Recaptured Gains from Stock Sale Qualified for Installment Method

Addressing an issue of first impression, the Tax Court determined that the installment method applied to the taxpayers’ gains from the sale of their stock to an employee stock ownership plan, which were previously shielded by Code Sec. 1042, after the taxpayers sold their qualified replacement property the following year. (Berman, 163 TC No. 1)

Making the 1042 election and subsequent sale.

On their 2002 tax returns, the taxpayers made an election under Code Sec. 1042 to defer recognition of the approximately $4 million in gains each received from their sale of stock to an ESOP. The taxpayers sold their stock in return for promissory notes and the first payment under the notes (about $450,000 to each taxpayer) was made in 2003.

In 2003, the taxpayers reported that they had purchased sufficient qualified replacement property (QRP) to defer the 2002 gains. This same year the taxpayers sold their QRP in a purported loan transaction, which they later conceded was a sale.

Note. Under Code Sec. 1042(e) a taxpayer’s sale of QRP triggers a recapture of the previously deferred gain.

Interplay of deferral and installment rules.

The Tax Court determined that the taxpayers’ Code Sec. 1042 elections to defer the gains they realized from their 2002 stock sale did not preclude them from subsequently using the installment method under Code Sec. 453 to report the recapture of those gains when they disposed of the QRP in 2003.

The court said that the taxpayers were entitled to use the installment sales method to report their gains from the 2002 stock sale because in 2003, those gains were no longer deferred under Code Sec. 1042 (due to the 2003 sale of the QRP) and the 2002 stock sale met the requirements of an installment sale because the installment notes required payment of the sales price in more than one tax year.

The Tax Court rejected the IRS’ argument that the amount and timing of any gains from the 2002 stock sale must be determined under Code Sec. 1042(e) because the taxpayers had validly elected to defer the gains from that sale. The court noted that the taxpayers never elected not to use the installment method to report their 2002 stock sale. As a result, the recaptured gain to be recognized on the 2003 disposition of the QRP was properly determined under the installment method.

For more information about the nonrecognition of gain on sale of “qualified securities” to an ESOP, see Checkpoint’s Federal Tax Coordinator ¶ H-12103.