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Court rejects business purpose in related partnership installment sale

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Court rejects business purpose in related partnership installment saleThe Fifth Circuit Court of Appeals has affirmed the Tax Court decision in Vest v. Commissioner that an individual could not deduct expenses for investigating his father’s death because the activity lacked a profit motive and an installment sale between two partnerships showed a tax avoidance motive.

Vest involved a taxpayer, Mr. Vest, who was a former CPA and entrepreneur. After selling his business, Mr. Vest devoted significant time and money investigating the circumstances surrounding his father’s death and caused partnerships that he controlled to pay large sums of money to fund the investigation. Though the investigation did not produce any leads, Mr. Vest believed that the story of his father’s death could be successfully adapted into a book or a movie and so he hired a writer to draft a manuscript and a publicist to promote the story. These activities never generated any revenue. However, they did generate significant tax losses at the partnerships, which flowed up to Mr. Vest. Mr. Vest also owned, directly or indirectly, substantially all of the interests in three partnerships, TB, VAS, and Metric. TB developed valuable ad-serving technology, which it sold to VAS along with computer equipment. TB concurrently sold computer equipment to Metric. VAS and Metric issued promissory notes to TB for the transferred assets, which were appraised at $3,752,000. The notes accrued interest annually and were payable in full after 10 years. VAS and Metric claimed stepped-up bases in the transferred assets and subsequently took significant depreciation and amortization deductions under Sections 168 and 197. TB reported the sales under the installment method pursuant to Section 453(a). TB did not receive any payments on the promissory notes during the tax years at issue and only recognized a small taxable gain related to depreciation recapture with respect to the installment sale.

The IRS examined TB’s tax returns for the 2008 to 2010 tax years and disallowed the deductions related to the investigation of the death of Mr. Vest’s father, claiming that the activity was “not engaged in for profit.” The IRS also denied the use of the installment method for TB’s asset sales to VAS and Metric because the parties were related within the meaning of Section 453(g)(1) and Mr. Vest had failed to establish that the transaction did not have as one of its principal purposes the avoidance of federal income tax.

The Tax Court considered various factors under Section 183 and held that Mr. Vest was not entitled to deduct the expenses related to the investigation of his father’s death because the investigation was not a profit-seeking activity. Citing section 453(g), which disallows the installment sale method with respect to sales of depreciable property between related parties unless the taxpayer shows that the sale did not have as one of its principal purposes the avoidance of federal income tax, the Tax Court also concluded that the installment method was not available to TB with respect to the assets it sold to VAS and Metric. The Tax Court rejected the taxpayer’s argument that the transaction’s principal purpose was to segregate certain assets into a separate legal entity in preparation of a potential sale.

The Tax Court also identified a tax avoidance purpose in that by utilizing an installment sale, the taxpayer was able to generate substantial depreciation and amortization deductions without recognizing any corresponding gain, while also effectively maintaining control over the transferred assets. These deductions would benefit the taxpayer for alternative minimum tax purposes, notwithstanding the taxpayer’s significant net operating losses. Mr. Vest appealed the case to the Court of Appeals for the Fifth Circuit, which affirmed the Tax Court’s decision on both these issues. This case illustrates the challenges that may be encountered by related-party taxpayers who seek to use an installment sale to defer gain. The mere assertion of a valid business purpose may not provide a defense against an IRS challenge where the transaction allows significant tax deductions to be taken immediately, while deferring any corresponding income.

Contact:
Grace Kim
Principal, Washington National Tax Office
T +1 202 521 1590

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