Category: Sales & Exchanges; Accounting Periods & Methods
Subject: Sale of Property to Related Party
Title: Effects on Installment Reporting Provisions
IRC Sections: 453, 1060, 197
Filename: 1291.html
Date Produced: 12/95

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Background
Your letter of November 24, 1995 is incorporated by reference into this document.

Discussion: Related Party Rules
You have expressed concern about the taxpayer's inability to use the installment reporting provisions because the sale is between the taxpayer and his son. There are two sets of related party restrictions within the installment sale provisions. One rule, Section 453(e), addresses the situation in which a taxpayer sells property to a related party, and the related party disposes of the property before the original seller recognizes all the gain from the original sale. The other rule, Section 453(g), prohibits installment reporting with respect to sale of depreciable property as between certain related parties.

I assume that the first rule of Section 453(e) is not a problem in this case. In other words the taxpayer does not expect his son to sell the business within two years of the original sale as between the father and the son. Section 453(e) would clearly apply to this situation in the event of a second disposition, because as you point out, the father and son are clearly within the group of related parties set forth in Section 453(f)(1). However, since no second disposition is anticipated within the two-year time period, this point is moot.

It seems to me that restriction on sale of depreciable property between related parties, Section 453(g), is inapplicable to this situation because father and son are not "related parties" as that phrase is defined solely for purposes of Section 453(g). The definition of the phrase "related party" which you cited as taking into account relationships as defined under Sections 318(a) and 267(b) is found at Section 453(f)(1). This definition of "related party" clearly would apply to a father-son sale. However, looking closely at the scope of Section 453(f)(1), we can see that it clearly does not apply to Section 453(g) transactions.

Observe the specific language of Section 453(f)(1).

For purposes of this section--

453(f)(1) RELATED PERSON.--Except for purposes of subsections (g) and (h), the term "related person" means--

453(f)(1)(A) a person whose stock would be attributed under section 318(a) (other than paragraph (4) thereof) to the person first disposing of the property, or

453(f)(1)(B) a person who bears a relationship described in section 267(b) to the person first disposing of the property. [Emphasis added.]

Notice that the definition of "related party" which includes Section 318(a) and Section 267(b) relationships is made specifically inapplicable to Section 453(g) which is the subsection with which we are concerned at the moment.

The reason the definition of "related party" under Section 453(f)(1) is inapplicable to Section 453(g) is very simple: Section 453(g) has its own, narrower definition of "related party". Observe the language of Section 453(g)(3).

453(g)(3) RELATED PERSONS.--For purposes of this subsection, the term "related persons" has the meaning given to such term by section 1239(b), except that such term shall include 2 or more partnerships having a relationship to each other described in section 707(b)(1)(B).

Section 1239 concerns itself with sales of depreciable property between commonly controlled entities. The restrictions of Section 1239 (and hence the restrictions of Section 453(g)) are entirely inapplicable to sales between individuals as in this case.

Discussion: Depreciation Recapture
It seems to me that depreciation recapture is whatever it is. The various depreciation recapture rules are highly mechanical: once the selling price of a particular asset is determined, depreciation recapture is simply a computational matter. Clearly, the selling price determination is the only opportunity to affect the outcome.

Based on the rules of Section 1060 and the regulations thereunder, one is required to allocate selling price based on the total fair market value of the assets included in various classes. Thereafter, one is required to allocate the selling price attributable to a given class to the specific assets in that class based on the relative fair market values of the assets contained in that class. It has been my experience that in many cases, the fair market value of depreciable personal property is often rather close to the tax basis of such property thus significantly mitigating the effect of the depreciation recapture provisions. I suggest starting with the premise that fair market value equals tax basis as a working hypothesis. This hypothesis may or may not be viable based on the specific circumstances of this sale. The hypothesis must be tested on an asset-by-asset basis. In the end, it is critical that the taxpayers understand that the determination of the fair market value of each asset sold is a question of fact. The taxpayers have the burden of proving whatever values they ultimately assign to each asset. In addition, the taxpayers can expect an extra layer of scrutiny because the sale is between related parties.

Discussion: Section 1060
I know of no reason that Section 1060 and its related regulations should not apply to this transaction. Section 1060 does not restrict its scope to exclude related party sales. In fact, it seems to me that because the parties are related, that is all the more reason that Section 1060 should apply. After all, Section 1060 creates purchase price allocation restrictions based on ascertainable standards, i.e., relative fair market value. Related party sales above all others should be subject to some objective outside standard.

Discussion: Use of an LLC
It seems to me that an LLC would not help us.

-First, in order for an LLC to be an option it must be treated as a valid partnership for federal tax purposes. This requires more than one participant. We have only one participant.

-Second, even if we assume away the one-man LLC problem for purposes of this discussion, an LLC does not solve the basic problems we face here. If the assets of the sole proprietorship were put into an LLC and sold therefrom, the result would be essentially the same as that set forth above. In the alternative, if the LLC interest itself were sold, we still have the same basic problems. Through operation of Section 453(i)(2) and Section 751, the seller of a partnership interest still faces immediate gain recognition with respect to his share of partnership depreciation recapture.

Discussion: Other Alternatives
The seller's problems could easily be solved by incorporating the assets of the sole proprietorship and then selling the stock to the son. If that option were deemed attractive, care should be taken to insure that the incorporation transaction is consummated separately and well prior to the sale of stock. It would be extremely critical to avoid any kind of contractual interdependence between the incorporation and the sale. Otherwise, the sale could be treated as an asset sale to by individual proprietor notwithstanding the legal form in which the sale was cast.

The obvious problem with selling stock is the carry over basis issue. Such a sale would deny the buyer the benefit of stepping up the acquired assets to fair market value.

Collateral Issue: Sale of Inventory
It would be easy to overlook the fact that the taxpayer in this case is selling inventory as part of this sale, and any profit therefrom is not reportable on the installment method.

Collateral Issue: Section 197
Have you considered whether Section 197 amortization will be available to the son given the related party status of this sale? Consider also the impact this determination might have on the attractiveness (or the lack thereof) of the option of selling stock rather than assets.