Tobacco Buyout Issues: Inherited or Gifted Tobacco Quota Buyout Installment Contracts

Tobacco Buyout Issues: Inherited or Gifted Tobacco Quota Buyout Installment Contracts Guido van der Hoeven Agriculture Extension Specialist North Carolina State University T. Michael Till Extension Assistant i

INHERITED OR GIFTED TOBACCO CONTRACT Tobacco quota installment payments will continue through 2014, and recipients reside in all 50 states as well as foreign countries. Some of the original recipients have died or given away their installment contracts. This issue looks at the tax treatment of an inherited or gifted tobacco transition payment contract. Background The American Jobs Creation Act of 2004 (Pub. L. No. 180-357) included the Fair and Equitable Tobacco Reform Act of 2004 (Tobacco Reform Act), which created the Tobacco Transition Payment Program (TTPP), often called the tobacco quota buyout. Taxpayers who owned tobacco quota and/or grew tobacco under the quota system are receiving installment payments unless they sold the installment contract for a lump sum. The first installment payment was made in the fall of 2005; subsequent annual installment payments are received in January each year, with the tenth and final payment to be made in 2014. The tobacco buyout includes two types of payments, plus, for some taxpayers, unstated interest. The first payment buys out the quota, which generally is a business asset (I.R.C. 1231; Notice 2005-51, 2005-2 C.B. 74; and Notice 2005-57, 2005-2 C.B. 267). Consequently, gain or loss from the sale of the quota is I.R.C. 1231 gain or loss, which is netted with other I.R.C. 1231 gains or losses for the year. A net gain is treated as a capital gain and a net loss is treated as an ordinary loss. The second payment replaces lost tobacco income for producers of tobacco. It is generally ordinary income subject to SE tax. Production localities of tobacco are listed below; however, tobacco quota installment recipients reside in all fifty states and many foreign countries, therefore, the tax consequences reach far beyond the locations listed. Types of tobacco grown are also listed. Flue-cured (types 11-14); Flue-cured tobacco is grown in Alabama, Florida, Georgia, North Carolina, South Carolina and Virginia. Burley (type 31): Burley tobacco is grown in Alabama, Arkansas, Georgia, Indiana, Kansas, Kentucky, Missouri, North Carolina, Ohio, Oklahoma, Tennessee, Virginia and West Virginia. Fire-cured (types 21-23): Fire-cured tobacco is grown in Kentucky, Tennessee, and Virginia. Dark air-cured (types 35 and 36); Dark air-cured tobacco is grown in Indiana, Kentucky and Tennessee. Virginia sun-cured (type 37): Virginia sun cured-tobacco is grown exclusively in Virginia. Cigar filler/binder (types 42-44 and 54 and 55); cigar filler/binder is grown exclusively in Wisconsin. 1

Taxpayers and the tax professionals who prepare tax returns that include TTPP installment income must reconcile the installment payment into the distinct parts of that payment: tobacco quota basis recovery, tobacco quota buyout gain (or loss), and unstated interest, if any. Some taxpayers also receive a grower payment (commonly called $3 money), and this income is treated separately from the buyout payment ($7 per pound). Taxpayers and tax professionals are beginning to encounter issues regarding the reporting of tobacco buyout installment payments when the original recipient dies or makes a gift of the TTPP installment contract. This discussion clarifies the tax issues that must be addressed when dealing with an inherited or gifted TTPP installment contract. Reporting by Original Recipient Understanding the original recipient s reporting of a TTPP contract provides a foundation for identifying and understanding the tax issues involved with contracts owned by a decedent s estate, a beneficiary, or a donee. Example 1. TTPP Reporting in 2005 Golden Leif is a former tobacco quota owner. Figure 1 shows the information reported on the Form 1099-S, Proceeds from Real Estate Transactions, that he received in 2005, plus other information that is needed to report the buyout of Golden s tobacco quota. FIGURE 1: GOLDEN S TOBACCO BUYOUT INFORMATION Item Information Source Closing date 7/08/2005 Box 1 of Form 1099-S Gross proceeds $85,449 Box 2 of Form 1099-S Date acquired 6/15/1994 Golden s records Basis of quota $20,000 Golden s records Amortization claimed None Golden s records Figure 2 shows the summary of unstated interest that was provided by the USDA with Form 1099-S, and the portion of each payment that is allocated to principal. FIGURE 2: SUMMARY OF UNSTATED INTEREST Year Unstated Interest Principal Total Payment 2005 $ 0.00 $8,544.90 $8,544.90 2006 0.00 8,544.90 8,544.90 2007 3,251.25 5,293.65 8,544.90 2008 1,989.96 6,554.94 8,544.90 2009 1,736.94 6,807.96 8,544.90 2010 1,474.15 7,070.75 8,544.90 2011 1,201.22 7,343.68 8,544.90 2012 917.75 7,627.15 8,544.90 2013 623.35 7,921.55 8,544.90 2014 318.00 8,226.90 8,544.90 Total $11,512.62 $73,936.38 $85,449.00 2

