Installment sales with contingent sales price.

AuthorMessina, Josh

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...

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