Tax Court allows installment treatment of ESOP gain deferral recapture

The Tax Court has issued a decision on an issue of first impression in Berman v. Commissioner (163 TC No. 1), ruling that the installment sale method under Section 453 can apply to the recapture of deferred gains for selling stock to an employee stock ownership plan (ESOP) under Section 1042(e).

The case hinged on the interplay between the installment sale rules under Section 453 and the gain recapture provisions related to the deferral for stock sales to ESOPs under Section 1042. The taxpayers addressed by the ruling originally sold stock in their C corporation to an ESOP and deferred the gain, but later faced recapture after a loan transaction.

The taxpayers sold the C corporation stock to the ESOP in 2002 and received promissory notes from the ESOP in the amount of the total purchase price of $8.3 million, and received total principal payments of $898,554 (and $397,946 in interest) in 2023.

An ESOP is a qualified retirement plan that is designed to invest primarily in qualifying employer securities. Section 1042 generally allows taxpayers to defer the recognition of gain on the sale of stock to an ESOP, provided that, among other conditions, the taxpayer acquires qualified replacement property (QRP) within the 15-month period beginning three months before and ending 12 months after the stock sale.

Within 12 months of the stock sale to the ESOP, the taxpayers acquired QRP in the form of floating rate notes issued by four unrelated companies in an amount equal to at least the total realized gain on the stock sale. Both taxpayers made a formal election on their 2002 returns to defer the recognition of the realized gain on the stock sale in accordance with the requirements of Section 1042.

In 2003, the shareholders used their QRP in “90% loan transactions,” in which they pledged the QRP as collateral for purported loans equal to 90% of the QRP’s value with the “lender” retaining the remaining 10% as a fee. The Tax Court noted that the repayment terms of the purported loans were such that the Tax Court and other courts have previously held that the purported loans were actually sales of the QRP pledged as collateral for federal income tax purposes. The shareholders did not dispute in the case proceedings that the 90% loan transactions should be treated as sales of the QRP in 2003, and the Tax Court analyzed the issues as if the shareholders sold their QRP in 2003.

The issue before the court was whether the taxpayers should immediately recognize all the deferred gain recaptured under Section 1042, or whether the gain should be recognized under the installment method under Section 453. Section 453 generally provides that, unless a taxpayer affirmatively elects not to have the provision apply, the gain from any disposition of property, where at least one payment is to be received after the close of the taxable year in which the disposition occurs, should be taken into account under the installment method, which generally defers gain until payment is received.

Analysis

The Tax Court determined that the transactions at issue in the case were simultaneously subject to both Section 453 and Section 1042, and the court noted that its task was to determine whether the two provisions could be reconciled in a manner to give effect to the language and intent of both provisions without depriving one or the other of its essential meaning.

The court initially noted that the installment method presumptively applies in the absence of an affirmative election not to have the installment method apply.

The court determined that the 2002 stock sale to the ESOP was an installment sale because at least one payment under the promissory notes was to be received after the close of the taxable year in which the sale occurred (2002). The court also determined that the shareholders did not affirmatively elect not to have the installment method apply, and therefore, the installment method presumptively applied to the 2002 stock sale to the ESOP.

The court also noted that the installment method applies without regard to whether a taxpayer reported income on their return consistent with that method — that is, a taxpayer’s failure to report income consistently with the installment method does not cause the method to cease to govern the proper reporting of income from an installment sale.

The deferred recognition of gain under Section 1042 generally operates through a basis reduction provision under Section 1042(d) and a gain recapture provision under Section 1042(e). The basis adjustment provision generally provides that a taxpayer’s basis in the QRP is reduced by the amount of the realized gain that is not recognized by reason of the acquisition of the QRP and the application of Section 1042(a). The gain recapture provision generally provides that “if a taxpayer disposes of any QRP, then notwithstanding any other provision of this title, gain (if any) shall be recognized to the extent of the gain which was not recognized under subsection (a) by reason of the acquisition by such taxpayer of such QRP.”

The IRS argued that an election under Section 1042 removes any deferred gain from installment sale treatment, and the recapture provision of Section 1042(e) becomes the exclusive means for recognizing the gain on the sale of the QRP. In addition, because the shareholders sold all of their QRP in 2003, the recapture provision of Section 1042(e) would require the shareholders to recognize the entire $8,245,144 gain realized on the 2002 stock sale, even though the shareholders had received only $898,554 for their stock through the end of 2003 — that is, the shareholders would have to recognize “phantom income” that they had not actually received.

In contrast, the shareholders argued that, because the 2002 stock sales were installment sales, they were entitled to report the gains recaptured pursuant to Section 1042(e) under the installment sale method of Section 453 – that is, the installment sale method should apply for purposes of determining any gains required to be recaptured under Section 1042(e).

The Tax Court ultimately adopted the shareholders’ position because it concluded that, under a careful reading of Section 1042, it can be reconciled with Section 453 and the two sections are not mutually exclusive. In particular, the court noted that the flush language in Section 1042(a) –  which provides for the deferred recognition of “…the gain (if any) on such sale which would be recognized…” (emphasis added) – should be interpreted under a plain reading to mean the gain that would be recognized on the sale of the ESOP stock in the absence of a Section 1042 election, which should depend upon the operation of Section 453 if the ESOP stock had been sold pursuant to an installment sale.

Under this interpretation, the court concluded that the basis reduction provision of Section 1042(d) would require a basis reduction in the QRP by only the amount of the realized gain on the ESOP stock sale which would have to be recognized under the installment method for 2002 and 2003 —  $889,568 (the total principal payments received under the promissory notes ($898,554) multiplied by the gross profit percentage (99%, calculated from $8,245,144/$8,300,000) — and not by the full amount realized on the 2002 stock sale that was not recognized because of Section 1042(a): $8,245,144 ($8,300,000 - $54,856).  

The court also concluded that, because the shareholders disposed of their entire QRP in 2003, their Section 1042 elections would no longer operate to defer any gains with respect to any principal payments received in 2004 or later years under the promissory notes received in exchange for the ESOP stock. Any such additional principal payments would trigger installment payment gain equal to 99% (the gross profit percentage) of the amount of each such principal payment.

In the absence of any contrary authority, these interpretations should apply to similar scenarios involving Sections 453 and 1042, including those not involving deemed sales of the QRP resulting from the pledge of the QRP as collateral for 90% loan transactions. For example, when there is an installment sale of stock to an ESOP, the sellers make a valid Section 1042 election (including satisfying all of the applicable conditions), the sellers do not affirmatively elect not to have the installment sale rules apply, and the sellers dispose of their QRP before receiving the last installment payment.

To avoid the double parentheses, which is hard to read and can cause confusion as parentheses have a different use in mathematical formulas, can we rephrase this as "(99%, or $8,245,144/$8,300,000)"?

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