In this blog, we cover the U.S. tax consequences of installment sales, both for immigrating aliens and for expatriating U.S. persons. We base our analysis on court cases and IRS guidance. We note that the below represents the U.S. federal treatment. Where relevant, state and local tax consequences should be considered as well.
Installment Sales - Generally
In general, under Section 453(b) of the U.S. Internal Revenue Code (the “Code”), a sale is treated as an “installment sale” for U.S. federal income tax purposes if at least one payment of consideration is to be received after the close of the taxable year in which the sale occurs. Under Section 453(a), gain realized from an installment sale must be reported under the “installment method” unless the seller specifically elects, in accordance with Section 453(d), not to have the installment method apply to the sale. Under the installment method, gain from an installment sale is reported as the taxpayer receives the installment payments.
Under Section 453(f)(3), the receipt of evidence of indebtedness in exchange for the disposition of property is not considered a payment of consideration; rather, the repayments of such indebtedness in future years are considered the payments of consideration and are therefore subject to the installment sale rules. However, importantly, under Section 453(f)(4), the receipt of evidence of indebtedness is considered a receipt of payment of consideration if the indebtedness is payable on demand.
Installment Method for Immigrating Aliens
In general, under Section 871 of the Code, income realized by a non-resident alien that is sourced without the United States is not subject to U.S. federal income taxation. In this regard, in general, under Section 865(a), income from the sale of personal property (including stock of a corporation) that is realized by a non-resident alien is sourced outside the United States. There are several exceptions to the general rule of Section 871, including with respect to capital gains of aliens present in the United States for 183 days or more in a taxable year, and income which is effectively connected with the conduct of a trade or business within the United States (“ECI”), both of which may be subject to U.S. federal income taxation, even if they are realized by a non-resident alien.
In addition to the above, if certain income realized by a non-resident alien is sourced within the United States, such income will also be subject to U.S. federal income taxation. For instance, under Section 871(a)(1) of the Code, U.S.-sourced “fixed or determinable annual or periodical” (“FDAP”) income (including interest income, among other things) of a non-resident alien, which is not ECI, is taxable at a flat rate of 30 percent on a “gross” basis, unless a specific exemption exception applies.
In contrast to the above, resident aliens (including “U.S. green card” holders) are taxed on worldwide income in much the same manner as a U.S. citizen.
Based on the above, the question has arisen as to how to apply the installment method in the case of an individual that sold property while he was a non-resident alien, but received payments from such sale in a subsequent year during which he obtained the status of a U.S. resident for federal income tax purposes.
The IRS first addressed this issue in Technical Advice Memorandum (“TAM”) 8708002 (October 29, 1986). The taxpayer in the TAM sold property, in 1981, to an unrelated foreign corporation. In the year of the sale, the taxpayer was a non-resident alien for U.S. federal income tax purposes. The sales contract provided for a payment in the year of sale plus annual payments each year thereafter until 2002. In 1982, the taxpayer became a resident alien subject to U.S. income tax laws. The taxpayer’s 1983 and 1984 U.S. federal income tax returns, which are the subject of the TAM, did not include the annual payments received in such years.
Under these facts, the IRS advised that the taxpayer is deemed to have elected under Section 453(d) not to report the sale of the property on the installment method, and therefore the installment method rules do not apply to the payments received in 1983 and 1984 by the taxpayer.
In Private Letter Ruling (“PLR”) 9412008 (March 25, 1994), the IRS again directly addressed this issue. The taxpayer in the ruling (“A”) was a resident of Canada in 1986, during which she and her mother, who was also a resident of Canada, sold jointly-owned real estate property located in Canada to an unrelated foreign corporation. The sales contract provided for an up-front payment in the year of sale, quarterly payments plus interest until 1994, and a payment of the balance owed in 1994. The taxpayer reported the gain from the sale on the Canadian income tax returns that she filed for the tax years 1986-1990. The ruling adds that it was represented that prior to 1993, which was the year that the taxpayer became a resident alien for U.S. federal income tax purposes, she was not required to file a U.S. income tax return.
The IRS cites the same legislative history cited in TAM 8708002, and states that “based on our consideration of the legislative history and the particular circumstances of this case, we conclude that the tax consequences of the subject installment should be determined as if A had elected under Section 453(d) of the Code not to report the sale on the installment method.” The PLR adds in relevant part, however, that “the above ruling does not apply to interest income which A receives on the subject installment contract.”
It is important to note that with respect to the treatment applied by the above authorities to immigrating non-resident aliens, i.e., treating them as if they elected out of the installment method, there are no authorities that contradict, overrule, or otherwise disagree with such treatment. Further, as a policy matter, such treatment seems to conform to the general principles of U.S. tax law, which seek to tax activities that have economic nexus to the United States. Since such immigrating non-resident aliens performed the income-producing activity outside the United States, when they were not yet residents of the United States, it seems appropriate that the income from such activity should not be subject to U.S. taxation.
Installment Method for Expatriating US Persons
In a 2016 Tax Court case, the issue of how to apply the installment sale to an expatriating U.S. person was at issue. Interestingly, the Court showed the effect the installment method could have both on the income tax consequences and the exit tax consequences.
In Topsnik v. Commissioner, 146 T.C. No. 1 (Jan. 20, 2016), Taxpayer (“T”), a German citizen, sold his stock in a U.S. corporation in 2004 in return for an installment note that paid monthly installments through 2013, including 2010, the year at issue. Previously, in 1977, T became a U.S. green card holder and renewed it every 10 years until he formally surrendered his green card and LPR status on November 20, 2010.
T failed to file the required Form 8854, Initial and Annual Expatriation Statement, and failed to certify, under penalties of perjury, that he has complied with all of his U.S. federal tax obligations for the five taxable years preceding the taxable year that includes the expatriation date as required under Section 877A of the Code (this is the Code section dealing with the exit tax rules). T filed a delinquent Form 1040NR, U.S. Nonresident Alien Income Tax Return, for 2010 reporting gains exempt under the U.S.-Germany Income Tax Treaty. The IRS assessed a tax deficiency, accuracy-related penalty, and a failure to timely file addition to tax for 2010 and issued a notice of deficiency to T, and a lawsuit then ensued.
Under these facts, the Tax Court held that T expatriated on November 20, 2010, when he formally abandoned his status as a green card holder. Further, T is liable for tax on gains attributable to the 11 monthly installment payments that were made during 2010 before his expatriation date. Lastly, T is liable for tax on gain from the deemed sale of his right to installment sale proceeds on the day before his expatriation date pursuant to Section 877A.
The decision has several important implications. It confirms that installment payments received after expatriation should not be subject to U.S. federal income taxation. However, the Court seems to count the right to installment payments as an asset for Section 877A purposes, the deemed sale of which can become subject to the exit tax. In this regard, the Court noted that an installment obligation is generally treated as property for purposes of the Code and valued at its fair market value with basis determined under Section 453B(b) of the Code.