The following article is adapted and reprinted from the M&A Tax Report, Vol. 11, No. 9, April 2003, Panel Publishers, New York, NY.

CAN YOU USE THE INSTALLMENT METHOD ON CORPORATE LIQUIDATIONS

By Robert W. Wood

Can accrual method taxpayers use the installment sale method? Some of the answer to that question depends on timing. Section 453(a)(2) of the Code was repealed by the Ticket to Work and Work Incentives Improvement Act of 1999. That Code provision had barred accrual method taxpayers from using the installment sale method. Moreover, the repeal was retroactive, surely adding insult to injury.

However, the repeal didn't last long. After some debate about the use of installment method and why it was important, Congress reinstated this Code provision in the Installment Tax Correction Act of 2000. The provision that is probably of greatest importance to M&A Tax Report readers is Section 453(h) of the Code. That subsection permits shareholders who receive qualified installment notes in otherwise taxable complete liquidations to use the installment method.

"H" is for Hot!

Section 453(h) of the Code is an important provision, at least if one has to deal with gain recognition. Since the General Utilities doctrine was repealed back in 1986, installment sales have helped shareholders to manage their personal level of gain recognition. Section 453(h) allows a shareholder who receives certain installment notes in exchange for stock in a Section 331 liquidation to treat the receipt of the payments under the note (rather than the receipt of the note) as payment for the stock. Of course, this doesn't ameliorate the sting of General Utilities repeal. The C corporation will presumably still pay tax on its distribution of assets. Still, the use of the installment notes distributed by the corporation to shareholders helps manage this second level of tax.

The regulations indicate that this favorable treatment on distributions applies only to distributions of qualifying installment obligations to qualifying shareholders. A "qualifying installment obligation" is any one of the following:

• not payable on demand or readily tradable;

• acquired in a sale or exchange of corporate assets by the liquidating corporation during the 12-month period beginning on the date the plan of complete liquidation is adopted; and

• if attributable to a sale of stock in trade or inventory, results from a sale or exchange from one person in one transaction and involves substantially all of such property attributable to the corporation's trade or business (in other words, a bulk sale).

What is a qualifying shareholder? This is simply a shareholder as to which Section 331 applies to the liquidating distribution. A creditor who receives an otherwise eligible installment note in exchange for some claim against the corporation would not be entitled to the favorable installment method, since that creditor is by definition not a "qualifying shareholder."

Ineligible Property

It is not uncommon, of course, for a shareholder to receive as a liquidating distribution not only installment notes that qualify under Section 453(h), but also cash or other property. If a shareholder receives a mixture of such items, unless the shareholder elects out of installment method treatment, the shareholder must report as received all of the cash and other nonqualifying property. Then, under the installment method, the taxpayer would report payments under the qualifying installment notes as and when received. See Reg. §1.453-11(a)(5), Example 2. See also §1.453-11(a)(3).

Shareholder by Shareholder

The use of the installment method for shareholders is determined on a shareholder by shareholder basis. This allows shareholders who do not wish to receive installment treatment to elect out of it. For a shareholder who elects out (or for whom Section 453(h) simply does not apply), he must recognize gain or loss on the liquidating distributions (including the installment note) at fair market value.

For a shareholder who does elect out, that election means the shareholder recognizes gain or loss on all distributions, including the value of the installment note computed at fair market value. The election would apply to all liquidating distributions only to that shareholder. Separate elections cannot be made for separate blocks of stock. See Reg. §1.453-11(a)(3).

Installment Treatment by the Corporation

So far, we have been talking solely about installment treatment to the distributee shareholders. Now, let's refer to a corporation's use of the installment method itself. Suppose, for example, that a corporation sells its assets for cash and an installment note. If the corporation distributes the installment note and the cash in liquidation before the installment note has been fully collected, what treatment applies to the corporation?

The answer depends in part on what has happened thus far. Presumably when installment payments are received by the corporation under the installment obligation (before the corporation liquidates, distributing the installment obligation), the corporation will recognize some of its gain under the traditional installment method computation. Then, on the subsequent liquidating distribution which includes the note, all remaining gain inherent in the installment obligation is accelerated and taxed to the liquidating corporation.

Bear in mind, of course, that this acceleration of gain to the corporation has nothing to do with the treatment that the shareholder might receive if the shareholder is entitled to collect the remaining payments due under the installment note.

Can You Use the Installment Method on Corporate Liquidations?, Vol. 11, No. 9, The M&A Tax Report (April 2003), p. 7.