In our May 2021 Business Law Insights, we discussed installment sales and reporting taxable gain on the installment method. In this month’s Business Law Insights, we discuss installment sales in light of potential tax law changes.
Nothing herein is intended to be, and should not be taken as, tax or legal advice. Many assumptions and guesses are made herein. Examples are for illustrative purposes only, are extremely simplified, and generally do not show complete results or methods. You should not rely on anything herein in making any decision. Tax consequences are highly dependent on the facts and circumstances of each taxpayer, so always contact an attorney when making, or seeking advice on, any legal or tax decisions.
A Quick Refresher
An installment sale is the disposition of property where at least one payment is to be received by the seller after the close of the taxable year in which the sale occurs. Installment sales do not require many payments over many years. For example, a sale by a calendar year taxpayer that is closed on 12/31/2021 and paid for on 1/1/2022 is considered an installment sale because at least one payment is made in a year after the year of sale.
Taxable gain arising from an installment sale must be reported under the installment method unless either the Internal Revenue Code specifically excludes such sale from installment method reporting or the taxpayer elects out of the installment method. Under the installment method, the seller defers gain on the sale, recognizing gain in each year that a portion of the purchase price is received. This allows the tax liability to be spread over two or more tax years.
Potential Tax Law Changes
First, it is important to point out that as of the date of this writing, no actual tax law changes have been enacted in 2021 (at least none that are relevant for purposes of this discussion), nor has any relevant legislation yet been introduced in Congress. Therefore, all of the potential tax law changes discussed herein are pure speculation, based solely on President Biden’s proposed tax plans and related statements. That being said, President Biden’s proposed tax plan includes the following:
- Increase corporate tax rate from 21% to 28%.
- Increase top individual marginal rate from 37% to 39.6%.
- Repeal or amendment of the qualified business income deduction under IRC §199A (which provides a deduction of up to 20% of qualified business income).
- Unknown whether the proposal is for a full repeal of §199A or rather an amendment to the law resulting in a complete phase-out of the deduction for those with income over a certain amount.
- Long-term capital gain rate and qualified dividends rate increased from 20% to 39.6% for those with adjusted gross income (AGI) over $1 million.
- If the 3.8% net investment income tax applies, the total rate will be 43.4% for high-earning individuals.
- Added payroll tax on all income over $400,000.
If these tax law changes are enacted in 2021, the effective date(s) of the changes will be very important. If new tax rates become effective starting January 1, 2022, then those planning to sell a business or other property within the next few years may accelerate their plans and attempt to sell no later than December 31, 2021. But, if new rates are effective retroactive to January 1, 2021 (which Congress can do), prospective planning is greatly hampered.
NOTE: THIS DISCUSSION ASSUMES THAT ANY CHANGES IN INCOME TAX RATES WILL BECOME EFFECTIVE ON JANUARY 1, 2022.
How Installment Sales Could Help (and Hurt)
From a mergers and acquisitions (M&A) and other property sales perspective, the most important proposed change in the law is an increase of the long-term capital gain rate from 20% to 39.6% for taxpayers with income over $1,000,000. It is very common in M&A transactions for a business owner to earn well more than $1,000,000 on the sale, even though such owner never earned over $1,000,000 in any year during which he or she owned and operated the business.
For transactions involving installment sales or seller financing (i.e., a portion of the purchase price is paid over a period of years), sellers may agree to a longer repayment period to keep annual income below $1,000,000 (or to buy time for possible tax changes under future presidential administrations or changes of party control in Congress). By spreading out the payments over a longer period of time to keep the seller’s AGI below $1,000,000, a seller may be able to avoid paying nearly double in taxes. There is always some risk in spreading payments out over a longer period, though. One risk is that a buyer mismanages the purchased business and within a couple of years is not able to make the remaining installment payments. Furthermore, the longer the payment period, the more interest that accrues on the outstanding balance. Such greater interest expense may cause some buyers to demand lower total purchase prices.
What about installment sales that have already occurred with payments remaining owing over the next few years? Assuming the gain is long-term capital gain, currently, the seller will pay no more than 23.8% in tax on each payment received (20% long-term capital gain tax + 3.8% net investment income tax). But beginning in 2022, the same seller could be paying taxes at a rate of 43.4%. Such sellers may seek to accelerate the payments to occur in 2021 or to otherwise accelerate the gain recognition even though the payments will continue to be paid over a period of years. By accelerating the payments or the gain recognition to 2021, the seller will have a higher tax bill in 2021, but will potentially save a vast sum in taxes overall. A seller may not be able to control whether payments are accelerated, though, as it will require the buyer to agree and such buyer might simply be unable to pay off the outstanding balance all at once in 2021.
Finally, a taxpayer can elect out of the installment method. While this requires a greater tax payment for the current tax year, electing out of the installment method for the tax year 2021 may save a seller a lot in taxes over time.
Lets take a look at an example…
Samantha owns 100% of the stock of ABC, Inc. She has owned such stock for many years. In 2021, Samantha agrees to sell all of the stock in ABC, Inc. for a total purchase price of $5,000,000. Closing is to occur on December 31, 2021, and long-term capital gain rates will go from 20% to 39.6% on January 1, 2022 (ignore the net investment income tax for purposes of this example). The purchase and sale agreement requires that the buyer pays Samantha $1,000,000 cash at closing and $2,000,000 in each of 2022 and 2023. By not electing out of the installment method, Samantha will pay $200,000 of tax for the tax year 2021 ($1,000,000 payment at closing on December 31, 2021 x 20%). In each of 2022 and 2023, Samantha will pay $792,000 in tax ($2,000,000 installment payments x 39.6%). Samantha’s total tax liability is, therefore, $1,784,000. But if Samantha elects out of the installment method by timely filing the proper statement with her 2021 tax return, she will report a gain on the entire $5,000,000 for the tax year 2021. Her total tax liability will be $1,000,000 ($5,000,000 total purchase price x 20%). But, by electing out of the installment method, Samantha saves $784,000 in taxes! The downside here is that the entire amount Samantha receives at the closing must be used to pay the tax (and this example ignores state taxes, so Samantha will likely have more than $1,0000,000 in total taxes owing for 2021). But if Samantha can withstand delivering her entire down payment received to the government, she will be much better off in the long run. Conversely, Samantha might negotiate a slightly higher payment to be paid at closing so that Samantha has some additional cash in her pocket.
Once again, we do not know what tax law changes (if any) are coming, nor do we know what specific limitations and exceptions any new tax legislation may impose. But, some tax law changes are likely coming in 2021. If you are planning on selling a business or other asset that may result in substantial capital gain, you should keep an eye on what happens in Washington, D.C., and begin to consider potential alternative plans.
If you have any questions about installment sales and the installment method, or about general planning in light of potential tax law changes, please contact your Carlile Patchen & Murphy LLP attorney.