The Taxation of Earnouts in Taxable Acquisitions, 0513 ALBJ, 74 The Alabama Lawyer 172 (2013)

• Author: Jackson M. Payne

The Taxation of Earnouts in Taxable Acquisitions

Vol. 74 No. 3 Pg. 172

Alabama Bar Lawyer

May 2013

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0 Jackson M. Payne

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0A buyer and seller frequently differ over the value of a business whose assets are to be sold or whose stock is to be sold and therefore the selling price to be paid for those assets or that stock. To close the gap between what the buyer is willing to pay and what the seller is willing to accept, and to consummate the sales transaction, the parties often agree that a portion of the selling price will be calculated and paid as contingent selling price payments or earnouts (the contingent payments).

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0For example, the parties may agree to base the earnout portion of the selling price upon the buyer’s EBITDA from the acquired business (meaning its earnings from operations before interest, taxes, depreciation and amortization, calculated as if the acquired business were being operated as a separate and independent business during an agreed period). Of course, other financial hurdles could be used to calculate the earnout payment such as basing the calculation and payment of the earnout on the net income or annual revenues of the acquired business in excess of agreed target amounts. And, earnouts are frequently capped in amount and payment period.

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0The Installment Method

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0If a disposition of property (including a sale of a business with a contingent selling price) qualifies as an installment sale, the installment method^[1] permits a seller to defer recognition of gain on the disposition. Thus, under the installment method, gain on an installment sale is spread over the period during which the installment payments are received, rather than being taxed in the year of sale.

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0An installment sale is defined as a disposition of property in which one or more payments are to be received after the close of the taxable year in which the disposition occurs.^[2] However, there are a number of statutory restrictions that limit the use of the installment method.^[3] And, there are other rules that reduce or eliminate the benefit of the tax deferral in certain transactions. These include an interest charge imposed if the face amount of certain installment notes arising during and outstanding at the end of a taxable year exceed $5.0 million.^[4]

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0The installment method permits gain from eligible installment sales to be reported as the seller receives installment payments.^[5] Each payment received is treated in part as (i) a nontaxable recovery of a portion of the seller’s adjusted basis in the property; (ii) a taxable realization of a portion of the seller’s gain; and (iii) interest. Thus, the seller is taxed only on the parts of the payment that represent gain on the sale and interest income. The amount of each payment that must be reported as gain is determined by multiplying the total amount of payments received during the year by the gross profit percentage.^[6] The gross profit percentage is equal to the ratio of the seller’s gross profit^[7] to the total contract price.^[8]

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Example (1): A sells Blackacre in which A has an adjusted basis of $50, 000. Blackacre is subject to $25, 000 of qualified indebtedness. The purchaser agrees to a selling price of $325, 000, payable as follows:

Cash Down Payment

$100, 000

Installment Note (payable in 10 equal annual installments)

200, 000

Assumption of qualified indebtedness

25, 000

Total selling price

$325, 000

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Reporting of contingent sales under the installment method depends on whether there is a stated maximum selling price, a fixed period for contingent payment or neither.

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0The seller’s gross profit is $275, 000 ($325, 000 – $50, 000); the total contract price is $300, 000 ($325, 000 – $25, 000); and the gross profit percentage is 92 percent ($275, 000/$300, 000). Therefore, 92 percent of each installment shall be reportable as gain attributable to the sale and 8 percent thereof is nontaxable recovery of basis.

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0A seller must report interest included in each installment payment separately as ordinary income.^[9] If the installment sale obligation does not contemplate an interest payment or the amount of interest is inadequate, the seller may be required to treat a portion of each installment payment as imputed interest.^[10]

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0The installment method can only be used to report gains. If an installment sale results in a loss, the installment method cannot be used. If the loss is a deductible loss, it is deductible only in the year in which the sale occurs.^[11]

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Contingent Payment Transactions

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Reg. Section 15a.453-1(c) governs the application of the installment method to contingent payment sales, such as earnouts. Reporting of contingent sales under the installment method depends on whether there is a stated maximum selling price, a fixed period for contingent payment or neither.

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0If the contingent payment is subject to a cap, then, for purposes of allocating basis among payments, the total capped selling price is assumed to be the selling price.^[12] That is, it is assumed that all contingencies will be resolved to maximize the selling price and accelerate payments to their earliest possible date. Because this method defers basis recovery and accelerates gain, it may not be in a seller’s interest, from a tax viewpoint, to negotiate a cap much above the amount of payments it is likely to receive. If later events reduce the maximum price, it can be recomputed.^[13] If this recomputation results in a loss, the seller reports the loss on the sale at the time the loss becomes final.^[14]

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0Example (2): A sells all of the stock of X corporation to B for $100, 000 payable at closing plus an amount equal to 5 percent of the net profits of X for each of the next nine years, the contingent payments to be made annually together with adequate stated interest. The agreement provides that the maximum amount A may receive, inclusive of the $100, 000 down payment but exclusive of interest, shall be $2, 000, 000. A’s basis in the stock of X, inclusive of selling expenses, is $200, 000. Selling price and contract price are considered to be $2, 000, 000. Gross profit is $1, 800, 000, and the gross profit ratio is 90 percent ($1, 800, 000/$2, 000, 000). Accordingly, of the $100, 000 received by A in the year of sale, $90, 000 is reportable as gain attributable to the sale and $10, 000 is nontaxable recovery of basis.^[15]

\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0\xA0If no maximum selling price can be determined, but the contingent payment is limited to a specific time period...