Almost everyone reading this article has by now received advice from their financial and tax advisors to accelerate sales of assets with built-in gains into the 2012 calendar year, to lock in the current 15% federal long-term capital gain tax rate. This is because, along with many other tax law changes, in the absence of Congressional action on January 1, 2013, the long-term capital gain tax rate will increase from 15% to as much as 23.8%. The long term capital gain tax rate for all sales will increase from 15% to 20%. A 3.8% Medicare surtax will apply to some, but not all, capital gains. Short-term capital gain tax rates will also increase.
The Tax Rate Dilemma
While selling early sounds good in theory, following such advice is complicated in the real world by uncertainty as to whether the tax rate change will in fact occur. No one wants to pay tax early, only to find out that they could have paid the same amount of tax later.
There are also practical problems: The typical sale cycle for many assets, including closely held businesses and many real estate assets, is too long to reliably predict whether a sale can close on or before December 31st. Even if a sale is feasible, many sellers are reticent to be held hostage by buyers who--being aware of a seller’s tax motivations--may renegotiate terms at the last minute.
Selling to a related party, including in some cases a corporation or LLC of which the seller is an owner, ameliorates some of the practical non-tax problems with year-end closings. With a trustworthy counterparty, the seller can have greater comfort that last-minute renegotiations will be avoided, and that payment will eventually be received. But selling to a related counterparty does not by itself solve the tax rate dilemma.
The Related Party Installment Sale Solution
This set of circumstances cries out for a tool that enables taxpayers to retroactively decide during 2013—after Congress has acted or failed to act--whether to pay long- term capital gain tax at the 2012 tax rate. Fortunately, in some circumstances, it is possible to achieve this objective if the taxpayer is willing to structure an “installment sale” to a related party before the end of 2012.
“Installment sales” are sales in which the buyer gives a promissory note instead of cash as purchase consideration at the closing. The seller often is not required to pay tax upon receipt of the promissory note at the closing, and can elect to defer capital gain recognition until the seller’s receipt of principal payments. The election does not have to be made until 2013, when the seller’s federal income tax return is filed. For most taxpayers, by electing to extend the filing date with respect to their 2012 federal income tax returns, the decision to pay capital gain tax in 2012 or in a subsequent year could be extended until September or October of 2013, which the outside dates for filing 2012 federal income tax returns for most persons and entities.
As a result, if Congress does not extend the 15% long-term capital gain tax rate or if the seller is unable to avoid the 3.8% Medicare surtax upon long-term capital gains, a seller taxpayer may in September or October of 2013 decide to elect to pay the tax as a 2012 capital gain. If the taxpayer is able to avoid the 3.8% Medicare surtax and the long-term capital gain tax rate remains 15%, the taxpayer may elect to be taxed as he or she receives payments from the buyer in 2013 or subsequent years. Furthermore, in some cases, if a taxpayer elects to be taxed as he or she receives payments, it may be possible to unwind the sale in future years, such that both the seller and the related-party buyer can be put back into circumstances which are similar to the circumstances in which they began.
Structuring the Sale
This planning will not always work. Each situation requires independent review to evaluate suitability. Amongst the limitations: The transaction must be a bona fide sale with an independent non-tax business purpose. This planning cannot be conducted directly with marketable securities or depreciable property. The taxpayer must also be willing to engage in the planning and close the sale transaction during 2012.
Related party installment sales are not a magic elixir for everyone. For some, however, such sales may create an opportunity to wait until September or October 2013 to make a decision as to whether to accelerate capital gain tax recognition into 2012. Those taking the opportunity will have bought flexibility, locking in the option to pay a historically low 15% long-term capital gains tax rate without committing to paying the tax early.
For more information regarding this article, please contact John Wagner or Mike Wilson. John can be reached at (941) 536-2037 or firstname.lastname@example.org. You can speak to Mike Wilson at (941) 536-2043 or email@example.com.