The CPA Journal

IRS Limits Agents’ Use of Constructive Receipt with Collateralized Letters of Credit

By Larry Maples

In two recent instances, IRS field offices attempted to treat a note collateralized by a letter of credit as immediate income under the doctrine of constructive receipt, only to be rebuffed by the IRS’s national office. The relevant technical advice memoranda (TAM) herald an important development for taxpayers that receive amounts in an installment sale collateralized by a letter of credit.

Background

Accrual taxpayers normally cannot defer income with a letter of credit since the receipt of a note is taxable regardless of the collateral arrangement. Cash basis taxpayers or installment sellers, on the other hand, can claim that a letter of credit is merely security and thus not taxable until either the note or the letter of credit is collected. The IRS has often taken the position, however, that a letter of credit is a cash equivalent under IRC section 451.

There is, however, judicial conflict over the meaning of this doctrine of cash equivalency. Taxpayers have often cited the Fifth Circuit’s decision in Cowden [61-1USTC 9382, 289 F.2d 20 (CA-5, 1961) rev’g 20 TCM 1635 (1961)] to establish that the fair market value of an item does not necessarily determine its cash equivalency. The Fifth Circuit believed that lack of transferability or a market where the instrument would trade at a substantial discount would argue against cash equivalency. The Ninth Circuit, however, held in Warren Jones [75-2 USTC 9732, 524 F.2d 788 (CA-9, 1975) rev’g 60 TC 663 (1973)] that the market value of the instruments should be included in income even if they could only be sold at substantial discounts. The Ninth Circuit observed that the availability of installment reporting would cushion taxpayer hardship in this situation. Such a cushion becomes moot, however, if the IRS treats the security for the note as “payment” under the installment sale rules.

The specific question of whether a letter of credit triggers income has never been clearly answered by the courts. In Watson [80-1 USTC 9302 (CA-5, 1980) aff’g 69 TC 544)], the Tax Court taxed a letter of credit received by a seller. The Tenth Circuit thought that a standby letter of credit avoids this fate because it is nontransferable [Sprague, 80-2 USTC 9631, 627 Fd 1044 (CA-10, 1986) rev’g DC 76-2 USTC 9566], but the Tax Court disagreed [Griffith 73 TC 933 (1979)].

Installment Sales

This judicial conflict was in the background as Congress amended the installment sales rules in 1980 by redefining payment as follows: “Payment does not include the receipt of evidences of indebtedness of the person acquiring the property (whether or not payment of such indebtedness is guaranteed by another person)” [IRC section 453 (f)(3)]. Thus, a third-party guarantee is not payment. IRC section 453 does not define third-party guarantees, but it invited the Treasury Department to issue regulations to carry out congressional intent. Temporary Regulations 15 a.453-1(b)(e) said that a standby letter of credit is not payment under IRC section 453. The Treasury Department’s position is very solid because it rests on a statement in the committee report that a standby letter of credit is an example of the type of third-party guarantee envisioned by Congress.

Although these temporary regulations mention no qualifying third-party guarantee other than the standby letter of credit, they give examples which clearly indicate that escrow accounts will not be considered third-party guarantees. Thus, it is crucial to understand what the IRS means by “standby letter of credit,” the type of property securing the letter of credit, and the effect, if any, of changes in the underlying security. IRS district offices have attempted to characterize letter of credit arrangements as payment under the installment sale rules. Two TAMs overruling these district offices illuminate the extent to which a letter of credit, will provide a safe harbor from the payment provision of the installment sale rules.

Recent TAMs

Both TAM 200105004 and TAM 200105061 concerned corporations selling stock in other corporations under an arrangement involving an installment note. The installment notes were secured by irrevocable letters of credit and the companies elected to report the gains under the installment method. The facts in these cases were very similar regarding the question of whether “payment” was received (TAM 200105004 also involved an application of section 1031 not relevant here); however, TAM 200105061 elaborates more on the National Office’s reasoning and specifically addresses the effect of the temporary regulations.

The letter of credit obtained by the buyer in TAM 200105061 was secured by mortgages on real property owned by the corporations sold. A year or so later, the buyer, after liquidating the acquired corporations and placing the real properties into partnerships, wished to end the partnerships and divide the real properties. In order to do so, the buyer (the original ownership group plus a new partner) needed to remove the mortgages. The buyer approached the seller about prepaying the installment note, thereby releasing the mortgages serving as collateral. As an alternative to prepayment, the seller preferred that the buyer obtain a substitute letter of credit in order to release the mortgages. This letter of credit was secured by the buyer’s cash deposit at the issuing bank and could be drawn on by the seller in the event of default on the note.

Just before the amended note was due, the buyer obtained a third letter of credit, also backed by a cash deposit. This note was endorsed to the bank as a condition of the issuance of the new letter of credit. The bank acknowledged that the buyer had no further liability to the bank because the secured obligations were to be paid from the investments purchased with the cash deposit. Moreover, the seller agreed to be responsible for any costs for the amended agreement, such as fees and legal expenses.

The appeals officer argued that payment was received under the constructive receipt doctrine when the collateral was changed and new letters of credit obtained under either of the restructuring arrangements. The temporary regulations clearly resolve the judicial quagmire discussed earlier by providing that payment does not include a standby letter of credit. Therefore, the issue in TAM 200105061 is whether the instruments used are true standby letters of credit.

No question was raised as to whether the initial financing involved a true standby letter of credit. The field office’s contention that the restructured arrangements constituted payment raises two questions: First, will cash collateral or a switch to cash collateral be considered payment? Example 7 in the temporary regulations clearly sanctions the use of cash collateral for a standby letter of credit. The field office’s position may have been based on a misreading of example 8 in the temporary regulations, where a $1 million note is secured by a $600,000 standby letter of credit and a $400,000 escrow account and treated as a $400,000 payment. Treating a cash escrow account as payment does not mean that the cash collateral should receive the same treatment.

The second question is more difficult to dismiss: Is it possible that the substance of an arrangement could be payment even when a standby letter of credit is in place? This agreement really goes back to principles derived from case law that predates IRC section 453 (f)(e) and the ensuing temporary regulations. The logic behind this position posits that as restructuring arrangements evolve toward relieving the buyer of further financial obligations a point may be reached where “payment” has in substance occurred. Under the final arrangement in TAM 200105061, the issuing bank held the note and the buyer had no further obligations to the bank because the secured obligations were to be paid from the investment collateral. Furthermore, the seller was responsible for costs and fees charged by the bank and even agreed to indemnify the buyer for additional income taxes that might be incurred due to the limit on deductibility of investment interest. Thus, although the buyer’s obligations were over, the National Office ruled that no payment had occurred.

Safe Harbor

The upshot of the National Office’s recent position is that a standby letter of credit apparently will be a safe harbor from the installment payment rules under IRC section 453. The National Office chose not to resurrect the old judicial arguments about cash equivalency in a situation where they might have applied. Apparently, the IRS plans to accept the obvious meaning of its temporary regulations as long as the definition of a standby letter of credit is met. The temporary regulations define a standby letter of credit as a “non-negotiable, non-transferrable (except together with the evidence of indebtedness which it secures) letter of credit issued by a bank or other financial institution, which serves as a guarantee of the evidence of indebtedness which is secured by the letter of credit.” According to temporary Treasury Regulations 15 a.453-1(b)(3)(iii), a letter of credit is not a standby letter of credit if it may be drawn upon in the absence of default in payment of the underlying evidence of indebtedness.

Larry Maples is the COBAF Professor of Accounting at Tennessee Technological University.