Installment sales with contingent sales price.

When selling a company, there are many factors to consider. By far, the most important aspect of the deal to the seller (especially for deals involving small, closely held or family businesses) is the cash to be received and the timing. Most transactions involve cash payments over time and are treated as Sec. 453 installment sales. Many times, a substantial majority of the cash proceeds are determined by an "earn-out" or contingent purchase price. While this structure makes sense from an economic perspective, it creates many tax issues for both the buyer and the seller. The timing and character of income and deductions, as well as gain recognition under the installment method, can be substantially different from that of actual cashflow, if all options are not carefully considered. For example, selling price, contract period and interest provisions can create unforeseen results.

When considering how to structure a deal, the tax adviser should review all of the possibilities put forth by the buyer and seller to ensure that both parties will achieve the desired results. For example, without proper planning, a seller could experience disastrous consequences, resulting in a capital loss that cannot be carried back and may not be usable.

Example 1:A, who owns 100% of X Corp., would like to sell his company for $15 million. B would like to buy X's assets, but does not want to fix the price at $15 million. To allow both sides to share in X's risks and rewards over the earn-out period, A and B agree to include a $7.5 million payment in year 1, an unspecified amount in year 3 and a final payment in year 5. The year 3 payment will be contingent on the growth in years 1 and 2; the year 5 payment will depend on the growth in years 3 and 4. A has a $12 million basis in his assets, which consist entirely of unamortized goodwill.

A and B agree that the sum of the contingent payments to be received by A in years 3 and 5 will equal a minimum of $3.5 million, and a maximum of $13.5 million, setting the total sales price at $10-$20 million. By doing this, A and B have set a maximum stated selling price. The payments years 3 and 5 are $3 million and $5 million, respectively. The installment sale is calculated as shown in Exhibit 1 at right. The gain is front-loaded into the first year; thus, A will have a $700,000 capital loss in year 5 that at he cannot carry back.

Example 2: The facts are the same as in Example 1, except A and B agree that the total contingent payments will be solely reflected by X's performance, without a minimum or a maximum. Because there is no stated maximum, a different method must be used to calculate the installment sale gain or loss. There is, however, a fixed period of time; A must recognize installment gain or loss by ratably using his basis over the period. Using the same payments as in Example 1 ($3 million in year 3 and $5 million in year 5), the effect on A's cashflow is shown in Exhibit 2 at right. This results in an after-tax cash difference of $105,000, primarily due to the fact that A can now fully use his capital loss from year 3 in year 5.

If there is neither a stated maximum selling price nor a fixed period, basis must be recovered in equal annual increments over a 15-year period (Regs. Sec. 15A.453-1 (c)(4)). Any basis not recovered in any year must be allocated ratably in future years. The income forecast method is available if the payments are to be based on receipts or units of production. If any of the aforementioned methods would result in a substantial distortion of basis recovery, an IRS ruling can be request ed to use a reasonable alternative. Regs. Sec. 15A.453-1(c) provides guidance on how to handle transactions with contingent payments. (Examples 1 and 2 assume that a sufficient rate of interest is stated, thereby removing the need for additional calculations; see below for a discussion of interest.)

Balancing Buyers' and Sellers' Needs

From the seller's perspective, use of basis and gain timing are the more important issues. However, on the buyer's side, sale price and principal payments are the salient points. Because all of the assets purchased in the transaction in Examples 1 and 2 are allocated to goodwill, there is a 15-year recovery period. Under Sec. 197, only contingent payments deemed to be principal are allocated to the basis of the asset purchased. Using the payment amounts in Examples l and 2, the timing of the basis pick-up and deductions is shown in Exhibit 3 below. The treatment to the buyer would be the stone regardless of the method the seller uses to pick up the income.

A way to simplify the structure of any deal involving contingent payments is by having stated interest ill addition to any amount otherwise payable under an agreement. When stating the interest, there is a minimum rate that must be used, which is based on the applicable Federal rate (AFR), depending on the facts. (A detailed discussion on determining and calculating interest is outside this item's scope. Tax advisers should consult Secs. 483 and 1274 for specific guidance.)

Accounting for interest separately in the agreement avoids additional calculations needed to bifurcate the selling price into principal and interest. Changing the selling price also changes the income's timing and character, giving both the buyer and seller different results than those anticipated. Once the minimum rate has been determined, it can be used as another tool in the negotiation process. A minimum rate tied to AFRs could be as low as 3%-5% currently; using a higher fixed rate of 8%-10% could allow for an array of options in structuring a deal and could be used to alter the income's timing and character, to tailor the transaction more closely to the buyer's and seller's needs.

Other potential issues not addressed in detail in this item include depreciation recapture, purchase price allocation and interest on deferred payments for installment amounts in excess of $5 million. These factors create other circumstances that could significantly affect both the timing and character of income recognition.

Conclusion

When advising a client on how to structure contingent payments, a tax adviser must be aware of the pitfalls that can change the deal's economics. As shown above, the timing and character of both income and deductions could effect both the seller's and buyer's cashflow. Shifts in the timing and ability to recover basis on both sides of the transaction should be carefully reviewed to ensure that both the buyer and seller receive the economic deal they negotiated.

Exhibit 1: Installment gain/loss calculation with gain front-loaded

                    Maximum       Year 1       Year 3

Selling price   $20,000,000   $7,500,000   $3,000,000
Basis            12,000,000    4,500,000    1,800,000
Gain/(loss)       8,000,000    3,000,000    1,200,000
Tax rate                             15%          15%
Tax payment                    (450,000)    (180,000)
Tax benefit
Net cash                      $7,050,000   $2,820,000

                    Year 5         Total

Selling price   $5,000,000   $15,500,000
Basis            5,700,000    12,000,000
Gain/(loss)      (700,000)     3,500,000
Tax rate               15%
Tax payment                    (630,000)
Tax benefit        105,000
Net cash        $5,105,000   $14,870,000

Exhibit 2: Effect of no minimum/maximum contingent payments on use of
capital loss

                Fixed period       Year 1        Year 3

Selling price        Unknown   $7,500,000    $3,000,000
Basis             12,000,000    4,000,000     4,000,000
Gain/(loss)                     3,500,000   (1,000,000)
Tax rate                              15%           15%
Tax payment                     (525,000)
Tax benefit                                     150,000
Net cash                       $6,975,000    $3,150,000

                    Year 5         Total

Selling price   $5,000,000   $15,500,000
Basis            4,000,000    12,000,000
Gain/(loss)      1,000,000     3,500,000
Tax rate               15%
Tax payment      (150,000)     (675,000)
Tax benefit                      150,000
Net cash        $4,850,000   $14,975,000

Exhibit 3: Effect of different payment amounts on the timing of the
basis pick-up and deductions

            Years 1-2      Years 3-4      Years 5-15          Total

Selling     $7,500,000     $3,000,000     $5,000,000     $15,500,000
price               15 *           13 *           11 *
               500,000        500,000        500,000
                              230,769        230,769
                                             454,545

Annual         500,000        730,769      1,185,315       15,500,00
deduction          35%            35%            35%             35%

Net cash      $175,000       $255,769       $414,860      $5,425,000
deduction

* Represents amortization period for the payments made. $7 million is
amortized over 15 years, because that was the payment made in year l.
$3 million is amortized over 13 years, because that was the payment
made in year 3 (intangible amortization period of 15 years, minus two
years that have elapsed since the original acquisition). $5 million is
amortized over 11 years, because that was the payment made in year 5.

FROM JOSH MESSINA, CPA, MT, COHEN & COMPANY, LTD., MENTOR, OH