Tax Court: Installment Method Applies to Deferred Gain on Sale of Stock to ESOP

(Parker Tax Publishing July 2024)

The Tax Court held that the owners of an S corporation made valid elections under Code Sec. 1042 to defer the gains realized on their sales of stock to an employee stock ownership plan (ESOP) in that year. The court further held, on an issue of first impression, that because the taxpayers did not affirmatively elect not to have the income from the installment sales of their stock taken into account under the installment method and also made gain deferral elections under Code Sec. 1042, the gain recognized on the disposition in the following year of notes the taxpayers purchased as qualified replacement property was determined under the installment method under Code Sec. 453. Berman v. Comm'r, 163 T.C. No. 1 (2024).

Background

E.M. Lawrence, Ltd. (E.M. Lawrence) was a New Jersey corporation owned by Edward Berman and his cousin, Annie Berman. Prior to November 2002, the company had an S corporation election in effect. By letter dated November 7, 2002, Edward, as the company's CEO, requested a revocation of the E,M. Lawrence's S election. The IRS granted the revocation effective September 1, 2002.

On September 1, 2002, E.M. Lawrence established an employee stock ownership plan (ESOP). On November 8, 2002, Edward and Annie agreed to sell 40,000 shares of E.M. Lawrence Class B ESOP Convertible Preferred Stock (ESOP stock) to the E.M. Lawrence Employee Stock Ownership Trust (ESOT) for a total purchase price of $8.3 million. Edward and Annie each had bases of $27,428 in the shares of ESOP stock that each owned. Each received a $4.15 million promissory note in exchange for the shares. The ESOT financed the purchase by borrowing $4.5 million from each of the Bermans. The Bermans did not receive any payments in 2002 pursuant to the promissory notes.

Edward and Annie both reported on their 2002 tax returns that they were electing under Code Sec. 1042 to defer recognition of gains on the sale of stock to the ESOP (Section 1042 election). Effecting the deferral under Code Sec. 1042 required that Edward and Annie purchase qualified replacement property (QRP) at a cost equal to or exceeding the realized gain within 12 months of the stock sales. In October 2023, Edward and Annie purchased floating rate notes (FRNs). They then pledged the FRNs to Bancroft Ventures, Ltd. (Bancroft), a company affiliated with Derivium Capital LLC (Derivium), as collateral for purported loans equal to 90 percent of the property's value with Bancroft (the purported lender) retaining the remaining 10 percent as a fee. The repayment terms of the purported loans were such that the Tax Court and other courts have consistently held that the purported loans were sales of the FRNs.

On their 2003 tax returns, Edward and Annie reported the acquisition of sufficient QRP in 2003 within the replacement period, ostensibly qualifying them to defer recognition of the entire $4,122,572 gain each realized on the ESOP stock sales under Code Sec. 1042. Under Code Sec. 1042(e), a taxpayer's sale of QRP triggers a recapture of the previously deferred gain through a basis reduction rule in Code Sec. 1042(d) that reduces the basis in the QRP by the amount of the realized gain for which recognition is deferred. The Bermans took the position that under the installment method, they need not recognize the gains triggered by the installment payments by virtue of having purchased QRP (the FRNs) at a cost equal to the amounts of the entire gains realized on the sales of their ESOP stock.

The IRS sent Edward and Annie separate notices of deficiency determining increases in their respective long-term capital gains for 2003 attributable to the deemed sales of their QRP to Bancroft. The Bermans petitioned the Tax Court for redeterminations. The parties filed cross-motions for partial summary judgment asking the court to decide whether the Bermans' Section 1042 elections precluded them from subsequently using the installment method to report the gains on the disposition of their QRP in 2003. This issue was one of first impression before the Tax Court.

Under Code Sec. 1042(e), a taxpayer's sale of QRP triggers a recapture of the previously deferred gain. This is accomplished through a basis reduction rule in Code Sec. 1042(d) that reduces the taxpayer's basis in the QRP by the amount of the realized gain for which recognition is deferred. Seeking to avoid the possible consequences of a Section 1042 election where their QRP has been deemed sold in the year it was acquired, the Bermans challenged the validity and irrevocable nature of their Section 1042 elections. First, they argued that they sold their ESOP stock before E.M. Lawrence's S election was terminated and that, consequently, the shares of ESOP stock were not "qualified securities" under Code Sec. 1042(c)(1). Second, the Bermans argued that, assuming they made Section 1042 elections, they were entitled to revoke them on the ground that the elections were based on material mistakes of fact.

