Asale of property is often not effected in a single day. The buyer and seller may spend weeks or months negotiating a contract, the contract will be signed and then a further "executory" period may pass before the closing occurs. During the executory period, various restrictions may be imposed on the seller's ability to deal with the property, in order to protect the buyer's rights.
Generally, the sale is considered complete for income tax purposes, the seller recognizes its gain (or loss) and the other collateral tax consequences of the sale, such as the buyer's beginning to claim depreciation deductions, take place when the "benefits and burdens" of ownership pass, even if that is before the formal closing. Two recent cases, one in the United States District Court in Utah, Benedict v. United States (April 4, 1995), and the other in the Court of Federal Claims, International Paper Co. v. United States (April 27, 1995), illustrate this analysis. The International Paper case also discusses the effect of a common provision in sales contracts, adjustment of the purchase price for a "pre-closing interest factor."
The tax provision directly at issue in Benedict was the deduction for imputed interest in the case of an acquisition of property in exchange for a noninterest-bearing promissory note. The computation of the precise amount of imputed interest turns on how long the note is outstanding from the time of the acquisition until payment is due; the longer the interval, the greater the portion of the face amount of the promissory note that will be recharacterized as interest, which may be currently deductible, rather than as a cost of the property.
On December 26, 1983, Hilltop West 44 ("Hilltop"), a partnership in which Marian Benedict and others were partners, agreed to purchase a condominium at the Pinnacle at Deer Valley project in Park City, Utah. Construction of that condominium had not yet begun, although some other condominiums at the project, as well as the project's infrastructure, had already been completed. Hilltop paid $10,000 in cash and delivered a noninterest-bearing promissory note for the remainder of the purchase price. (Although the court speaks of the note as a "recourse" note, certain liquidated damages provisions described in the next paragraph effectively limited Hilltop's exposure.) Under the note, a payment of $556,650 was due on December 27, 1985. The seller agreed to use reasonable efforts to complete construction of the condominium by March 15, 1985, and the court inferred from Hilltop's failure to assert a default on the seller's part that construction was in fact completed by that date.
Title to the condominium did not pass at the time of the 1983 agreement. Rather, the seller deposited a deed to the condominium into escorw. Hilltop deposited three documents under the same escrow arrangement: a "deed of trust" to secure post-1985 payments under the promissory note; a "judgment note" (apparently equivalent to a confession of judgment) in the amount of $50,000, to be delivered to the seller if Hilltop defaulted on the promissory note; and a "quit-claim deed," conveying Hilltop's interest in the condominium back to the seller, which was also to be delivered only in the event of default. The purchase agreement provided that forfeiture of the original $10,000 payment and collection of the $50,000 judgment note would constitute liquidated damages for Hilltop's failure to close the transaction and to make the December 1985 payment. Hilltop's interest in the condominium was subordinated to the seller's construction financing.
Hilltop made the December 1985 payment in a timely manner and received title to the condominium at that time.
Under the rules in effect for sales during 1983, Hilltop would be entitled to a deduction for imputed interest paid during 1985 if the "sale" occurred more than six months prior to the due date of the December 1985 payment. Hilltop argued that the benefits and burdens of ownership of the condominium passed to it in December 1983 and the court, while it did not explicitly accept that date, did find that Hilltop acquired the benefits and burdents at some point at least six months prior to December 1985.
In reaching its conclusion, the court reviewed a series of factors that had been laid down in a 1981 Tax Court case and evaluated Hilltop's transaction in light of those factors. Certain factors did suggest that the sale should not be considered to have been consummated prior to December 1985 -- Hilltop did not have title until that time, its equity in the condominium was small, the seller bore the risk of loss in the event of Hilltop's default if the seller's actual damages were greater than $60,000 and there were restrictions on Hilltop's ability to transfer the condominium without the seller's consent.
Other factors, however, suggesting that the benefits and burdens of ownership passed before December 1985, preponderated. Hilltop had the sole right to possession of the condominium and the right to any profits from appreciation in its value. Hilltop also bore the risk of loss, at least to the extent of the liquidated damages that it would be required to pay in the event of default. The court did not view Hilltop's ability to limit its damages to $60,000 in the event of a default as making Hilltop a mere optionee, rather than the owner of the condominium.
Accordingly, the sale to Hilltop was treated as having taken place at least six months prior to December 1985 and the claimed deduction for imputed interest was allowed.
International Paper involved a sale of stock of the Bay Line Railway Co. by International Paper Co. ("IP") to SWF Gulf Coast, Inc. ("SWF"). Under the contract between IP and SWF, closing was to occur upon a specified date, subject to extensions for obtaining Interstate Commerce Commission approval. The sale was contingent on obtaining that approval and on the satisfaction of a number of other conditions, including an absence of "material loss, casualty or adverse change" to the business of Bay Line, resolution satisfactory to SWF of certain Bay Line litigation and IP's complying with covenants not to take certain actions regarding Bay Line during the executory period without SWF's consent.
At the closing, SWF was obligated to deliver $13,000,000 to IP and agreed "to pay interest on said sum," as part of the purchase price, at the rate of 10-1/2% per annum from the date of contract to the date of closing. At the closing on September 12, 1979, IP received $739,375 from SWF pursuant to this "interest" provision. For income tax purposes, IP treated this amount as a portion of its proceeds from the sale of the Bay Line stock (i.e., as additional capital gain), rather than as ordinary interest income. SWF and the Internal Revenue Service both took the position that the "interest" should be treated like any other interest income and expense.
The court first concluded that IP was not bound by any unambiguous contractual description of the amount in issue as "interest," finding that an ambiguity was created by the contract's alternative (and contradictory) description of the amount as part of the purchase price.
Turning then to the substance of the transaction -- as distinct from the parties' description of it -- the court looked at when the benefits and burdens of ownership of the Bay Line stock passed, in order to determine whether there was a "use or forbearance of money" for which interest could be paid; the existence of some other sort of obligation, such as an obligation to close the transaction if the conditions to closing were satisfied, would not suffice. The court concluded that the intent of the parties to defer the time of sale until actual closing, coupled with the existence of substantial conditions, prevented the sale for tax purposes from taking place until the closing date. Thus, there was no use of IP's money by SWF prior to that date (or forbearance by IP from collecting money due to it from SWF) on which interest could be earned.
These cases illustrate some of the factual and legal contexts which raise the question of whether benefits and burdens have passed. Sometimes, as in Benedict, it is the taxpayer which seeks to treat a sale as occurring prior to the formal closing date; more commonly, perhaps, as in International Paper, it will be the Internal Revenue Service which takes that position. Taxpayers need to be sensitive to this issue, which can have quite unanticipated results. International Paper also illustrates the potential danger of characterizing payments relating to the executory period in an offhand, colloquial way. Although IP prevailed in the Court of Federal Claims, it was put to substantial expense to defend its position.