Monday, November 21, 2011

Modification of Installment Sale Was Not a Disposition

The IRS has determined in a private letter ruling that modification of a stock purchase agreement and promissory note would not constitute a disposition of an installment obligation under Code Sec. 453B (IRS Letter Ruling 201144005). Therefore, the seller did not need to recognize gain or loss at that time.

An installment sale is a sale of property at a gain where at least one payment is to be received after the tax year in which the sale occurs. Under the installment method, taxpayers include in income each year only part of the gain the taxpayer receives, or is considered to have received. Code Sec. 453B provides that, if an installment obligation is satisfied at its face value or if it is distributed, transmitted, sold, or otherwise disposed of, the seller must recognize gain or loss at that time.

The taxpayer was the sole shareholder of a corporation. The taxpayer and five employees entered into stock purchase agreements and executed promissory notes to purchase shares in the corporation owned by the taxpayer.

The taxpayer undertook the sale as part of her business succession planning.

The employees agreed to make nine equal payments of principal and interest on the outstanding balance. The employees intended to use the corporation's annual distributions to make the payments. However, the economic downturn in recent years prevented the employees from making any payments beyond their initial payments. The employees proposed to reduce the purchase price and interest rate.

Several rulings, the IRS noted, have reviewed whether a modification of an installment obligation amounts to a disposition of the obligation. In Rev. Rul. 68-419, 1968-2 CB 196, the buyer purchased stock with a note providing for five equal annual payments. The buyer encountered financial difficulties and asked the seller to modify the note by deferring each payment for five years. The seller agreed and, in return, the buyer agreed to increase the interest rate. The IRS determined that these modifications of the note were not to be considered a disposition of an installment obligation.

In Rev. Rul. 74-157, 1974-1 CB 115, the taxpayer sold a parcel of land for cash and a promissory note secured by a deed of trust on the land. Because the purchaser wanted to divide the property into two parcels, the seller agreed to accept substitution of two promissory notes, each secured by a deed of trust on a parcel of land for the original unpaid note and deed. The revenue ruling holds that the substitution of the deeds and notes were not a disposition of an installment obligation.

The IRS subsequently held in Rev. Rul. 74-457, 1974-2 CB 122, that the substitution of obligors, deeds of trust, and promissory notes, without any other changes, would not constitute a disposition of an installment obligation. In Rev. Rul. 82-122, 1982-1 CB 80, the IRS further provided that substitution of a new obligor and a change in the rate of interest was not a disposition of an installment obligation.

Here, the IRS determined that the modification of payment terms between the taxpayer and the employees would not constitute a disposition of the installment agreement. The payment terms identified by the IRS included deferring/increasing payment dates, which were modifications similar to the modifications in the earlier rulings, such as Rev. Rul. 82-122. The IRS further determined that, where the original installment note is replaced, the substitution of a new promissory note without any other changes is not sufficient for the original note to be treated as "disposed of."

Reference: PTE §18,370

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