$8.7 million partnership income adjustment by IRS disallowed

Family mobile home business's promissory notes were not includible in income, the Tax Court holds.
By Maria M. Pirrone, CPA, LL.M.

The Tax Court held that a mobile home business could not use the Sec. 453 installment method for reporting mobile home sales. In addition, the IRS could not change the partnership's accounting method from the cash method to the accrual method to increase reported income.

Facts: In 1985, Gary and Janel Joyner began to purchase large tracts in Arkansas and subdivide the land for resale. They marketed the lots primarily to low-income individuals who placed mobile homes on the lots. In most cases, the Joyners also provided financing and executed promissory notes with the buyers. The Joyners extended the loans generally without regard to buyers' credit history or requiring documentation of their income. Purchase agreements and notes did not state the loans' terms or include an amortization schedule or the number of payments or amount required to fully pay off the loans. The Joyners typically did not collect any down payments.

In 1998, the Joyners organized the Joyner Family Limited Partnership (JFLP). They expanded their business to include the purchase and resale of mobile homes on their lots and then to include mobile home rentals. JFLP used the cash method for tax purposes and reported income from the land sales under the installment method. JFLP did not report income from the receipt of the notes; rather, it reported income as it received payments.

In 2015, the IRS issued a notice of Final Partnership Administrative Adjustment to JFLP for 2010, 2011, and 2012, asserting that JFLP was not entitled to use the Sec. 453 installment method to report the mobile home sales and must report income for the sales upon receipt of the notes, increasing JFLP's gross receipts by $1,759,306; $1,250,278; and $606,412, respectively.

The IRS claimed in an amended answer that JFLP was not entitled to report its land-only sales under the installment method and thereby increased JFLP's 2010 and 2011 gross receipts by a further $1,001,665 and $19,328, respectively, for the land-only sales. In addition, the IRS asserted that JFLP was not entitled to the worthless-debt deductions previously allowed. As a result, the IRS sought an increase in JFLP's taxable income for the years at issue of over $8.7 million.

Issues: Sec. 453 allows taxpayers to delay recognition of gain until they receive payments on installment sales. An installment sale is defined as a "disposition of property where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs." Dealers of real property (other than unimproved residential lots) do not qualify for Sec. 453 reporting. A cash-method taxpayer must report income when it is actually or constructively received.

The issues before the Tax Court were: (1) whether JFLP was entitled to use the Sec. 453 installment method to report the mobile home sales or the land-only sales; (2) whether the IRS could change JFLP from the cash method of accounting to the accrual method; and (3) whether the IRS abused its discretion by requiring JFLP to report its income from the mobile home sales upon receipt of the notes on the basis of the notes' face values and by asserting a related Sec. 481 adjustment.

The IRS claimed that JFLP had made significant improvements to the land lots it sold, and, therefore, it was a dealer for its sales of the lots. It claimed that the cash method of accounting did not clearly reflect JFLP's income and asserted its authority under Sec. 446(b) to change its method of accounting from the cash method to the accrual method.

JFLP argued that the IRS should be precluded from raising the change to the accounting method because the IRS did not timely raise this issue. JFLP also argued that a note is included in income upon receipt only if it is the equivalent of cash for cash-method taxpayers and that the notes were not cash equivalents.

Holding: The Tax Court held that JFLP was entitled to use the Sec. 453 installment method for reporting land-only sales, finding that because JFLP did not make improvements to the lots in the land-only sales, it was not a dealer for those sales. However, it was a dealer for the mobile home sales, so it could not use the installment method for those sales. In addition, the court held that the IRS could not force the partnership to change its method of accounting from the cash method to the accrual method because it had not timely challenged the partnership's accounting method or timely exercised its authority under Sec. 446 to change the method of accounting.

Also, the court agreed with the partnership that it was not required to report income for the years it received promissory notes because it had met its burden to prove that the notes weren't cash equivalents. The court found that they were not cash equivalents because there was not a reasonable expectation of full repayment, due to the borrowers' poor credit histories and high default rates. In addition, there was no market for the notes, and they had no ascertainable value.

  • Joyner Family Limited Partnership, T.C. Memo. 2019-159

By Maria M. Pirrone, CPA, LL.M., associate professor of taxation, St. John's University, Queens, N.Y.

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