Tax implications of transactions involving contingent consideration.

• Author: Stock, Toby

When buying or selling an asset with significant uncertainty about its current value, there are often sound theoretical and practical business reasons for incorporating this uncertainty into the asset's selling price. This incorporation of uncertainty often takes the form of price adjustments after the sale date based on some future economic event or events. A study of over 900 taxable corporate acquisitions found that taxpayers structured about 20% of taxable acquisitions to include contingent payments. (1) In addition, the study's empirical evidence indicates that sellers with higher marginal tax rates are more likely to desire contingent payments in the contract. These price contingencies raise tax issues that practitioners must address when planning and reporting such transactions.

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Contingent consideration is not consideration with an uncertain future value. Instead, a transaction includes contingent consideration when the quantity of the consideration transferred depends on an uncertain condition, situation, or set of circumstances that future events will ultimately resolve. Taxpayers can use contingent consideration as payment in a sale transaction or as compensation for services performed.

Not all uncertainties inherent in the accounting process give rise to contingencies. For instance, estimates required in allocating the cost of a depreciable asset over its useful life or estimates used in determining the accrued liabilities are not contingencies because there is nothing uncertain about the fact that those assets or liabilities have been incurred. An example of contingent consideration as payment in a property transaction is an earn-out component of selling price in a corporate acquisition where the selling price equals $100,000 plus one-quarter of the target firm's operating cashflow for the next two years. An example of contingent consideration as payment for services performed is the compensation of an executive with shares of restricted stock. Typically, the restriction is that the stock vests with the employee over time, provided that the employee remains employed by the employer. In both of these examples, the amount or transfer of the contingent consideration depends on future events (i.e., the target firm's future performance and the continued employment of the executive).

The first part of this article discusses the tax and financial reporting consequences of contingent consideration used as payment in property transactions, particularly corporate acquisitions. The second part examines the tax and financial reporting consequences of incorporating contingent payments as compensation for services performed by employees.

Contingent Consideration in Property Transactions

Including contingent payments in a property or service purchase agreement can benefit buyers and sellers from both tax and nontax perspectives. Contingent payments may allow for a better risk-sharing arrangement between buyer and seller. For example, if an acquiring firm is unwilling to purchase a target firm because of uncertainties about the target firm's value, the seller can provide a future earnings-based payout after the sale date based on the future performance of the target firm. This contingent payment effectively transfers some risk from the buyer to the seller of the target firm.

Another advantage of including a contingent element in the sales price involves the tax consequences of the sale. As discussed later in this section, price contingencies can sometimes allow the seller to defer some or all of the gain and resulting tax on a sales transaction.

Despite these advantages, not all sales transactions include contingent payments because they also impose nontax costs on buyers and sellers. Buyers must wait until the contingency lapses to determine the actual payment amount. There are also contracting and monitoring costs associated with the resolution of the contingent portion of the sales price. For example, an earnings-based contingent payout in a corporate acquisition can result in additional audit and accounting costs to verify the target firm's earnings number.

Statement of Financial Accounting Standards (FAS) No. 141R, Business Combinations, addresses the financial accounting and reporting for contingent consideration in a corporate acquisition. GAAP defines contingent consideration as "an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met." (2) In general, the acquirer will recognize the acquisition date fair value of contingent consideration as part of the consideration transferred in exchange for the acquiree. (3) International Financial Reporting Standards (IFRS) also require that contingent consideration be measured at fair value at the time of the business combination. (4) This recognition principle is equivalent to the "closed transaction" approach discussed later in this section.

GAAP and IFRS are also consistent in the subsequent accounting for a contingent consideration. Changes to contingent consideration resulting from events after the acquisition date are to be recognized in profit or loss. If the amount of contingent consideration changes as a result of a postacquisition event (such as meeting an earnings target), accounting for the change in consideration depends on whether the additional consideration is an equity instrument, cash, or other assets paid or owed. If it is equity, the original amount is not remeasured and the subsequent settlement is accounted for within equity. If the additional consideration is cash or other assets paid or owed, the changed amount is recognized in profit or loss. If the amount of consideration changes because of new information about the fair value of the amount of consideration at acquisition date (rather than because of a postacquisition event), retrospective restatement is required. (5)

The tax issues relating to contingent consideration in a property transaction include (1) whether contingent consideration triggers a taxable transaction on the sale date and (2) when gains are recognized if there are contingent payments. Current tax law uses three general approaches to tax these...