpayer was required to pay interest on his deferred tax liability. Under section 453A(c), this interest is calculated by multiplying the "applicable percentage" of the "deferred tax liability" by the underpayment rate in effect under section 6621(a)(2). The "applicable percentage" is determined by dividing the portion of the aggregate face amount of Taxpayer's outstanding installment obligations as of the close of the taxable year in excess of $5,000,000 by the aggregate face amount of such obligations as of the close of the year. The "deferred tax liability" for a taxable year is the amount of the gain with respect to an obligation which has not been recognized as of the close of the taxable year multiplied by the maximum individual or corporate tax rate, whichever is appropriate, in effect for such year.

[27] The result of this section 453A computation is that Taxpayer paid an interest charge each year on a portion of the tax liability that was deferred (ie., the tax liability on deferred gain in excess of $5,000,000) as result of his use of the installment method. In effect, by charging these amounts, Congress required Taxpayer to forgo the time value that could be earned on the deferred taxes, thereby placing Taxpayer in a position similar to a taxpayer who elected out of the installment method. If Taxpayer were permitted a refund of these amounts, then Taxpayer would be treated more favorably than a taxpayer who elected out of the installment method and permanently lost any time value that could have been earned on the amounts used to pay his or her tax liability. Under either scenario, Congress provided no mechanism for Taxpayer to recover the time value on the taxes previously paid. Moreover, neither the Code nor the legislative history of section 453A indicate that Congress intended such disparate treatment of these taxpayers. Therefore, we believe Taxpayer is not entitled to a refund for these amounts.

Issue (2) -- Whether Taxpayer and his spouse, who each separately own shares in X, an S corporation, are considered a single taxpayer for the purpose of applying the $5,000,000 limitation of section 453A.

[28] In year 1, Taxpayer owned aa% of the outstanding shares of X's stock. Simultaneous with the sale of X's assets to Y, Taxpayer transferred dd% of X's stock to A, his spouse, leaving himself with a ee% interest in X. As a result, after the sale, Taxpayer determined that his share of the installment note was $f, and A's share of the installment note was $m.

[29] Under section 453A, a taxpayer is only required to pay interest on deferred tax liability with respect to an installment obligation if the face amount of all such obligations held by the taxpayer exceeds $5,000,000 ("the $5,000,000 limitation"). See section 453A(b)(2). In addition, to compute section 453A interest, a taxpayer must apply the interest rate only to an "applicable percentage" of the deferred tax liability. See sections 453A(c)(2); 453A(c)(4). As noted above, this applicable percentage is determined by dividing the portion of the aggregate face amount of a taxpayer's outstanding installment obligations in excess of $5,000,000 by the aggregate face amount of such obligations.

[30] Because Taxpayer determined that his share of X's installment obligation was $f and this amount exceeded $5,000,000, Taxpayer included interest on his deferred tax liability with respect to his share of the installment obligation on his year 2 tax return in accordance with section 453A. For purposes of calculating section 453A interest, Taxpayer computed the applicable percentage as the excess of $f over $5,000,000, divided by $f. Thus, Taxpayer calculated interest on only the deferred tax liability attributable to outstanding installment obligations in excess of $5,000,000.

[31] The revenue agent takes the position this calculation of section 453A interest is incorrect. Specifically, the agent contends that, because of the marital relationship, Taxpayer and his spouse must share one $5,000,000 limitation to be applied against each of their outstanding installment obligations. In other words, the agent believes that each spouse is required to pay section 453A interest if and to the extent that his or her outstanding installment obligations exceed $2,500,000, rather than the $5,000,000 limitation set out in sections 453A(b)(2) and 453A(c)(4). Therefore, the agent concludes that Taxpayer was required to calculate interest on the deferred tax liability attributable to his outstanding installment obligations in excess of $2,500,000.

[32] As support for this position, the agent cites to certain language in section 453A(b)(2). As noted above, section 453A(b)(2) provides, in part, that the requirement to pay interest under section 453A shall apply only if a taxpayer's installment obligation is outstanding as of the close of such taxable year, and the face amount of all such obligations held by the taxpayer which arose during, and are outstanding as of the close of, such taxable year exceeds $5,000,000. However, section 453A(b)(2) further provides that all persons treated as a single employer under subsection (a) or (b) of section 52 shall be treated as one person for purposes of this paragraph and section 453A(c)(4), governing the calculation of the applicable percentage.

[33] The agent believes that Taxpayer and his spouse should be treated as a single employer under the principles of section 52(a). Under section 52(a) corporations are treated as a single employer if they are members of the same "controlled group of corporations" as defined in section 1563(a) with certain modifications. Under section 1563(a)(2), a "controlled group of corporations" includes two or more corporations if 5 or fewer persons who are individuals, estates, or trusts own stock possessing at least 80% of the total combined voting power or the total value of shares of each corporation, and more than 50% of the total combined voting power or the total value of shares of each corporation, taking into account the stock ownership of each such person only to the extent such stock ownership is identical with respect to each such corporation. For purposes of applying this section, section 1563(e)(5) provides an attribution rule whereby an individual shall be considered as owning stock in a corporation owned, directly or indirectly, by or for his spouse except if certain conditions are satisfied.

