Can a Failed ESOP be Saved by Installment Sale Rules? – Houston Tax Attorneys

Imagine a building with two entrances. Once you’re inside, does it really matter which door you used to enter?

This analogy often applies to tax disputes when there are overlapping tax laws. The IRS frequently argues that taxpayers are bound by their initial choice of tax treatment–insisting they stick with the “door” they first entered through. However, if that chosen “door” results in less tax revenue, the IRS may invoke concepts like economic substance to argue that the other “door” should apply instead. There are examples of where one tax law cannot apply if another one does.

This brings us to the recent case of Berman v. Commissioner, 163 T.C. No. 1 (2024). The case involves two separate tax laws that allow for tax deferral. The taxpayers initially opted for one method, but it turned out they didn’t fully meet the qualifications for deferral under that particular law. The ensuing tax dispute addressed whether the taxpayer can rely on the second tax deferral provision when the first one does not provide the intended result.

Facts & Procedural History

The taxpayers are married. They sold the stock of their business to an employee stock option plan (“ESOP”) in 2002. The sale resulted in a $4.1 million dollar gain for each spouse.

The stock was purchased from the taxpayers by the ESOP using promissory notes. The promissory notes did not provide for payments to the taxpayers in 2002. In 2003, the spouses each received approx. $450,000 in payments from the ESOP pursuant to the promissory notes.

To avoid paying tax on the $4.1 million dollar gain, the taxpayers made an election in 2002 to defer recognition of the gain under Section 1042. As explained below, this is a provision that allows one to pay tax at a later date if they sell stock to an ESOP. To qualify, taxpayers generally have to purchase certain replacement property. The taxpayers will then pay tax when they sell the replacement property. This is the tax deferral aspect of this court case. The taxpayers sold the replacement property in 2003, which ended the tax deferral just one year into the deal.

The transaction ended up before the IRS. The IRS determined that the sale of the replacement property in 2003 triggered recognition of the entire deferred gain from 2002 under Section 1042(e). The taxpayers noted that despite Section 1042(e), they were entitled to pay tax on the amount they received. Put another way, the taxpayers argued that the installment method for reporting payments under an installment note applied. So, according to the taxpayers, they should pick up the gain as income over time as payments were received.

The dispute ended up in the U.S. Tax Court. The court had to decide which provision governs when there are two deferral rules, and one of the rules is not met.

ESOPs & Section 1042 Deferral

Section 1042 is intended to encourage business owners to sell their companies to their employees through Employee Stock Ownership Plans or ESOPs. Section 1042 provides an incentive to do so, i.e., the ability to defer capital gains taxes on the sale of company stock. This is a fundamental aspect of ESOPs.

Here’s how it works in simple terms: When a business owner sells their company stock to an ESOP, they would normally have to pay capital gains tax on any profit from that sale. Section 1042 allows them to postpone paying these taxes if they follow certain rules.

The main requirement is that the seller must use the proceeds from the sale to purchase other qualifying investments, known as “qualified replacement property,” within a specific timeframe. These investments typically include stocks and bonds of domestic operating companies.

By reinvesting in this way, the seller can defer paying taxes on their gain from the sale. It’s important to note that this is a deferral, not an elimination, of the tax. The tax liability is essentially transferred to the new investments. If the seller later sells these new investments, they would then have to pay the deferred taxes.

This provision is particularly attractive to owners of privately held companies who are looking to transition their business while also managing their tax burden. It not only provides a tax benefit to the selling owner but also promotes employee ownership, which can have positive effects on company performance and employee satisfaction.

However, as with every tax benefit provided by Congress, there are numerous rules and limitations. There are rules about what qualifies as replacement property. There are rules about the timing of the reinvestment. There are rules about the potential for future tax recapture. There are rules about other rules.

Installment Notes & Section 453

Section 1042 provides for deferral for the sale of stock to an ESOP. Section 453 provides for deferral for the sale of property with payments to be received in one or more later years.

Deferral under Section 453 is known as the installment method. This method allows sellers to spread the recognition of gain from certain sales over multiple tax years, aligning the taxation of the gain with the receipt of payments (this involves the same rules that are the basis of monetized installment sales and the same rules that apply in normal transactions, such as the sale of property).

The installment method applies to what the tax code defines as an “installment sale.” Under Section 453(b)(1), an installment sale is 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. This definition encompasses a wide range of transactions, from traditional seller-financed sales to more complex arrangements.

Under the installment method, the seller recognizes gain in proportion to the payments received. Specifically, Section 453(c) states that the income recognized for any taxable year is “that proportion of the payments received in that year which the gross profit (realized or to be realized when payment is completed) bears to the total contract price.”

A key feature of Section 453 is that it applies automatically to qualifying transactions unless the taxpayer elects out. This “default in” approach, established by the Installment Sales Revision Act of 1980, reversed the previous requirement that taxpayers had to affirmatively elect to use the installment method.

Just as with deferral under Section 1042, there are rules for deferral under Section 453. For example, certain types of sales are excluded from installment method treatment. This includes dealer dispositions of property and sales of inventory items. Additionally, depreciable property sales between related persons are subject to special rules that can limit the benefits of installment reporting.

As with deferral under Section 1042, the installment method can provide significant tax advantages by allowing sellers to defer recognition of gain by spreading a tax liability over several years. This can be particularly beneficial when the seller receives a small down payment and larger payments in future years, as it prevents a large tax bill in the year of sale when the cash received might be limited.

Which Deferral Provision Applies?

This sets up the dispute in this case. The taxpayers agree that they did not meet the Section 1042 requirements for deferral after 2003, as they sold the replacement property in 2003. The taxpayers argued that even though they did not get tax deferral under Section 1042, they should get it under Section 453.

The tax court first found that the taxpayers had made valid Section 1042 elections on their 2002 tax return. The tax court then considered whether the installment method under Section 453 could apply concurrently with a Section 1042 election. The tax court concluded that the two provisions are not mutually exclusive and can both apply to the same transaction.

The tax court then focused on the language in Section 1042 which says that the gain is the gain “which would be recognized as long-term capital gain.” The court interpreted this to mean the gain that would be recognized in the absence of Section 1042, which in this case would be determined under the installment method of Section 453. Through this interpretation, the court found a way to harmonize these sections, determining that Section 1042 initially defers the gain that would otherwise be recognized under the installment method, but this deferral is subject to recapture when the qualified replacement property is sold.

Based on this, the tax court agreed with the taxpayers. It determined that the taxpayers were entitled to use the installment method to report the gain on the sale of their business stock.

The Takeaway

This case highlights the potential benefits of when multiple tax deferral provisions may apply. It shows that taxpayers may have more than one option for deferring gains, even if they don’t fully meet the requirements of their initial choice. Tax planning for ESOP transactions and other installment sales is quite popular, so this case helps in that regard too. This case adds to the growing list of court cases that explain when and how tax deferral strategies can be structured for various transactions.