Berman v. Comm'r,1 released on July 16, 2024, is a great example of making lemonade when life hands you a lemon. Although the taxpayers lost the federal income tax deferral of a stock sale to an employee stock ownership plan (an "ESOP") by entering into a constructive sale of their qualified replacement property ("QRP"), they were able to avoid full current taxation by establishing that the constructive sale was entitled to installment sale treatment. The ability to use installment sale treatment allowed the taxpayers to continue to defer the tax due on the sale of their stock to the ESOP. That ability was key to avoiding tax on phantom income because the ESOP ultimately defaulted on its obligation to pay for the stock. We explain more in this Legal Update.
I.The Facts of Berman v. Comm'r
As further described below, Section 1042 of the Internal Revenue Code ("Code") allows taxpayers to defer the gain on the sale of stock to an employee stock ownership plan if certain requirements are met. Each of the taxpayers held 50% of the outstanding shares of E.M. Lawrence, Ltd. ("Lawrence"), a New Jersey corporation. In late 2002, they each sold a portion of their Lawrence stock to the trust (the "ESOT") of a newly formed employee stock ownership plan for $8.3 million ($4.15 million each). The ESOT paid for the stock by issuing its promissory notes to the shareholders. Each of the shareholders realized a gain of over $4 million as they had only a de minimis basis in their stock. The ESOT did not make any payments on the promissory notes in 2002. On their 2002 federal income tax returns, the taxpayers reported the transaction as a sale to an ESOP for which Code Section 1042 applied and did not file a statement (Internal Revenue Service ("IRS") Form 6252) that they were adopting the installment sales method of accounting.
The sale to the ESOT would have allowed the shareholders to avoid federal income tax on the sale, provided that the sale proceeds were invested in qualified replacement property ("QRP") within 12 months of the sale.2 In 2003, the taxpayers purchased floating rate notes ("FRNs") as QRP. The taxpayers purchased the FRNs with cash and the proceeds from borrowings. Although the opinion is somewhat muddled on the point, it appeared that each taxpayer purchased $4.15 million in FRNs as QRP, the full amount realized in the stock sale to the ESOT.
Immediately following their purchase of the FRNs, the taxpayers transferred the FRNs to special purpose companies owned by Derivium Capital, ostensibly as collateral for additional loans that would have caused the outstanding debt against each FRN to be equal to 90% of the face amount of each FRN. At trial, the taxpayers conceded that the Derivium Capital transactions did not result in indebtedness but instead resulted in sales of the FRNs for federal income tax purposes.3 The dispositions of the FRNs for federal income tax purposes potentially resulted in a recapture of the gain the taxpayers were able to exclude by reason of the sale to the ESOT.4
In 2003, the ESOT made principal payments of $449,277 on each of the promissory notes that it issued to the taxpayers. The decision states that the ESOT subsequently defaulted on the notes.
II.The Federal Income Tax Position of the Parties
The IRS asserted that in 2003, the taxpayers should include as income the full $8.3 million of gain that was excluded from their income and rolled into the FRNs because they disposed of the QRP. The taxpayers countered that they had never taken advantage of the rules for stock sales to ESOPs, but instead had made installment sales of the Lawrence stock and were entitled to defer the gain under the installment sales rules. After an in-depth discussion, the court rejected the claim that the taxpayers had not taken advantage of the rules for stock sales to ESOPs, citing the taxpayers' tax return filings. The court also refused to allow the taxpayers to revoke their elections to apply the rules for stock sales to ESOPs.5
The court, however, was more sympathetic to the claim that the taxpayers could take advantage of the installment sales rules. The court noted that the installment sales rules apply unless a taxpayer affirmatively elects out of such rules and those rules apply for all purposes of the Code. In addition, citing older caselaw, the court noted that even a failure to properly report income in a manner consistent with the installment sales rules does not cause a loss of a taxpayer's ability to use that method of reporting.6 After consideration, the court held that installment sale reporting is compatible with ESOP sale reporting, and that the language of the installment sale rule supported the conclusion that the gain excluded by the ESOP rule was only the gain that would have been recognized under the installment sales rules.7
Specifically, the court held that Code Section 1042 allows a taxpayer to avoid recognition of the gain that they would have recognized in the absence of Code Section 1042's allowance of a deferral on sales to ESOPs. This reading puts the installment sales rules first: the first step in interpreting Code Section 1042 is to determine the amount of gain that the taxpayer would have otherwise recognized. Since the installment sales rule only requires gain recognition with respect to payments made on an installment note, the amount of gain protected by the ESOP statute was only the amount that would have been recognized under the installment sales rules, i.e., the payments on the promissory notes.
The court found that the Lawrence stock sales by the taxpayers to the ESOT met the literal definition of an installment sale: at least one payment was to be made after the close of the taxable year in which the sale was made.8 Under the installment sales rules, since only $449,277 in payments were made on each Lawrence promissory note in 2003, each taxpayer only recognized $444,784 of gain in that year (the ratio of gross profit to the total contract price), instead of the full amount of gain that had been rolled into the FRNs.
The court also held that the $444,784 gain recognized in 2003 reduced the basis of the QRP. This left each shareholder with a basis of $3,705,216 in the FRNs ($4.15 million minus $444,784). In the deemed sale to Derivium, each shareholder received $3,735,000. Thus the court required each shareholder to recognize an additional $29,784 of gain.
III.Take Aways
The taxpayers paid substantial fees to enter into the ESOP and the Derivium transactions under the false impression that they could cash out of their stock position without any significant taxes. Instead, they found themselves in court having to defend against paying tax on phantom gains. They were very fortunate that the court reached a reasoned position that prevented them from having to pay more tax than the cash they realized on the transactions. If it sounds too good to be true, it always is.
And, of course, stock sellers in ESOP transactions should include the installment sales reporting form with their tax returns, when applicable.
Footnotes
2 Section 1042(a)(3) of the Internal Revenue Code of
1986, as amended (the "Code"). To the extent that the
cost of the QSP is less than the amount realized, gain is
recognized. Code § 1042(a) (flush lang).
3 For an in-depth analysis of this issue, please see Leeds, A Riff on Cliff: Calloway and Anschutz Expand Tax Ownership Authorities from Debt to Equities, The Tax Lawyer, Vol. 64, No. 3 (Spring 2011), pp. 657 – 700.
4 Code § 1042(e)(1).
5 Temp. Treas. Reg. § 1.1042-1T(Q&A 3(a)
(elections to take advantage of the rules for stock sales to ESOPs
are irrevocable).
6 Bolton v. Comm'r, 92 TC 303 (1989). If a taxpayer
reports the full gain in the year of sale, however, they are
treated as though they elected out of installment sales reporting.
Treas. Reg. § 15a.453-1(d)(3)(i).
7 Code § 453 provides that "[e]xcept as otherwise provided in this section, income from an installment sale shall be taken into account for purposes of this title under the installment method." § 453(a) (emphasis in opinion).
8 Code § 453(b)(1).
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