Edward & Ellen Berman v. Comm., 163 T.C. No. 1

In 2002, Edward and Ellen Berman each sold stock to an ESOP for $4,150,000 in which they had bases of $27,428, thereby realizing a gain of $4,122,572 each. As payment, each received a $4,150,000 promissory note, on which a first payment of $449,277 was made in 2003. They made valid elections under §1042 on their 2002 federal income tax returns to defer recognition of the gain each realized for 2002. Effecting that deferral required that they purchase qualified replacement property (QRP), at a cost equal to or exceeding the realized gain, within 12 months of the stock sales, a period that extended into their 2003 taxable year. On their 2003 returns they reported the acquisition of sufficient qualified replacement property in 2003 within the replacement period, ostensibly qualifying them to defer recognition of the entire $4,122,572 gain each realized on the stock sales, pursuant to §1042.

Borrowing against QRP stock is a sale. During 2003 the Bermans used the QRP in so-called Derivium 90% loan transactions; that is, they pledged the QRP as collateral for purported loans equal to 90% of the property’s value with the purported lender retaining the remaining 10% as a fee. The repayment terms of the purported loans were such that the courts have consistently held that the purported loans were sales of the property pledged as collateral. The Derivium 90% loan transactions in which they engaged using the QRP constituted sales of that property. Deferred gain was triggered.

Under §1042(e) a taxpayer’s sale of QRP triggers a recapture of the previously deferred gain. This is accomplished through the imposition of a basis reduction rule whereby the taxpayer’s basis in the QRP is reduced by the amount of the realized gain for which recognition is deferred. Citing the section 1042(e) recapture rule, IRS took the position that the Bermans’ sale of the QRP in 2003 requires them to recognize the entire $4,122,572 of gain each deferred, notwithstanding the fact that each had received a payment of only $449,277 for the stock in that year (and nothing in 2002).

Was there an election out of the installment sale? The Bermans contend that because they disposed of their stock in installment sales, they are entitled to recognize any gains on the sales — no longer shielded by §1042 — under the installment method. In that event, the gains they are required to recognize for 2003 would be that proportion of the $449,277 payment each received in 2003 which the gross profit on the sale bears to the total contract price. IRS argued that selling the QRP not only triggered the deferred gain, but was effectively an election out of the installment sale. 

How to elect out of the installment sale? Section 453(a) provides generally that income from an installment sale “shall” be taken into account under the installment method. A taxpayer may elect not to have the installment method apply, but he or she must do so affirmatively on or before the due date of the return for the year of the sale; the installment method presumptively applies in the absence of such an election.

Gain taxed under installment sale rules The Court agreed with the Bermans, finding that the §1042 gain deferral claimed in 2002 (that became essentially invalid at the sale of the QRP a year later) did not constitute electing out of the installment method on the original sale.