Using the installment method with escrow arrangements.

• Author: Andreozzi, William G.

EXECUTIVE SUMMARY

* Tax practitioners may incorrectly assume that if sales proceeds are to be received in tax years after the year of sale, the sale is reported on the installment method and not currently taxed.

* Generally, use of the installment method is mandatory if the seller realizes a gain and the transaction meets the Sec. 453 requirements.

* "Payment" may include not only amounts actually received, but amounts constructively received as well.

Putting proceeds from a sales transaction into escrow does not guarantee that a cash-basis taxpayer can use installment reporting. The presence of restrictions or limits may require use of the installment method, or the constructive receipt or economic benefit doctrine may apply to preclude installment reporting. This article examines the obstacles to be cleared for a cash-basis taxpayer to be eligible to elect installment sale reporting.

As a result of both years of economic growth and a trend in many industries toward consolidation, owners of closely held businesses are receiving (and accepting) rewarding offers to sell their businesses in record numbers. Many of these transactions are structured as taxable stock or asset purchases. More often than not, the stock or asset sale agreement provides for some portion of the sales proceeds to be placed in escrow, or otherwise held back from the sales proceeds due the seller at closing. Typically, some or all of these proceeds be released to the seller in a future tax year after satisfaction of certain conditions, or when the buyer is assured that he has received the benefit of his bargain.

Tax practitioners may readily assume that if sales proceeds are to be received in tax years after the year of sale, the sale is reported on the installment method, and not currently taxed. However, this conclusion has to be based on the facts and circumstances of the individual case, and cannot automatically be assumed whenever a sales agreement provides for an escrow or holdback of sales proceeds.

This article examines the tax rules involved in determining whether sales proceeds deferred under the terms of a sales agreement are subject to installment sale treatment or must be included in income currently. The focus is on taxable sales; the article does not address the installment method as it relates to qualified escrow accounts or qualified intermediaries in the deferred like-kind exchange context.(1) Additionally, because of the recent repeal of the installment method for accrual-basis taxpayers,(2) this article focuses solely on the installment method rules applicable to cash-basis taxpayers.

What Is an Escrow?

An escrow usually takes the form of a written agreement between a buyer, seller and an escrow agent. Typically, the escrow agent will establish an account in which the buyer deposits a portion of the purchase price. The escrow agreement may place restrictions or limits on the seller's right to receive the escrowed sales proceeds. For example, the seller may forfeit some or all of the escrowed funds in the event he has misrepresented to the buyer the company's true financial position or quality of assets. Further, the seller may forfeit the escrowed funds if the company is subject to claims that were unforeseen when the deal was negotiated.

In other circumstances, an escrow agreement may...