A uniquely qualified dealer in capital assets
Toll Free: 866-345-7561 - Email Us
176. Does an Installment Sale Defer the Tax on Recapture of Accelerated Depreciation? No. Can the Tax on Recapture of Accelerated Depreciation Nevertheless Be Deferred When an Installment Sale Occurs? Yes.
162. Transfer a Family Business to the Next Generation During the Parent's Lifetime, Retain an Asset for Income, Give the Transferee a Stepped-up Basis, Defer the Gain on Sale, Support the Parent with Deductible Rent, and Finance the Transaction, Too
December 11, 2012
With the possibility that the estate-tax exemption will fall to $1 million on January 1, we’re getting more calls from people for whom the estate tax, rather than the capital-gains tax, is their immediate concern. Their main question is this: Can a collateralized installment sale or "C453" transaction help to reduce estate-tax liability?
You’ve probably guessed already that my answer is yes, because otherwise I might not be writing this.
To illustrate how this works, let’s take the case of Philias Fogg, whose marketable assets are worth $10 million. The assets consist of real estate, part ownership of two businesses which he helps to manage, some limited-partnership investments, and the remains of a flying machine.
Philias enters into a long-term, interest-only installment contract with S.Crow Collateral Corp., which agrees to purchase the assets from Philias for their $10 million value. (As a dealer in capital assets, S.Crow Collateral Corp. will re-sell the assets immediately or as soon as possible. The buyer from S.Crow Collateral Corp. may be a relative of Philias, or someone completely unrelated.) So, on the completion of the closing of the sale, Philias’ estate consists of the installment contract, instead of the real estate and other assets. Although the installment contract is for $10 million, the installment contract is worth less in Philias’ taxable estate than the $10 million value of the assets which S.Crow Collateral Corp. bought.
That is because of several factors (I mention four here) which an appraiser implicitly or explicitly takes into account and which reduce the fair market value of the installment contract.
The first of those is default risk: the risk that the installment buyer might not pay some part or all of the amount owing. Any potential buyer of an installment contract would take that risk into account, and that’s one reason why it’s generally impossible to sell an installment contract for the face amount owing on the contract. Because that is true, the installment contract is discounted for estate-tax purposes.
The second factor concerns marketability: the limited market that exists for selling and buying installment contracts. The market for selling and buying installment contracts has far fewer participants than, say, the market for selling and buying real estate. For that reason, too, an installment contract is discounted for estate-tax purposes.
The third factor is interest risk: the risk that the rate of return which the installment contract generates may not keep pace with market rates from time to time. A below-market interest rate on an installment contract will make the contract worth less for estate-tax purposes than the value of an otherwise equal investment which produces a higher return. For that reason, too, an installment contract may be discounted for estate-tax purposes.
The fourth factor is extended illiquidity: the long period of time which a buyer of the contract may have to wait to receive the principal—particularly in the case of installment contracts, such as those S.Crow Collateral Corp. uses, which are non-amortizing and postpone the payment of any principal until the end of the contract term, which may be 30 or more years away. Because a buyer of the contract would have to wait many years to receive the principal, the contract is discounted for estate-tax purposes.
The amount of the illiquidity discount can be substantial, to reflect the present-day value of a sum of money that won’t be paid until far into the future.
Solely for artistic ease—my artistic ability being somewhat limited—the four discounts are shown here in a way that may suggest that each of them is equal to each of the others. I do not mean to suggest that.
Since the installment contract is worth less than the assets it replaced, why should you use an installment sale? Well, among other reasons, because in the case of what we call a "collateralized" installment sale, you may enjoy immediate liquidity in the form of non-taxable loan proceeds from a third-party lender which will agree not to compel you to pay more to repay the loan than you actually receive from S.Crow Collateral Corp. on the installment contract. (The loan proceeds will be in your estate, but they’re balanced by a deduction for the liability of the debt.)
There is an irony here, though. Many people work throughout their adult lives to build their estates, and then they look for ways to reduce their estates because of the estate tax. Philias Fogg won’t find a better way than this.—Stan Crow
Share Article On LinkedIn:
The Latest Installment addresses situations, questions and issues which are brought to us in the course of the consideration, negotiation or execution of transactions. We don't use the real names of parties to transactions, and we may edit the statement of the question to try to tell the story better. Please feel free to comment, or to take issue, or to raise your own question or situation. If you do the latter, please do not relate any confidential information.
The Latest Installment blog is edited by Stanley D. Crow, who is president of S.Crow Collateral Corp.