“One of its Principal Purposes” for an Installment Sale

What if you could transfer depreciable assets from one legal entity that you own to another legal entity that you own, not report the gain from the sale until some future year, and then step up the tax basis in the assets due to the sale and start taking increased depreciation deductions using the stepped up tax basis in the current year? In Vest v. Commissioner, T.C. Memo. 2016-187, the court considered a rule that would seem to allow for this.

Tax on Gain in the Year of Sale

The general rule is that the sale of assets between entities that the taxpayer owns is usually a taxable event. The gain from the sale is subject to tax for the selling entity in the year of the sale. The installment sale rules provide an exception to this general rule.

The Installment Sale Rules

The installment sale rules apply when property is sold and at least one payment is to be received after the close of the tax year. With these rules, the gain from the sale of the property is recognized ratably as the payments are received. The idea is that the tax liability should be spread out over time and paid when the gain from the sale is received.

The Sale of Depreciable Property to a Related Party

There is also an exception to the installment sale rules. This exception (to the installment rule exception) provides that the installment sale rules do not apply to sales of depreciable property between related persons. When this exception applies, all of the gain is recognized in the year of sale even though the payments are to be received in subsequent tax years.

For Sales that are not to Avoid Tax

There is an exception to this exception. The exception to the installment sale rules for sales of depreciable property, does not apply “if it is established to the satisfaction of the Secretary that the disposition did not have as one of its principal purposes the avoidance of Federal income tax.” The term “one of its principal purposes” is not defined, which is the issue in the Vest case.

“One of its Principal Purposes”

In Vest, the taxpayer argued that its principal purpose for the related-party sales was not to avoid Federal income tax. It argued that it had a valid business purpose for the related-party sales:

[The taxpayer] … testified at trial that the asset sale had a valid business purpose, namely, to isolate distinct assets in three separate partnerships as a prelude to a possible sale.

The court did not agree:

This rationale is unconvincing: It is not clear why a potential buyer would care in which entity the assets happened to be located. In any event, the existence of a valid business purpose for a transaction does not negate the conclusion that “one of its principal purposes” was the avoidance of tax.

The court went on to say that:

This tax-avoidance purpose is particularly clear with respect to the intangible assets sold…. Those assets had a zero cost basis in [the first entity’s] … hands, thus yielding zero amortization deductions to it. But [the second entity] … claimed a stepped-up basis in those assets of $2,885,175, yielding amortization deductions of $192,345 annually. The enhanced amortization deductions claimed by [the second entity], totaling $644,772 for 2008-2010 alone, dwarf the $29,798 gain that [the first entity] reported for 2008.

The court also considered the taxpayer’s argument that there was no tax avoidance purpose given that it had significant net operating losses (“NOLs”) that eliminated his tax liability. Since the NOLs only offset regular tax and not Alternative Minimum Tax (“AMT”), the court concluded that the taxpayer’s argument failed. Thus, without explanation, the court concluded that the AMT is a “Federal income tax liability” that is to be considered for this purpose.

The Takeaway

The takeaway is that the word “principal” in the term “one of its principal purposes” is to be accorded little weight. To the extent there is any tax benefit–even an AMT benefit–this exception to the exception will not apply.

This is consistent with prior case law, such as Tecumseh Corrugated Box Co. v. Commissioner, 932 F.2d 526 (6th Cir. 1991) and Guenther v. Commissioner, T.C. Memo. 1995-280.

This leaves one wondering when the exception to the exception could ever apply, as the transfer of depreciable assets that get a stepped up basis will result in some tax benefit. Does anyone have an example of when the exception to the exception could ever apply or is it mere surplusage in the Code?


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