Installment Sales
Individuals who sell their business or personal property at a gain are oftentimes faced with the dilemma of recognizing the gain immediately or deferring some or all the gain. Generally, the entire profit is ordinarily taxable in the year of the sale. However, by making a sale in one tax year with part of the proceeds payable over the following tax year(s), an eligible seller recognizes the taxable gain in the tax year the installment payment is received or deemed received. Each payment received is treated as part non-taxable recovery of basis and part taxable gain. Such an arrangement is known as an “Installment Sale".
- What is an Installment Sale?
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An Installment Sale is 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.”Installment Sales generally permit sellers to defer gain on certain property dispositions to the tax year in which the related sales proceeds are received. Not all property dispositions where payments are received in later tax years qualify as Installment Sales (e.g. sales of inventory, sales by dealers in real and personal property, sales of securities traded on established exchanges, the portion of a sale of real or personal property that is subject to depreciation recapture and certain sales of property between related persons). Sellers should consult with their own independent tax advisor to see if a sale qualifies as an Installment Sale.
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- How Do Installment Sales Work?
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In general, with respect to a typical sale of property eligible for an Installment Sale, the Seller and the Buyer agree that the Buyer will pay a certain amount of the purchase price through making at least one payment after the tax year of the sale. The Seller should consult with his or her own independent tax advisor to see if a sale qualifies as an Installment Sale. Each Installment Sale payment received by the Seller consists of the following three components:
- Non-taxable recovery of the investment or basis
- Taxable gain
- Interest
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- Structuring the Sale Transaction
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Once the sales transaction is completed, the Buyer immediately assigns its periodic payment obligations to the Assignment Company. The assignment is effected through executing an Assignment of Obligation agreement. This assignment agreement between the Buyer and the Assignment Company makes no changes to the terms of any prior agreement between the Buyer and the Seller. The Buyer assigns to the Assignment Company the Buyer’s obligation to make the periodic payments as specified in the Assignment of Obligation agreement. The structured sale may appeal to the Seller who has concerns with relying on the credit quality of the Buyer.
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- The Structured Sale Strategy
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A Seller agrees to take part of the funds from the sale of a business or property in the form of periodic payments from the Buyer, or what is commonly referred to as an Installment Sale.
Steps to Complete the Structured Sale (Assuming that there is a valid installment sale):
- 1. Buyer and the Assignment Company enter into an Assignment agreement whereby the Buyer transfers to the Assignment Company its obligation to make future payments and thereby making the Assignment Company responsible for making future payments. The Seller is not a party to the assignment, and the Buyer will remain liable to the Seller pursuant to any agreement between the Buyer and the Seller.
- 2. Broker ensures all necessary documents, including, but not limited to, Purchase Agreement, Assignment Agreement, annuity application, and wire transmittal forms are sent to the assignment company.
- 3. Buyer then wires funds to the Assignment Company as agreed.
- 4. The Assignment Company wires funds to the Life Company to purchase an annuity contract, for which it retains all rights and incidents of ownership.
- 5. The Assignment Company, for its convenience, directs the Life Company to make payments directly to the Seller.
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- Assignment Documents and the Assignment Company Obligations
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The Assignment Company’s primary business involves assuming liabilities to make periodic payments to payees on behalf of obligors. An obligor enters into an agreement with the assignment company whereby, in exchange for consideration, the Assignment Company agrees to assume the liability of the obligor to make periodic payments.
The Assignment Company and the Buyer enter into an agreement called an “Assignment.” The assignment document provides that the Assignment Company’s obligation to make the periodic payments to the Seller will be no greater than that of the Buyer/Assignor immediately preceding the assignment.
The Assignment Company subsequently purchases an annuity contract from the Life Company to fund its payment obligations to the payee. The Life Company will accept applications for annuities from the Assignment Company Assignments, Ltd. The Assignment specifically provides that all rights of ownership and control of such annuity contract shall be and remain vested exclusively in the Assignment Company. Although the Assignment Company may direct the Life Company to send the payments directly to the payee, such direct payment would be for the Assignment Company’s convenience only. Thus, the payee has no rights under the annuity contract.
After the purchase of the annuity, the Life Company provides the payee with an “Agreement to Pay” wherein the Life Company states that the payee will receive all payments required to be made by the Assignment Company under the terms of the Assignment of Obligation agreement. The Agreement to Pay is a separate and independent agreement that is entered into by the Life Company at the time the Assignment Company purchases an annuity contract with the Life Company to fund its obligations to the payee. There is no consideration for the Life Company’s Agreement to Pay. This Agreement does not give the payee any status greater than that of a general creditor of the Life Company and does not impose any greater obligation on the Life Company than that of the Assignment Company. The payee is at risk for the insolvency of the Assignment Company and neither the Assignment Company nor the Life Company set aside any funds or assets as security or collateral for the benefit of the payee.
The structured sale transaction involves three independent steps, demonstrated in the graphic over to the right.
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Recent article authored by Attorney Robert Wood, Esq. regarding the advantages of a Structured Sale