Golden did not elect out of installment reporting. In 2005, his tax preparer calculated his gross profit and reported it on Form 6252, Installment Sale Income, as shown in Figure 3. FIGURE 3: GOLDEN S 2005 FORM 6252 The 2006 and 2007 installment payments were also reported on Form 6252. For each year, the taxable portion of the principal payment was carried to Form 4797, Sales of Business Property, and then to Schedule D (Form 1040), Capital Gains and Losses. There was no unstated interest for 2006, as shown in Figure 2, so the entire $8,544.90 installment payment was reported on line 21 of Form 6252. For 2007, the $5,293.65 principal reported on line 21 of Form 6252 is the $8,544.90 installment payment reduced by the $3,251.25 unstated interest. 3

Unstated Interest The Tobacco Reform Act does not state any interest for the TTPP payments, but I.R.C. 483 and 1274 require unstated interest to be calculated and reported. I.R.C. 483 applies to installment sales for at least $3,000 but not more than $250,000. I.R.C. 1274 applies to installment sales for more than $250,000; this interest is treated as original issue discount (OID). TTPP recipients received either a Form 1099-INT, Interest Income, or a Form 1099-OID, Original Issue Discount, in 2007 and they will also receive one of those forms in each subsequent year. The unstated interest reported for each year should match the amount found on the Form 1099-S supporting table, as illustrated in Figure 2 for Golden Leif. Example 2. TTPP Reporting in 2007 and Later Years Golden Leif received his third $8,544.90 TTPP installment payment on January 15, 2007. Because his contract amount is less than $250,000, the I.R.C. 483 unstated interest rules apply, and he received a Form 1099-INT reporting $3,251.25 of interest in box 1, which matches the table he received in 2005 (See Figure 2). Golden reported the unstated interest on his 2007 Schedule B (Form 1040), as shown in Figure 4. FIGURE 4: GOLDEN S 2007 SCHEDULE B (FORM 1040) Golden reported only the $5,293.65 principal portion of the 2007 TTPP installment payment on his 2007 Form 6252, as shown in Figure 5. Observation Common Error A frequent error is failing to subtract the unstated interest from the total payment before reporting the principal amount on Form 6252, because the taxpayer does not receive an annual Form 1099-S showing the principal amount of the payment for that year. 4

FIGURE 5: GOLDEN S 2007 FORM 6252 Golden continues to report his TTPP installment payments in this manner until the end of the contract in 2014. Figure 6 summarizes the 2005, 2006, and 2007 reporting of Golden s TTPP installment payments. FIGURE 6: SUMMARY OF GOLDEN S TTPP INSTALLMENT PAYMENTS Year Payment Received Unstated Interest Principal Basis Recovered Gain Reported 2005 $8,544.90 $0.00 $8,544.90 $2,311.40 $6,233.50 2006 8,544.90 0.00 8,544.90 2,311.40 6,233.50 2007 8,544.90 3,251.25 5,293.65 1,431.94 3,861.71 Totals $25,634.70 $3,251.25 $22,383.45 $6,054.74 $16.328.71 Example 3. Reporting Grower Payment in 2007 Golden Leif also receives grower installment payments. His average production was 12,207 pounds for the years used to calculate the grower portion of the TTPP payments. Because he continues to actively and materially participate in his farming business, Golden reports the annual grower payment on Schedule F (Form 1040). Golden s grower payments will total $36,621 (12,207 lbs. $3/lb.) over the 10-year period, so his annual payment is $3,662.10. Golden reports this income on line 6a and 6b of his Schedule F (Form 1040), as shown in Figure 7, and it becomes part of his net earnings from self-employment. 5

