The use of the installment method of reporting gain on the disposition of property is one of the most common - and basic - tax-planning techniques. The installment method has also been a favorite target of legislative attention since 1980 and, in a series of amendments to the relevant statutory provisions, Congress has gradually limited the benefits that can be achieved by its use. In a recent case, the Tax Court applied one of the limitations added by the Installment Sales Revision Act of 1980, the triggering of gain upon a "second disposition" of property sold to a related person. Shelton v. Commissioner (August 16, 1995).
In a series of cases dating back to 1969, taxpayers had developed a device for deferring gain on the sale of property, even as persons related to them received cash consideration for that property. In its simplest form, this device entailed a sale of the property to the taxpayer's family members (or trusts for their benefit), in exchange for installment obligations. This sale resulted in the family members' taking a "stepped-up" cost basis in the property. The property would then be sold by the family members for cash to its ultimate purchaser, at a price approximately equal to its new basis. The family members would realize little or no gain on the cash sate, while the original owner would not take his gain into account until the installment obligations were paid.
In order to preclude transactions of this sort, Congress added subsection (e) of section 453 to the Internal Revenue Code. Under that provision, if a taxpayer sells property to a "related person" in an installment sale and, within two years, the related person disposes of the property, the proceeds received by the related person may be treated as payments received by the taxpayer on the related party's installment obligation. The definition of "related party" is moderately expansive and incorporates a number of rules of constructive ownership (commonly called "family attribution" and "entity attribution"); for example, an individual is considered related to a corporation if more than 50% of its stock is owned by one or more of his children or grandchildren, even if unrelated persons own the remaining stock and the individual directly owns no stock at all in the corporation.
The rigor of section 453(e) is somewhat diminished by the application of a "two-year cutoff." If the disposition by the related party occurs more than two years after the sale by the taxpayer to the related party, the gain-triggering rule does not generally apply. However, the running of the two-year period is suspended for any period during which, by means of any transaction, the related party's risk of loss with respect to the property is substantially diminished.
On June 22, 1981, James Shelton sold 97% of the stock of El Paso Sand Products Inc. ("EPSP") to Wallington Corp. ("Wallington"), a corporation owned by his children and trusts for his grandchildren, in exchange for a $17,460,000, 20-year, self-amortizing promissory note, bearing interest at 6%. Shelton's tax basis in the stock was only a bit more than $1,000,000. Shelton did not dispute that Wallington was "related" to him for purposes of section 453(e).
On March 31, 1983, less than two years after the sale by Shelton, EPSP adopted a plan of liquidation and sold all of its assets to a third party for $35,000,000 in cash and assumption of certain liabilities. On March 15, 1984, more than two years after the sale by Shelton, EPSP and Wallington were liquidated and distributed their assets, including more than $33,000,000 in cash, to their shareholders. Because of the basis increase achieved through the installment sale, the amount of gain recognized by Wallington's shareholders in the liquidation was almost $16,500,000 less than that which would have been recognized by Shelton had he continued to hold the stock of EPSP.
The Internal Revenue Service asserted that the liquidation of EPSP should be treated as a disposition of the property sold by Shelton, giving rise to a triggering of his installment gain during 1984. Shelton argued that a liquidation of corporate stock is not the sort of second disposition that was intended to accelerate gain recognition under section 453(e). The Tax Court agreed with the Service.
A corporate liquidation is generally treated as a disposition of stock by the shareholder. Moreover, in one of the leading pre-1980 cases involving the mechanism at which section 453(e) is aimed, stock was sold to a related person in anticipation of the corporation's liquidation. The Congressional committee reports explaining the 1980 Act evidence Congress's intent to change the result in that case, since, just as in Shelton's situation, the "related group [is] cashing out the appreciation in the stock on a current basis while deferring the recognition of gain." Therefore, the liquidations of EPSP and Wallington constituted a second disposition of the property sold by Shelton to Wallington and section 453(e) could apply.
Shelton also raised a second argument. As noted above, the liquidations giving rise to Wallington's disposition of its stock in EPSP (and to Wallington's shareholders' disposition of their stock in Wallington) did not occur until more than two years after Shelton had sold the stock of EPSP to Wallington. Therefore, under the general rule of the "two-year cutoff," there would not be a triggering of Shelton's gain on the liquidations.
The Service, however, contended, and the Tax Court agreed, that the sale of EPSP's assets and its adoption of a plan of liquidation, which did occur within the two-year period, substantially diminished Wallington's risk of loss with respect to the EPSP stock. This was particularly the case since EPSP conducted no further business and served as a mere holding company for the cash received in the asset sale until it was liquidated. Therefore, the two-year period was suspended on the date of the asset sale and did not commence to run again prior to the date that Shelton's gain was triggered by EPSP's liquidation.
If EPSP had waited but three months more before selling its assets, the Service would have been unlikely to prevail on this issue. However, Shelton and his family may have been pressed by business exigencies to conclude the transaction, and they did realize a very large profit on the sale of EPSP's business. Moreover, the Service had a number of other arguments supporting the triggering of Shelton's gain in 1984 in the event that the Court had decided the section 453(e) question in Shelton's favor. Perhaps, all things considered, we should not feel too sorry for James Shelton.
Ronald A. Morris and Elliot Pisem, members of the New York bar, are partners in the law firm of Robert & Holland LLP, New York City and Washington, D.C.