What happens, however, when a sale contract provides for the possibility of payments outside of the year of the sale? Buyers and sellers are increasingly incorporating such terms in sale contracts, as these provisions offer a level of risk mitigation for the buyer by deferring payments and tying them to conditional outcomes, while also providing potential upsides to sellers if the sale proves lucrative for the buyer.
For example, a contract may provide for a partial cash payment from the buyer to the seller in the year of the sale, but also provide that the buyer shall pay the seller a future percentage of earnings derived from the asset for a set number of years. Alternatively, a buyer and seller may agree to a payment structure whereby proceeds will become payable upon the realizations of certain milestones related to the purchased asset. How do taxpayers account for and report the sale of a capital asset when the amount ultimately payable is unknown in the year of the transaction?
This article will discuss the three methods—installment, closed transaction, and open transaction—available to taxpayers for reporting sales that involve contingent consideration potentially payable outside the year of the sale. Each of the methods described below has its own benefits and pitfalls that taxpayers and tax professionals should examine before electing a particular approach.
The Installment Method
The installment method is the default method for reporting sales involving future-year contingent consideration (IRC section 453), subject to certain exceptions—namely, sales of publicly traded stock cannot be reported using the installment method, and instead must be reported using the closed transaction method per IRC section 453(k). A taxpayer who is eligible to report transactions using the installment method is required to account under this method unless he elects out of the method on his tax return for the year in which the transaction occurs [IRC section 453(d)].
While the installment method is most often thought of as applying to sales that involve set payments over a period of several years, it also applies to asset sales where there is a possibility (not just a guarantee) of payment outside of the tax year of the transaction.
The regulations accompanying IRC section 453 explain how various sale scenarios involving contingent consideration should be accounted for under the installment method. For example, if a “maximum selling price” can be determined (i.e., there is a set dollar limit on potential future-year payments), the taxpayer should report the sale proceeds earned in the year of the transaction, but the taxpayer’s basis in the asset should be apportioned so that it is recovered over time on the assumption that all contingencies will be realized [Treasury Regulations section 15a.453-1(c)(2)]. A separate set of rules governs contingent sales where the maximum selling price is unknown, but where there is a set date by which all payments will be made [Treasury Regulations section 15a.453-1(c)(2)]. Sales where both the maximum selling price and the timeline for payment are indeterminable are subject to yet another set of rules [Treasury Regulations section 15a.453-1(c)(4)]. The common principle that drives the rules governing these transactions is that the taxpayer should only be required to account for cash proceeds in the year that they are realized, while recovery of basis in the sold property should be spread out over time to account for the potential for additional consideration.
Under the installment method, unless the sale contract provides for the payment of interest, a portion of the payments earned in future tax years (assuming the contingencies are realized) will be treated as imputed interest income [Treasury Regulations section 15a.453-1(c)(2); see also IRC section 483]. To the extent the taxpayer does not realize contingency payments (e.g., because milestones were not met), the taxpayer’s deferred basis will be treated as a capital loss in the year when the right to the contingent payments expire [IRC section 453A(b)(2)(B)]. Unfortunately, in situations where the right to contingent payments is not time- or dollar-limited, a taxpayer may be forever precluded from claiming a capital loss for unrecovered basis.
While the installment method is the most favorable accounting method for many taxpayers, because it allows for the deferral of recognition of proceeds until the year that they are realized, it does have several drawbacks. First, taxpayers whose basis in their property is high, relative to the amount of proceeds to be realized in the year of the transaction, will not be able to fully recover their basis in the year of the transaction. This can be especially problematic where potential future payments are high, but expected realization is low. Under such a scenario, the recovery of a large portion of the taxpayer’s basis will be delayed (possibly indefinitely), even though it is unlikely that the taxpayer will actually receive future proceeds.
While the installment method is the most favorable accounting method for many taxpayers, because it allows for the deferral of recognition of proceeds until the year that they are realized, it does have several drawbacks.
Another major pitfall associated with the installment method is the deferred interest payment described in IRC section 453A, which is applicable to taxpayers whose future payments have a “face amount” exceeding $5 million [IRC section 453A(b)(2)(B)]. Pursuant to that provision, taxpayers are required to pay interest on their “deferred tax liability,” which is defined as “the amount of gain with respect to an obligation which has not been recognized as of the close of such taxable year, multiplied by the maximum rate of tax in effect under section 1 or 11, whichever is appropriate, for such taxable year” [IRC section 453A(c)(3)]. While the statute, codified in 1987, includes a provision instructing the Treasury Secretary to issue regulations “to carry out the provisions of this subsection including regulations providing for the application of this subsection in the case of contingent payments” [IRC section 453(A)(c)(6)], no regulations have been promulgated to date. As a result, significant uncertainty exists as to whether individuals holding rights to contingent payments are liable for the interest payments under IRC section 453A, and if they are, how such interest payments should be calculated. [See, e.g., IRS CCA 201121020 (May 27, 2011): “In the absence of regulations under Section 453A(c)(6), the Service allows taxpayers to use a reasonable method of calculating the deferred tax and interest on the deferred tax liability with respect to contingent payment installment obligations.”]