FIGURE 7: GOLDEN S 2007 SCHEDULE F (FORM 1040) Retired or Disabled Taxpayers The IRS has not released any guidance about reporting of the TTPP grower payments. It is unclear whether these payments are subject to SE tax for retired or disabled recipients. Consequently, if a recipient of grower payments is retired or disabled, there are two alternatives to using Schedule F (Form 1040) for reporting this income. One is to use lines 3a and 3b of Form 4835, Farm Rental Income and Expenses. The second alternative is to report this income as other income on line 21 of Form 1040. The grower payments are clearly ordinary income, because they are a replacement for tobacco sales. The recently pass 2008 Farm Bill includes a provision excluding CRP payments from self-employment taxation for individuals who are retired or who are permanently disabled (receiving Social Security Payments). Practitioners may be able to stake out a position using the new Farm Bill. Inheriting a TTPP Contract When a taxpayer who owns a TTPP installment contract dies, the contract becomes an asset of the decedent s estate. A technical correction to the initial legislation allows a subsequent transfer of ownership. Successor in Interest The TTPP contract is an agreement entered into by the USDA and a taxpayer who formerly owned a tobacco quota. Once the contract is accepted and formalized by both parties, only the taxpayer is entitled to receive the installment payments. If the taxpayer dies, the original legislation allowed only a surviving spouse to receive the payments. If there was no surviving spouse, the estate was to remain open until the contract period ended. Fortunately, a technical 6

correction to the original legislation allows the payments to be made to beneficiaries other than a spouse. If the taxpayer dies after receiving the current year s installment payment (the payment for the year of death) and he or she directed the disposition of the TTPP contract in a will or other document, the executor of the decedent s estate should use USDA Form CCC-968, Tobacco Transition Payment Program Master Successor-in-Interest Contract, to transfer the payments to the successor. USDA Form CCC-968 An electronic copy of USDA Form CCC-968 can be obtained from the following Web site: http://content.fsa.usda.gov/tobacco/assets/facts/ccc0968.pdf. Example 4. Successor in Interest of TTPP Contract On March 15, 2007, Golden Leif died without a surviving spouse. His son, Dark Leif, inherited the TTPP contract. As executor of Golden s estate, Dark used Form CCC-968 to notify the USDA that he is the successor in interest of Golden s tobacco installment contract. Income in Respect of Decedent Installment contract payments that are unpaid at the time of death of a decedent are income in respect of a decedent (IRD) to the estate or other recipient of the contract [I.R.C. 453B(c)]. The total IRD is the excess of the face amount of the remaining installment obligation over the decedent s basis in the contract at the time of death [I.R.C 453B(b) and 691(a)(4)]. The remaining gain on the contract is not generally reported on the decedent s final income tax return [I.R.C. 691(a)(4)]. Instead, the IRD is reported by the recipient of the payments as the remaining payments are made. Cancellation at Death An exception applies if the remaining payments on an installment contract are canceled on the death of the contract holder, or if the buyer of the installment contract inherits the remaining payments. When this occurs, the payments are treated as being made in full to the estate in the year of death, and the estate must report the gain on its income tax return. Installment payments received by a decedent s estate or other beneficiary are included in gross income in the same way the decedent would have reported them [Treas. Reg. 1.691(a)- 5(a)]. In other words, an installment contract does not receive a basis adjustment to FMV upon the death of the contract holder. Therefore, a TTPP installment contract has continuing income tax consequences for the estate or the beneficiaries who inherit it. The character of the IRD for the estate or beneficiaries is the same as it was for the decedent [I.R.C. 691(a)(3); Treas. Reg. 1.691(a)-3(a)]. The IRD is reported for the tax year it is received by 1. The decedent s estate, if the estate acquires the right to receive the TTPP payments 2. The person who obtains the right to the TTPP payments when the right passes outside of the decedent s estate 7

3. The person who obtains the right by bequest, devise, or inheritance if the TTPP payments are received after the decedent s estate distributes that right to receive the income Example 5. Estate Reporting of TTPP Income Golden Leif, from Example 4, received his January 2007 TTPP installment payment before he died on March 15, 2007, so that 2007 installment payment was reported on his final income tax return as illustrated in Figure 5. Because the estate did not distribute any assets before the January 2008 payment was received, Golden s executor, Dark Leif, reports the January 2008 TTPP installment on a 2008 Form 6252 filed with the estate s Form 1041, U,S. Income Tax Return for Estates and Trusts. The Form 6252 result flows to Schedule D (Form 1041) and then to line 4 of Form 1041 as shown in Figures 8, 9, and 10. The $1,989.96 of unstated interest shown in Figure 2 for 2008 is reported on line 1 of Form 1041. As in Example 3, the grower payment is reported on Schedule F (Form 1040), but it then is entered on line 6 of Form 1041. The estate had no other income, so its total income reported on line 9 of Form 1041 is the $10,433.89 that is recognized from the 2008 TTPP payments. FIGURE 8: 2008 FORM 6252 FOR GOLDEN S ESTATE 8

