Category: Sales & Exchanges; Accounting Periods & Methods
Subject: Installment Sales
Title: Allocation of Installment Proceeds Among Classes of Assets Sold
IRC Sections: 453
Filename: 1220.html
Date Produced: 04/95

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Background
Taxpayer (TP) operated a retail pharmacy as a Schedule C activity. In 1994, TP sold all the assets of the business (including the inventory) for $250,000, receiving $175,000 in cash at closing and a note for the balance payable over three years.

Issues
1. Can the inventory portion of TP's assets be sold on the installment basis?

2. If not, how are the down payment and the note allocated as between inventory and non-inventory items?

Answers
1. Inventory, even when sold as part of a bulk sale, is not eligible for installment reporting.

2. Allocation of the proceeds between the various categories of assets is a question of fact. If TP cannot show, either through the terms of the contract or through some other means, an allocation of the various components, the down payment and the note are allocated prorata based on the value of each category of asset.

Discussion
Internal Revenue Code Section 453(b)(2)(B) explicitly excludes inventory-type items from reporting under the installment method. This exclusion apparently extends not only to inventory sold in the ordinary course of business but also to inventory sold in bulk in connection with sale of an entire business as a going concern. The case of Carl Wesley Murry v. Commr., 66 TCM 1015, dealt with the sale of a convenience store including its inventory. The taxpayer attempted to include inventory in the amount reported on the installment method. The court, citing Section 453(b)(2)(B), unceremoniously rejected the taxpayer's position.

There is considerable literature with respect to allocation of proceeds between various classes of assets. Prior law denied installment sale treatment if the amount received in the year of sale exceeded 30% of the selling price. Accordingly, allocation of the down payment as between assets eligible for installment reporting versus those assets ineligible for such reporting was a critical issue.

Rev. Rul. 68-13, 1968-1 CB 195, Rev. Rul. 55-79, 1955-1 CB 370, and J.A. Johnson, 49 TC 324, Dec 28,802 consider the issue and all reach essentially the conclusion set forth above: namely, allocation of the components of the proceeds of a sale as between the various assets sold is essentially a question of fact. If the contract of sale is silent (as it almost always is) and the taxpayer is unable to produce evidence of the intent of the parties from some other source, e.g., testimony of the buyer or other involved parties, the proceeds must be allocated as between the various groups of assets prorata based on the relative values of each group.

As I understand it, the contract of sale is silent on this issue. The question for you and your client is whether there was an understanding between buyer and seller that some certain portion of either the down payment or the installment note was allocable to one or another class of assets. If there was such an understanding and your client feels that he could bear his burden of proof if the matter were later scrutinized by the IRS, it seems there is ample justification for allocating the proceeds in this case in accordance with whatever understanding existed and can be supported if scrutinized. Otherwise, it seems clear that the prorata method of allocation is necessary.