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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
October 9, 2014
The question arose this week whether a “collateralized installment sale” or “C453” transaction can be used to defer the tax on the sale of an in-force life insurance policy, such as a sale by an insured to a life settlements investor.
The answer is yes, for part of the transaction. The tax can be deferred on the other part, too, but for a different reason and in a different way.
The Internal Revenue Service treats life insurance policies as capital assets, but that fact alone doesn’t mean that an installment sale of such a policy will permit deferral of all of the tax under the installment-reporting section (Section 453) of the tax code. That’s because part of the gain may be treated not as proceeds of the sale but as an assignment of an accrued right to receive ordinary income: the net inside build-up that the insured would otherwise receive if the insured simply surrendered the policy to the life insurance company. It has long been true that the IRS doesn’t generally allow taxpayers to escape tax on earned ordinary income by assigning that income to someone else. When an insured sells his or her policy, that part of the selling price which is a substitute for net inside build-up will be taxed as ordinary income (that is, not as capital gain from the sale of a capital asset), and a C453 transaction by itself doesn’t enable the insured to defer the tax on that part.
For the insured to be able to defer tax on the sale of a life insurance policy, I recommend that the insured sell, pursuant to an installment contract with S.Crow Collateral Corp., only a fractional interest in the policy, that is, all of the policy except the net inside build-up, which will continue to be the insured’s property. The insured will retain the right to receive payment of the net inside build-up when the policy matures. Because the insured retains that right, there is no assignment of an accrued right to receive income.
When S.Crow Collateral Corp. buys that fractional interest, it will re-sell it to the investor who is the ultimate buyer, and that investor will agree to collect the policy’s net inside build-up when the policy matures and to pay the same to the insured.
Because of the C453 30-year installment purchase by S.Crow Collateral Corp. of a fractional interest in the policy, S.Crow Collateral Corp. will owe the insured a lump-sum payment of the purchase price in 30 years, for that fractional interest. That should enable the insured to defer for 30 years the entire tax on the gain on that sale of the fractional interest, under Section 453.
For the other part—the net inside build-up—the investor should agree with the insured to pay the insured the net inside build-up when the investor receives that sum on the maturity of the policy. With that agreement in place between the insured and the investor, S.Crow Collateral Corp. can step into the investor’s shoes by assuming the investor’s debt for that amount to the insured. Then S.Crow Collateral Corp., with the insured’s consent, can agree to pay that amount in thirty years, rather than when the policy matures. The insured and S.Crow Collateral Corp. can agree that the amount which S.Crow Collateral Corp. will pay in 30 years will be the actual inside build-up in whatever amount it turns out to be, or they may settle on a formula or fixed sum in lieu of the eventual actual amount.
That means that upon the installment sale of the policy and upon S.Crow Collateral Corp.’s assumption of the investor’s debt to the insured for the inside build-up, S.Crow Collateral Corp. will be required to pay the insured, 30 years from now, two amounts: (1) The purchase price for the fractional interest in the policy, and (2) the amount on which they agree for the inside build-up portion. The first should be deferred capital gain on an installment sale under Section 453, and the second should be deferred ordinary income for the simple reason that the income itself is deferred. (One is not generally taxed on income until one receives that income.)
Also, at the closing of both of those transactions, the lender with which S.Crow Collateral Corp. works will generally be willing to lend to the insured, in a monetization loan up front, an amount equal to 95% of the total of (1) and (2).
So, the insured immediately obtains non-taxable cash in the form of loan proceeds, and the investor will be paid the death benefit when the insured’s death occurs.
(A variation on this transaction process can be utilized to defer the ordinary income tax to the investor on the death benefit when the policy matures.)—Stan Crow
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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.