FIGURE 9: 2008 SCHEDULE D (FORM 1041) FOR GOLDEN S ESTATE FIGURE 10: 2008 FORM 1041 FOR GOLDEN S ESTATE 9

Reporting on Form 1040 If Dark Leif had requested a succession in interest to himself as the sole beneficiary of Golden Leif s estate, his income tax reporting of the TTPP payments would be similar to the estate s reporting. Dark would report the following amounts on schedules attached to his 2008 Form 1040: $1,989.96 of interest on Schedule B (Form 1040) $3,662.10 of grower payments on Schedule F (Form 1040), or on line 21 of Form 1040, as discussed later in this section $4,781.83 of gain on Form 6252, carried to Schedule D (Form 1040) Sale of Inherited TTPP Contract Beneficiaries and executors who manage TTPP installment contracts may choose to cash out by selling the TTPP contract to a financial institution that is willing to buy the contract at a discount. Because the contract proceeds are IRD, the beneficiary or estate reports income or loss in the same manner as if the original owner had made the sale. The gain or loss is the difference between the contract s FMV (generally, its selling price) and the remaining basis in the contract [I.R.C. 691(a)(4); Treas. Reg. 1.691(a)-5(b)]. If a beneficiary who inherits a TTPP installment contract sells the contract to a financial institution, the Form CCC-698 discussed earlier in this section is used to transfer the contract to the purchasing financial institution. Example 6. IRD from Sale of TTPP Contract The facts are the same as in Example 5, except that the estate distributed the installment contracts to Dark Leif on June 15, 2007. On November 15, 2007, Dark made a lump-sum sale of both the TTPP installment contract and the grower payment installment contract for 75% of their face value to an unrelated financial institution. He received $44,860.72 (75% of the $59,814.30 remaining balance on the TTPP contract) plus $19,226.03 (75% of the $25,634.70 remaining\ balance on the grower contract) in one lump-sum payment. Because these payments retain their character as capital gain and ordinary income, Dark must report the amounts separately on his personal tax return. He computes his basis in the TTPP contract by subtracting the $6,054.74 basis that was recovered in the first three payments (see Figure 6) from the original $20,000 basis in the contract. The result is $13,945.26. Dark reports the $44,860.72 that is allocated to the TTPP contract and its $13,945.26 basis on Form 4797, as shown in Figure 11, and carries the $30,915.46 gain to line of Schedule D (Form 1040) as shown in Figure 12. He reports the $19,226.03 payment for the grower contract as other income on line 21 of Form 1040. 10

FIGURE 11: 2007 FORM 4797 FOR DARK LEIF Contract Retains I.R.C. 1231 Character Gain from the sale of a TTPP installment contract is I.R.C. 1231 gain, because the underlying asset (the tobacco quota) was an I.R.C. 1231 asset [Treas. Reg. 1.453-12(d)]. Also, assets that are inherited are deemed to be long-term assets in the hands of the beneficiary [I.R.C. 1223 (9)(B)]. 11

FIGURE 12: 2007 SCHEDULE D (FORM 1040) FOR DARK LEIF Observation Form 1040 Line 22 If Dark Leif, in the above example, was not a farmer, a plausible argument might be made to report the Grower Payment on line 22, Other Income, Form 1040. The IRS has not issued guidance relative to the Grower Payments under TTPP. Inherited Grower Contract Although the grower TTPP contract payments are subject to SE tax when they are received by the grower, they are arguably not subject to SE tax when they are received by a beneficiary. The beneficiary was not involved in the production of tobacco in the years 2002, 2003, and 2004, upon which the grower payments are based. In Rev. Rul. 59-162, 1959-1 C.B. 224, a surviving spouse received commissions on life insurance policies that her husband sold before his death. The commissions received by her husband before his death were SE income because he was a self-employed agent, but the commissions she received after his death were not SE income for her because they were not derived from a trade or business that she carried on. In the case of grower TTPP contracts, the beneficiary can argue that the payments are not derived from a trade or business carried on by the beneficiary. That argument can be made by a beneficiary even if he or she is an active farmer, because the payments are not derived from the beneficiary s trade or business. Based on this argument, the beneficiary who inherits a grower contract reports the installment payments on line 21, Other income, of Form 1040. Deduction of Estate Tax The value of the right to receive IRD is included in the decedent s gross estate for assessment of the estate and generation-skipping transfer taxes. Nevertheless, when beneficiaries receive the income, they must report and recognize the IRD on their individual tax returns. The Internal Revenue Code provides a measure of relief from potential double taxation (although it is not an efficient measure of relief). 12