Finally, the installment method may lead to unfavorable outcomes for taxpayers whose sales qualify for other exclusions and benefits under the tax code. For instance, a taxpayer who sells qualified small business stock that meets the requirements under IRC section 1202, but where the aggregate potential gain under the sales contract exceeds the allowable maximum income exclusion under that provision, will not be permitted to claim the full amount of the exclusion in the year of the transaction, and instead will be required to apportion the exclusion over time if the installment method is elected. (See 2019 Instructions for Schedule D.)
The Closed Transaction Method
For those sellers looking for an alternative accounting method, taxpayers may elect to treat a sale with contingent obligations as a closed transaction, which falls under IRC section 1001. Pursuant to that provision, the gain from the sale or other disposition of property “shall be the excess of the amount realized there-from over the adjusted basis” [IRC section 1001(a)]. The “amount realized” is the “sum of any money received plus the fair market value of the property (other than money) received” [IRC section 1001(b)]. Accordingly, if electing this method, the taxpayer will pay tax on the cash received in the year of the transaction plus the fair market value of the contingent obligations. Taxpayers typically elect this method by reporting the transaction on Form 8949 or Schedule D, but not on Form 6252 [IRS Publication 537, Installment Sales (2019)].
While the term “fair market value” is not defined in the statute, it is widely defined in case law and various Treasury Regulations as the price at which a buyer would be willing to purchase the noncash property in an arm’s-length transaction [See, e.g., Treasury Regulations section 25.2512-1; fair market value for purposes of gift tax is the “price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.”] When a taxpayer elects to use the “closed transaction” method, the “fair market value of [the] contingent payment obligation shall be determined by disregarding any restrictions on transfer imposed by agreement or under local law” [Treasury Regulations section 15a.453-1(d)(2)(iii)]. Moreover, the “fair market value of a contingent payment obligation may be ascertained from, and in no event shall be considered to be less than, the fair market value of the property sold (less the amount of any other consideration received in the sale).”
Accordingly, if a taxpayer elects this method, it is imperative that she adequately determine the fair market value of the contingent obligations at the time of the sale closing. Ideally, this will be done with the assistance and expertise of an appraiser who can value the contingent obligation, or through other independently verifiable means, such as reference to a public market for identical or similar contingent obligations. Importantly, as noted in the Treasury Regulations, if the purchase agreement restricts the seller from transferring the right to contingent payments, this restriction cannot be considered for valuation purposes.
Unlike the installment method, the closed transaction method allows taxpayers to fully recover their basis in the sold property in the year of the transaction. Moreover, unlike the installment method, there is no interest payable to the IRS for “deferred” payments with a “face amount” exceeding $5 million. The downsides to the closed method include the requirement that the taxpayer pay tax on the fair market value of the contingent obligation (assuming the taxpayer realizes a gain from the sale), even though such payments may never materialize. This method is likely favorable for those taxpayers with a high basis in the sold property but where the contingent payments are unlikely to be realized. When contingent obligations are unlikely to be met, the fair market value of such obligations will likely be relatively low in the year of the transaction. The benefit of fully recovering basis under such scenarios will often outweigh the added costs of reporting a gain equal to the fair market value of the contingent obligations.
Unlike the installment method, the closed transaction method allows taxpayers to fully recover their basis in the sold property in the year of the transaction.
The Open Transaction Method
The final method available, which is also often the most favorable for taxpayers, is the “open transaction” method [see Burnet v. Logan, 283 U.S. 404 (1931)]. It is reserved for those “rare and extraordinary cases involving sales for a contingent payment obligation in which the fair market value of the obligation … cannot reasonably be ascertained” [Treasury Regulations section 15a.453-1(d)(2)(iii)].
Under the open transaction method, a taxpayer is taxed on sale proceeds as they are realized, and the basis is immediately recovered rather than deferred. The IRS is aware that taxpayers, if given the option, would likely choose the open transaction method. To discourage taxpayers from electing this method, the IRS has issued a warning in its regulations that any such transaction will be scrutinized, hinting at an almost certain audit [Treasury Regulations section 15a.453-1(d)(2)(iii)]. To survive such an audit (or a subsequent court case), taxpayers would be advised to retain an expert who could competently testify to the fact that the contingent obligations cannot be valued.
It is important that taxpayers and their advisors consider the nature of the transaction involving contingent obligations, the likelihood that the contingent payments will be realized, and the amount of future-year potential payments when choosing the appropriate tax-reporting method. Because the method of accounting for a transaction is usually irrevocable, once a taxpayer makes a method election, that method will likely govern regardless of the eventual outcome of the contingent consideration.