Rev. Rul. 81-98

ISSUE

What are the federal income tax consequences of the transfer of an installment obligation to an irrevocable reversionary trust under the circumstances described below?

FACTS

A, an individual taxpayer, sold property and accepted a cash down payment and an installment note providing for payment in monthly installments over 15 years plus interest at 8 percent on the unpaid balance. The note can be prepaid without penalty after the first year. A reports the gain on the sale on the installment method of accounting under section 453 of the Internal Revenue Code.

When more than 12 years of installment payments on the obligation were still outstanding, A transferred the installment note to an irrevocable trust. Under the terms of the trust all interest on the note received by the trustee is to be paid currently to B, an individual to whom A owes no duty of support. The portion of each installment payment representing the deferred profit, as well as the return of capital (principal) is to be paid by the trustee currently to A. The trust will be terminated 10 years and 1 month after A transferred the installment obligation to the trust, at which time the installment note is to be returned to A.

LAW AND ANALYSIS

Section 61(a) of the Code and the Income Tax Regulations thereunder provide that, except as otherwise provided by law, gross income means all income from whatever source derived, including (but not limited to) gains derived from dealings in property, interest, and income from an interest in a trust.

Section 453B of the Code provides that if an installment obligation is disposed of, gain or loss shall result to the taxpayer who disposed of the obligation in the taxable year in which the disposition occurs.

Section 671 of the Code provides that when the grantor is treated as the owner of any portion of a trust, there shall be included in computing such owner's taxable income and credits, those items of income, deductions and credits against the tax of the trust that are attributable to that portion of the trust to the extent that such items would be taken into account in computing taxable income or credits against the tax of an individual.

Section 1.671-1(c) of the Income Tax Regulations provides that the provisions of sections 671 through 679 of the Code do not apply in situations involving an assignment of future income whether or not the assignment is to a trust.

Section 1.671-2(b) of the regulations provides that income of a trust over which the grantor has retained substantial dominion or control should be taxed to the grantor or other person rather than to the trust that receives the income or to the beneficiary to whom the income may be distributed. For purposes of subpart E, the term "income" ordinarily refers to income determined for tax purposes and not to income for trust accounting purposes.

Section 677(a) of the Code provides that the grantor shall be treated as the owner of any portion of a trust whose income without the approval or consent of any adverse party is, or, in the discretion of the grantor or a non-adverse party, may be distributed to the grantor.

Rev. Rul. 74-613, 1974-2 C.B. 153, provides that the transfer of an installment obligation to a trust is not treated as a disposition of an installment obligation where the transferor is treated as the owner of the portion of the trust in which is included the deferred profit portion of the installment obligation. (Rev. Rul. 74-613 concerns section 453 prior to its amendment by Public Law 96-471, 1980-2 C.B. 489, which added section 453B to the Code. However, there is no change in the law concerning the disposition of installment obligations that would affect this transaction.)

Under section 677(a) of the Code, A is treated as the owner of the portion of the trust in which is included the deferred profit portion (as well as the return of capital) of the installment obligation.

With respect to the interest income element of the installment payments, sections 671-679 of the Code may not apply. Incident to the codification of the grantor trust provisions in the Code, Congress specified in S. Rep. No. 1622, 83rd Cong., 2nd Sess. 365 (1954), that those provisions would have "no application in situations involving assignments of future income," and that the situations would continue to be governed by the principles of Helvering v. Horst, 311 U.S. 112 (1940), 1940-2 C.B. 206, "whether or not the assignment is to a trust." In Horst, the taxpayer owned bonds with detachable coupons. Prior to the time the debtor was required to pay the interest on the bonds, the coupons were given to the taxpayer's son. The Court held that the taxpayer, in making the investment in the bonds, had created the right to receive the income and, thus, could not avoid being taxed on it even though the gift of the coupons prior to the payment of interest prevented the income from vesting in the taxpayer's possession. See section 1.671-1(c) of the regulations.

In this case, the grantor, A, is treated as owner of that portion of the trust in which is included the deferred profit portion (as well as the return of capital) of the installment obligation similar to the ownership of the bonds by the taxpayer in Horst. Furthermore, in selling the property for the installment obligation, the grantor, as did the taxpayer in Horst, created the right to receive payments on the installment obligation. The grantor, by retaining the right to receive the portion of each installment payment representing the deferred profit, as well as the return of capital (principal), cannot avoid being taxed on the interest income even though the gift of the interest prior to its payment prevented the income from vesting in the taxpayer's possession. Thus, the use of a trust to assign the interest payments to B is ineffective for federal income tax purposes.

HOLDING

The transfer in trust is not a disposition of the installment note by A, and A will continue to report the deferred profit as installment payments are received by the trust.

In addition, A must continue to include in gross income the interest income as it is received by the trustee.