[34] Based on these provisions, the agent opines that, for purposes of section 1563(a), two corporations would be considered members of the same controlled group of corporations if, for example, Taxpayer owned all the stock in one corporation and his spouse owned all the stock in another corporation. If this were the situation, then these two corporations would be treated as a single employer under section 52(a), and accordingly, as one person for purposes of sections 453A(b)(2) and 453(c)(4). As such, these two corporations would only be entitled to one $5,000,000 limitation between them. while the agent recognizes that Taxpayer and his spouse are not corporations, the agent believes that the same attribution rule should be applied to individuals for purposes of determining whether they are one person, or one taxpayer, under section 453A(b)(2). In addition, the agent is concerned that Taxpayer was trying to avoid the rules of section 453A in part by transferring a portion of his X stock to his spouse.

[35] We do not agree with the revenue agent's interpretation of section 453A(b)(2). While section 453A(b)(2) provides a limited attribution rule for persons treated as a single employer under sections 52(a) and (b), these provisions do not apply, by their terms, to Taxpayer and his spouse. Moreover, we do not believe that this attribution rule should be expanded beyond the specific parameters of section 52. In particular, if Congress had intended that married individuals be treated as one taxpayer for purposes of applying the $5,000,000 limitation set out in section 453A, it could have easily provided for this attribution in express terms rather than resort to a strained and unlikely interpretation of sections 52 and 1563. In fact, in numerous other Code provisions, Congress has specifically provided for the allocation of various limitations among married individuals. See, e.g., section 38(c)(3) (limitation on the general business credit); section 163(h) (limitations on amounts treated as acquisition or home equity indebtedness); section 179(b)(4) (limitation on election to expense certain depreciable business assets); section 1211(b) (limitation on capital losses). Where Congress is silent on this point, as in section 453A, we do not believe that an allocation between married individuals can be implied.

[36] In addition, section 453A(b)(2) specifically states that this section shall apply to certain installment obligations only if "the face amount of all such obligations held by the taxpayer which arose during, and are outstanding as of the close of, such taxable year exceeds $5,000,000." This language indicates that the $5,000,000 limitation is applied to the installment obligations held by the "taxpayer." Generally, married individuals are treated as separate taxpayers under the Code. See section 1 (imposing a tax on the taxable income of every married individual whether they file joint or separate returns). Since Taxpayer and his spouse are considered separate taxpayers under the Code, it follows that each individual should be entitled to apply the $5,000,000 limitation to installment obligations that each separately holds. This result is even more warranted in the present case where Taxpayer and his spouse filed separate tax returns.

[37] Finally, the legislative history of section 453A provides additional authority for treating Taxpayer and his spouse as separate taxpayers for purposes of applying the $5,000,000 limitation. The Conference Report accompanying the enactment of section 453A provides that "the Conferees anticipate that the regulations relating to pass- through entities will treat the installment obligations of a partnership as owned directly by the partners in proportion to each partner's share in the partnership." H.R. Rep. No. 495, 100th Cong., 1st Sess., 930 (1987). This approach was incorporated into Notice 88- 81, 1988-2 C.B. 397, which provided interim guidance to passthrough entities (i.e., partnerships, S corporations, and certain trusts) after Congress' repeal of the proportionate disallowance rule under section 453C and amendment to the interest and pledging rules under section 453A. Notice 88-81 provides that, in the case of a passthrough entity, the $5,000,000 threshold under section 453A is applied, and the interest calculations are made, at the owner level and each such owner must report its share of interest on the owner's tax return. Because Taxpayer and his spouse each owned stock individually in X, a passthrough entity, Taxpayer's application of a $5,000,000 limitation to compute the section 453A interest on his share of X's installment obligation would be consistent with the provisions of the Notice and legislative history of this section.

[38] Accordingly, based on the forgoing analysis, we believe that Taxpayer and his spouse, who each separately own shares in X, an S corporation, may be considered separate taxpayers for the purpose of applying the $5,000,000 limitation of section 453A. Thus, Taxpayer was entitled to apply the entire $5,000,000 limitation to determine the interest on his deferred tax liability for purposes of section 453A.

[39] No opinion is expressed and no inference is intended regarding whether Taxpayer's transfer of his shares of X stock to A, his spouse, was a bone fide transaction or whether such transfer should, in fact, be respected for federal income tax purposes.

[40] A copy of this technical advice memorandum is to be given to Taxpayer. Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.

[41] Temporary or final regulations pertaining to one or more of the issues addressed in this memorandum have not yet been adopted. Therefore, this memorandum will be modified or revoked by the adoption of temporary or final regulations, to the extent the regulations are inconsistent with any conclusion in the memorandum. See section 17.05 of Rev. Proc. 98-2, 1998-1 I.R.B. 74, 95. However, a technical advice memorandum involving a continuing transaction generally is not revoked retroactively if the taxpayer can demonstrate that the criteria in section 17.06 of Rev. Proc 98-2 are satisfied.