When a beneficiary reports IRD income on his or her current year s tax return, the beneficiary can deduct an allocable portion of the estate or generation-skipping transfer tax paid by the estate. The deduction is taken on Schedule A (Form 1040) as a miscellaneous itemized deduction that is not subject to the 2%-of-AGI floor. The allowable deduction is calculated by prorating the estate tax or generation-skipping tax to the IRD income included in the gross estate [I.R.C. 67(b)(8)]. Gifting a TTPP Contract Giving an installment contract to another taxpayer can have both gift and income tax consequences for the donor. Gift Tax Consequences Gifts are complete when the donor relinquishes any and all rights, claims, or control over the property [Treas. Reg. 25.2511-2(b)]. Gifts include transfers of present and future interests in property [I.R.C. 2503(b)(1) and Treas. Reg. 25.2503-2], but gifts of future interests do not qualify for the annual gift tax exclusion ($12,000 in 2008) [I.R.C. 2503(b)(1)]. Treasury regulations define a present interest in property as an unrestricted right to the immediate use, possession, or enjoyment of property or the income from property (Treas. Reg. 25.2503-3). A gift of a TTPP installment contract is a gift of present interest because the done could sell the contract for a lump-sum payment to a financial institution. Gift Tax Nature Gift tax is imposed on the transfer of property, not on the transferred property itself [I.R.C. 2501 (a)]. Value of a TTPP Contract For purposes of both income taxes and gift taxes, the value of a TTPP installment contract is the present value of the future payments [Treas. Reg. 1.7520-1(a)(1) and 25.2512-5(a)]. The present value of the future payments is calculated by multiplying the aggregate amount payable annually by the appropriate actuarial factor that corresponds to the applicable I.R.C. 7520 interest rate and annuity period. The applicable I.R.C. 7520 interest rate is 120% percent of the mid-term applicable federal rate (AFR) in effect under I.R.C. 1274(d)(1) for the month in which the valuation date falls. The rate is rounded to the nearest two-tenths of 1%. Actuarial factors for an annuity payable for a term certain for valuation dates after April 30, 1999, are published in IRS Publication 1457, Actuarial Values Book Aleph, Table B [Treas. Reg. 25.2512-5(d)(2)(iv)(A)]. Market for TTPP Installment Contracts There is a thin market for TTPP installment contracts, which could be used to determine the FMV of the contracts. However, the IRS is likely to require using the I.R.C. 7520 factor to value a gift of the right to receive the remaining payments on a TTPP installment contract. 13

Example 7. Value of TTPP Contract Golden Leif, from the previous examples, gave his TTPP installment contract to his son Dark Leif immediately after Golden received his fourth installment payment in January 2008. For both income and gift tax purposes, the amount of the gift is the present value of the six remaining $8,544.90 annual payments. Golden s basis in the contract is $12,172. That is his $20,000 basis in the tobacco quota reduced by the basis he recovered to offset gain on the first four installment payments. Figure 6 shows the $6,054.74 basis recovered on the first three installment payments. The basis he recovered on the fourth (2008) payment is $1,773.11 the $6,554.94 principal payment shown in Figure 2 reduced by the $4,781.83 gain ($6,554.94 0.7295 gross profit ratio). Golden computes the present value of the payments by first finding the I.R.C. 7520 interest rate for January 2008, which is 4.4% [Rev. Rul. 2008-4, 2008-3 I.R.B. 272, Table B]. The actuarial factor for a 6-year term-certain annuity at a 4.4% interest rate is then located in Table B of IRS Publication 1457. This factor is 5.1746. Finally, Golden multiplies the $8,544.90 amount of the annual payments by the 5.1746 actuarial factor to find the $44,216 value of the TTPP installment contract. As shown in Figure 13, Golden reports the $44,216 gift on line 1, Part 1, Schedule A, of Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. The $12,000 annual exclusion is deducted on line 2, Part 4, Schedule A, of Form 709, reducing the taxable gift to $32,216, which is reported on line 1, Part 2, of Form 709. Golden does not pay any gift tax because his total taxable gifts since 1976 are less than the $1,000,000 applicable exclusion amount. 14