Analysis

The Tax Court rejected the Bermans' argument that their Section 1042 elections were invalid. The court found that the duty of consistency prevented them from arguing that the termination of E.M. Lawrence's S election was ineffective. The court also found that under Reg. Sec. 1.1042-1T a Section 1042 election is irrevocable and that added that under the doctrine of election, a taxpayer election that is a free choice between alternative, legally valid tax treatments that is communicated to the IRS by an overt act is generally irrevocable.

Next, the court considered whether the Bermans were entitled to recognize the gains recaptured under Code Sec. 1042(e) on account of the sales of their QRP under the installment method. The court found that the IRS's argument that a Section 1042 election supplants the installment method was foreclosed by the plain text of Code Sec. 453. The command of Code Sec. 453(a) that income from an installment sale be taken into account under the installment method, the court observed, is as sweeping as the command of Code Sec. 1042(e) that gain upon the disposition of QRP be computed and recognized pursuant to its terms.

The court found that the Bermans' sales of their ESOP stock were installment sales because at least one payment was to be received after the close of the tax year in which the sale occurred. As a result, the court determined that the transactions at issue were simultaneously subject to both Code Sec. 1042 and Code Sec. 453. Because the Bermans disposed of all their QRP in 2003, Code Sec. 1042(e) would require them to recognize the entire $4,122,572 gain realized for 2002 (i.e., the $4,150,000 sale price less basis of $27,428), notwithstanding the fact that the Bermans each received only $449,277 in payment for their ESOP stock in 2003 and in total received only $499,425 (Edward) and $499,061 (Annie) for the stock. Under Code Sec. 453, by contrast, the Bermans' recognized gain would be limited to the gross profit proportion of each payment on their promissory notes, when received.

The court reconciled Code Secs. 1042 and 453 by observing that the flush language in Code Sec. 1042(a), which addresses the treatment of the gain "which would be recognized" in the absence of a Section 1042 election, was enacted six years after the enactment of Code Sec. 453. Thus, the court found that Congress presumably was aware that the gain which "would otherwise be recognized" in the absence of Code Sec. 1042 could depend upon the operation of Code Sec. 453, if the qualified securities had been sold pursuant to an installment sale.

The court found that, when securities have been sold to an ESOP in an installment sale where no payment is received in the year of sale, the gain that would be recognized for that year in the absence of a Section 1042 election is zero, because that is the result under the installment method. As the Bermans sold their ESOP stock in 2002 in installment sales pursuant to which no payment was made in that year, their gain "which would be recognized as long-term capital gain" for that year if no Code Sec. 1042 election had been made was zero.

Next, the court determined that the Bermans' receipt of installment payments in 2003 triggered recognition of gain under Code Sec. 453(c) equal to "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." According to the court, the gain which would be recognized in 2003 in the absence of a Section 1042 election was $444,784 (99 percent of the $449,277 payment). But because of the Bermans' Section 1042 elections, Code Sec. 1042(a) operated - at least initially, before the Bermans' sales of the QRP - to defer any recognition of the $444,784 of gain "which would be recognized" under the installment method for 2003.

As a consequence of this deferral, the court said that a corresponding basis adjustment was required under Code Sec. 1042(d). That is, the basis was reduced "by the amount of gain not recognized by reason of" the purchase of the QRP and the application of Code Sec. 1042(a); namely, $444,784. The QRP was reported as purchased in 2003 at a cost of $4,150,000, giving it an initial basis equal to that amount. Accordingly, the court found that the QRP's $4,150,000 basis must be reduced by $444,784 to $3,705,216 pursuant to Code Sec. 1042(d). Finally, when the Bermans disposed of their QRP in 2003 (by virtue of the deemed sales to Bancroft), they each received net proceeds of $3,735,000. As Edward and Annie each had an adjusted basis in the FRNs of $3,705,216, the court found that they each had a gain of $29,784 on the deemed sale.

For a discussion of Section 1042 elections, see Parker Tax ¶113,530. For a discussion of installment sales, see Parker Tax ¶244,510.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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