IRS Limits Agents' Use of Constructive Receipt with Collateralized Letters of Credit
Maples, Larry, The CPA Journal
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 of changes in the underlying security.
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.
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)].
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 thirdparty 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 dearly 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. …