FIGURE 13: GOLDEN S 2008 FORM 709 15

Donee s Liability for Gift Tax The federal gift tax is imposed on the donor [I.R.C. 2502(c)]. However, if the gift tax is not paid when due, I.R.C. 6324(b) imposes the tax on the donee and creates a lien on the property that was given to the donee. State Gift Taxes Some states impose a gift tax that may be more significant than the federal gift tax. Income Tax Issues for Donor Gifting a TTPP installment contract can create an income tax pitfall for the donor, because the gift is treated as a disposition of the installment obligation [I.R.C. 453B(a) and Rev. Rul. 79-371, 1979-2 C.B. 294]. The donor realizes and recognizes gain (or loss) equal to the difference between the contract s FMV and its remaining basis [I.R.C. 453B(a) and (b)]. The contract s FMV for income tax purposes is calculated in the same manner as the gift tax value [Treas. Reg. 1.7520-1(a)(1)]. Example 8. Gain on Gift of TTPP Contract Because Golden gave the TTPP contract to his son, Dark Leif, he must recognize gain as if he had received the contract s FMV in cash at the time of the gift. Using the facts in Example 7, the contract s FMV is $44,216 and his remaining adjusted basis is $12,172. Golden must report the $32,044 gain on his 2008 Form 4797, Schedule D (Form 1040), and Form 1040 as if he had sold the TTPP installment contract for $44,216 just as the sale of the contract was reported in Example 6. Double Taxation In giving the this gift of the installment payment, Golden is seemingly subject to double taxation, gift tax and income tax on the same transation. 16

Income Tax Issues for Donee The TTPP contract is not an installment contract in the hands of the donee, because the donor was required to recognize the gain on the contract. The contract becomes an annuity contract in the hands of the donee. I.R.C. 72 requires annuity payments to be included in the donee s income to the extent they exceed the exclusion ratio. To calculate that ratio, the donee s basis in the contract must be determined. Donee s Basis in TTPP Contract The donee s basis in the contract is the donor s basis [I.R.C. 1015(a)], increased by any gift tax paid that is attributable to the appreciation [I.R.C. 1015(d)]. Because the gift triggers recognition of gain by the donor, that gain is added to the donor s basis before it is transferred to the donee [I.R.C. 1015(a) and Rev. Rul. 79-371, supra]. If the basis (adjusted for any gift tax paid) is less than the face value of the remaining payments, the difference is treated as original issue discount (OID). Generally OID is treated and reported as interest on Schedule B Form 1040. Exceptions to OID Rules There are exceptions to the OID rules for nonpublicly traded debt instruments such as TTPP installment contracts. These exceptions are found in I.R.C. 1274 and supporting Treasury Regulations 1.1274. The rules are complicated. Example 9. Basis of Gifted TTPP Contract In Example 8, Dark Leif received the TTPP contract as a gift from his father, Golden Leif. Dark s basis is $44,216 (the sum of Golden s $12,172 basis and the $32,044 gain Golden recognized on the deemed disposition). Donee s Income from Contract Payments I.R.C. 72(b) allows the donee to exclude a portion of each payment from income. The amount excluded is the part of the payment that bears the same ratio to the annual payment as the basis in the contract bears to the expected total payments [Treas. Reg 1.72-1(c)]. Example 10. Payments Received by Donee Dark Leif will receive six annual payments of $8,544.90, for a total of $51,269.40. He reports the $8,544.90 annual payment on line 16a of Form 1040, excludes $7,369.39 [($44,216 $51,269) $8,544.90] of each payment, and reports the remaining $1,175.51 taxable amount as ordinary income on line 16b of Form 1040. Subsequent Sale of Contract If the donee sells the TTPP contract, he or she must recognize the difference between the basis in the contract at the time of the sale and the amount realized on the sale as gain or loss. The gain or loss from the sale of a right to receive future ordinary income is ordinary gain or loss [Commissioner v. P.G. Lake, Inc., 356 U.S. 260 (1958)]. 17

Planning Pointer Avoid Gifts of TTPP Contract Instead of giving the TTPP contract to the donee, it is better to give the payments from the contract to the donee each year as they are received. That avoids accelerating the reporting of gain on the TTPP installment contract. 18