In Mingo v. Commissioner, No. 13-60801 (5th Cir. 2014), the Fifth Circuit Court of Appeals affirmed the Tax Court’s holding (105 T.C.M. 1857) that the portion of a note attributable to unrealized receivables was not eligible for the installment method but that the taxpayer received basis in the note equal to the amount of the unrealized receivable recognized.
The taxpayer was a partner in a consulting business of PricewaterhouseCoopers LLP (PwC). In 2002, PwC sold the consulting business to IBM. To execute the transaction, PwC formed PwCC, LP (PwCC), a partnership owned by certain PwC subsidiaries. PwC transferred the consulting business and its uncollected accounts receivables to PwCC.
PwC then transferred an interest in PwCC, as well as cash, to each of the consulting partners in exchange for each partner’s interest in PwC. In October 2002, PwCC and the consulting partners sold their respective interest in PwCC to IBM for convertible promissory notes. At the time of sale, the taxpayer’s partnership interest was valued at $832,090, of which $126,240 could be attributed to unrealized receivables.
On her 2002 tax return, the taxpayer reported the sale of her partnership interest as an installment sale for the full amount of $832,090 and didn’t recognize any income relating to the note other than interest income. The taxpayer also didn’t report any income other than interest income from the note for any of the subsequent tax years through 2006. In 2007, she converted the note into IBM stock in a series of transactions. The taxpayer reported the exchange of the installment obligation for IBM stock as a long-term capital gain and the conversion of the debt to stock as a long-term capital loss.
In May 2007, the IRS issued a notice of deficiency for the taxpayer’s 2003 tax year, determining that the amount received in 2002 for the partnership interest, to the extent attributable to the unrealized receivables, couldn’t be reported under the installment method. Nonetheless, the IRS determined that the taxpayer established a method of accounting and imposed a Section 481(a) adjustment for the 2003 tax year.
The Tax Court concluded that the gain realized on the sale of the taxpayer’s partnership interest, to the extent attributable to the partnership’s unrealized receivables, was ineligible for the installment method under Section 453, and that the taxpayer should have properly reported an additional $126,240 of ordinary income on her 2002 federal income tax return instead of reporting it under the installment method.
Additionally, the Tax Court held that the IRS properly made a Section 481(a) adjustment of $126,240 for the 2003 tax year and that this adjustment was necessary to remedy the omission of ordinary income that occurred for the 2002 tax year as a result of the taxpayer’s impermissible election to use the installment method. See a previous analysis.
On appeal, the taxpayer challenged the IRS’s determination that the installment sale reporting of the unrealized receivables in 2002 did not clearly reflect her income and the IRS’s authority to change her method of accounting in 2003, given that the allegedly erroneous reporting under the installment method occurred in 2002, the year of the sale.
The Fifth Circuit affirmed the Tax Court and held that “the proceeds from the unrealized receivables, classified as ordinary income, do not qualify for installment method reporting because they do not arise from the sale of property . . . [and therefore], the installment method did not adequately reflect the income Mingo received from the unrealized receivables.” Noting that the taxpayer had not permanently avoided reporting the income and that she had merely deferred taxation on the unrealized receivables until 2007, the Fifth Circuit also stated that the IRS “did not abuse [its] discretion by forcing Mingo to report the amount as taxable income in 2003 as opposed to 2007 in light of the [IRS’s] correct determination that Mingo’s use of the installment method was improper.”