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

• Author: Beck, Allen M.

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...