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Sales price adjustments and the claim-of-right doctrine.

Business asset sales are complex transactions, commonly completed over more than one tax year and requiring payments over several years. Taxpayers report income as they receive money or other property. However, when they are confronted with sales price adjustments, many things can and do happen. This item focuses on the claim-of-right doctrine and adjustment(s) that result from claim(s) about the representations and warranties made as part of the sale of a business.

Sellers normally must indicate that they are in compliance with all contract terms or that all sales and use taxes owed are paid or recorded. Because of the seller's ability to know that 100% of all the contract terms for every contract are being met (including verbal modifications), it is understandable that some claims for sales price adjustment may arise. The same may apply to other issues (nexus for state tax purposes, product warranties, etc.).

When sellers face a proposed adjustment to an unpaid sales price or a demand of repayment in a subsequent year, the tax treatment may be cloudy. The first issue is how to handle the adjustment. The adjustment should be applied to the overall sales price and not to the installment note's or other obligation's unpaid balance. Of course, the "adjusted sales price" must be reallocated among the various asset classes (such as accounts receivable, inventories, intangibles, fixed assets, etc.). Because of the adjusted sales price, overall gain/loss will change accordingly, affecting the prior year's gain/loss, as well as any unrealized gain/loss.

The second issue is an adjustment's timing. Because the event giving rise to the adjustment was not a correction of an error, but part of a separate transaction, the adjustment should be reported in the year it occurs, and not as an amendment to a prior-year's return. If the adjustment to the, sale is made in the sale year, it might be netted against the original sale as reported. If the adjustment occurs in a subsequent year, it should be reported in that year. Thus, an adjustment arising in a subsequent year does not require an amended return. The seller might find that the reduced sales price will produce a smaller gain (or even a loss). If the sale is reported as an installment sale, the current-year amount realized might be less than the remaining basis; and the gross profit percentage must be changed, perhaps producing an installment-sale loss. The character of a sale may create a capital loss, which either may be limited, carried over for many years or lost entirely.

Sec. 1341 represents Congress' response to the inequitable consequences that sometimes result from the long-standing principle that taxable income and tax liability must be determined each year at the close of the tax year, regardless of subsequent events. Thus, a taxpayer who receives income and believes that he or she has a right to the money or property (i.e., a claim of right) is required to report and pay tax on the income, even if he or she may be required to return the income in a later year (North American Oil Consol. Co., 286 US 417 (1932)). Moreover, a taxpayer who repays the income in a subsequent year is not entitled to a refund for the year in which he or she received the payment initially (Lewis, 340 US 590 (1951)).

The apparent conflict of these principles has resulted in hardships and inequities for taxpayers required to pay taxes on income in one year, only to return it in a subsequent period, with no effective mechanism to recover the taxes originally paid.

Sec. 1341(a) requires:

1. An item was included in the taxpayer's gross income for a prior tax year because it appeared that the taxpayer had an "unrestricted right" to the income;

2. In the absence of Sec. 1341, the taxpayer would be entitled to a deduction for the current tax year because it was established after the close of the prior tax year that the taxpayer did not have an unrestricted right to the item; and

3. The amount of such deduction exceeds $3,000.

The key to a claim is whether it "appeared to the taxpayer that he had an unrestricted right to the income." To satisfy this requirement, a taxpayer must have had "an unrestricted right" to the income in the "year received as distinguished from an unchallengeable right (which is more than an `apparent' right) and from absolutely no right at all (which is less than an `apparent' right)"; see Rev. Rul. 68-153. Under Regs. Sec. 1.1341-1(a)(2), the appearance of an unrestricted right must be based on "all the facts available in the year" the taxpayer included the amount at issue in income. A taxpayer's facts are critical to protecting an overall tax adjustment.

In Rev. Rul. 78-25, a corporation sold its assets to a third party and then liquidated, distributing the sale proceeds to its shareholder. The shareholder paid tax on the capital gain in the distribution year. Under the purchase agreement's terms, the selling corporation placed cash in escrow to indemnify the buyer against liabilities, damages and costs incurred as a result of the failure of the seller or the seller's shareholder to fulfill the agreement's conditions. A judgment was rendered against a former subsidiary of the seller in the year following the liquidation and sale, on a transaction that occurred prior to the sale. As a result, the shareholder paid damages to the buyer. The IRS ruled that Sec. 1341 applied to the shareholder's situation.

A more recent case, Dominion Resources, Inc., 219 F2d 359 (4th Cir. 2000), also shows the application of Sec. 1341. In determining whether it "appears" that a taxpayer had an "unrestricted right" to income in a prior year, the Fourth Circuit focused on the relationship between the income and the subsequent deduction events. In Dominion Resources, the court set forth a "substantive nexus" standard (i.e., as long as there is "substantive nexus" between the right to the income and the circumstances requiring the settlement payment, Sec. 1341(a)'s first requirement will be met). In the case, the substantive nexus between the sales proceeds and the settlement payment is obvious, as both the income reported and the repayment that occurred in a later year arose out of rights and obligations contained in a purchase agreement.

Cases that deny taxpayers the right to use Sec. 1341 are readily distinguished, because of the clear determination of fraudulent activity on the seller's part. In these cases, taxpayers failed outright to have the appearance of an unrestricted right to the income. Several cases that involve Sec. 1341 in the context of a taxpayer's criminal activities (e.g., Culley, 222 F3d 1331 (Fed. Cir. 2000) and Parks, 945 F.Supp. 865 (WD PA 1996)) show that inappropriate actions cause the loss of adjustment or repayment of tax benefits.

Conclusion

How should taxpayers plan? First, they should try to avoid absolute representations and warranties, because these allow a buyer the right to adjust (or even rescind) a purchase price. Instead, taxpayers should consider setting a minimum level of adjustment (e.g., identification of a $50,000 unknown liability before an actual offset or adjustment of the purchase price can occur).

Second, the need for proper due diligence on a seller's part is as important as a buyer's. A taxpayer must show no pattern of deceit, attempt to conceal relevant information, criminal investigation or accusation, nor any pattern indicating that he or she knowingly obtained funds as a result of fraudulent activities. Accurately knowing a business will allow a seller not to be burdened or agree unknowingly to broad representations and warranties. While a seller may believe that a buyer has the burden of knowing what he or she is buying (i.e., a "buyer beware" attitude), the seller is constrained by the representations and warranties that he or she makes. The all-encompassing nature of representations and warranties might allow a buyer to raise claims against a seller even if the buyer had purchased substantial due diligence services. Put simply, if a seller misrepresents the items being sold, a buyer, who may have made a poor business decision, would have an opportunity to recoup some, or even all, of the purchase price.

FROM H. MARTIN FETSCH, CPA, MBA, ELLIN & TUCKER, CHARTERED, BALTIMORE, MD
COPYRIGHT 2002 American Institute of CPA's
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Article Details
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Author:Beck, Allen M.
Publication:The Tax Adviser
Date:Oct 1, 2002
Words:1391
Previous Article:Employee-owner compensation in C and S corporations.
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