The CPA Journal

Contingent Sales under the New Installment Sale Regime

By Sujin Chung and Anthony P. Viola, CPA, Marks Paneth Shron, LLP

Businesses often enter sales transactions in which the sales price is not determined at the time of sale. In some cases, the sales price is contingent on a future event. For example, a seller may contract for a percentage of the purchaser’s net profits for five years. Temporary Treasury Regulations section 15A.453-1(c) defines a sale in which the aggregate selling price cannot be determined by the close of the taxable year as a contingent payment sale. Subsection (1) specifies the use of the installment method of accounting unless the seller elects not to have the installment method apply to the sale. However, for accrual taxpayers with contingent payment sales, the December 17, 1999 repeal of the installment method involves immediate, unfavorable tax consequences.

Repeal of Installment Sales for Accrual Taxpayers

Before December 17, 1999, accrual basis sellers using the installment method could pay the capital gains tax on their sale profits as they received the money from the buyer. However, IRC Section 453(a)(2) was added by the Tax Relief Extension Act of 1999 (Title V, section 536 of the Ticket to Work and Work Incentives Improvement Act of 1999) and provides that accrual basis taxpayers can no longer use the installment method.

If the taxpayer elects to pay interest under section 453(l), IRC section 453(a)(2) does not change the law regarding the use of the installment method of accounting for property used or produced in the business or trade of farming and for timeshares and residential lots. However, a private letter ruling [PLR 106-170, 113 Stat. 1860 (1999)] provides that the installment method of accounting does not apply to taxpayers on an accrual basis of accounting. IRC section 453(a)(2) is effective for sales occurring after December 17, 1999.

IRS Notice 2000-26 (IRB 2000-17, April 10, 2000) provides guidance on the application of section 453(a)(2). Scenarios for sales of corporations and partnerships enumerate the effects of section 453(a)(2). Notice 2000-26 also discusses the treatment of a sale that cannot be reported using the installment method.

Generally, an accrual basis taxpayer must recognize the entire amount of the gain from the installment sale in the year of the sale. Question 11 points out that, if an installment sale provides for one or more contingent payments, the taxpayer generally cannot take advantage of the “open transaction” method in Burnet v. Logan [283 U.S. 404(1931)], which allows gain deferral until all events become fixed. The taxpayer recovered her basis in the property first, then recognized the gain. Notice 2000-26 states that this method applies “only in those rare and extraordinary cases in which the fair market value of the obligation cannot reasonably be ascertained [See Treasury Regulations section1.1001-1(a) or section1.1001-1(g)].”

Example

X Corporation has two Internet-based business segments. Segment A is an established business and sells tangible personal property online. Segment B, a relatively new business, provides an exchange site for customers and suppliers that wish to conduct business over the Internet.

X is an accrual basis taxpayer. X sells segment A to Y Corporation for $500,000 in year 1. However, the sales agreement stipulates that if Y can generate $3 million in gross sales for B by the end of year 2, Y will not have to pay X the $500,000 for A. Because of the conditions of the sale, no payment is to be made by Y until year 2.

Analysis

Generally, when reporting income on the accrual basis the right to receive income determines when an amount is included in gross income, not the timing of the cash receipt (Enright, SCt, 41-1 USTC para. 9356; Spring City Foundry Co., 4 USTC para. 1276). Income is includible when all events that fix the taxpayer’s right to receive the income have occurred and the amount can be determined with reasonable accuracy [Regulations sections 1.446-1(c)(1)(ii) and 1.451-1(a)].

An accrual method taxpayer’s right to receive income becomes fixed when the taxpayer’s right to receive the item is unconditional and free from contingencies even when the actual receipt of the income is contingent (Flamingo Resort, Inc., CA-9, 82-1 USTC para. 9136). The likelihood that the amount will be received does not have to be absolute. The accrual of an item may not be postponed merely because of a possibility that the income will have to be returned or will be subject to diminution or offset in the future (A.M. Brown, SCt, 4 USTC para. 1223).

A reasonably accurate estimate may be based on a contractual statement or other information available by the end of the year (Resale Mobile Homes, Inc., CA-10, 92-1 USTC para. 50,282). In cases where the accrual of an income item has been properly based on a reasonable estimate and the exact amount determined in a later year, the difference is taken into account in the later year [Regulations sections 1.446-1(c)(1)(ii) and 1.451-1(a)].

Tax Treatment and Reasoning

In the preceding example, because Y receives possession of A in year 1 but the exact combination of cash and other valuable considerations cannot be determined by the close of the taxable year (year 1), the transaction is a contingent payment sale. The maximum potential cash payment is $500,000, but the minimum cash payment is zero. Despite the contingency, the fair market value of A remains $500,000 because, presumably, the value of driving $3 million of business to B is $500,000. The actual exchange of $500,000 cash for $3 million in business traffic is separated from the sale transaction for purposes of determining the year of inclusion.

Thus, under the new installment sale rules for accrual basis taxpayers, X will recognize the entire amount of the gain or loss from the installment sale in year 1. Assuming the basis in the assets of A is $100,000, X would recognize a $400,000 gain on the sale in year 1. If, at the end of year 2, Y cannot satisfy the $3 million in sales to meet the B requirement, Y must pay $500,000 to X for A. X will not recognize any gain in year 2 because the sale was recognized in year 1.

On the other hand, if Y generates $3 million in sales for B, it does not have to pay X $500,000 for A. In this event, X will record a loss representing the $500,000 of proceeds recognized but never received on X’s books in year 1. As case law dictates, the character of the initial transaction determines the character of later related transactions (J.M. Smith, 48 TC 872, aff’d on this issue and rev’d in part 70-1 USTC para. 9327, 424 F2d 219, 9th). Thus, to the extent that the original accrual in year 1 resulted in capital gain, the subsequent adjustment in year 2 is a capital loss, a particularly onerous result due to the limitations (for corporations and individuals) on deducting capital losses.

Implications

The new installment sale reporting prohibition for accrual basis taxpayers effectively lowers the value of a closely held business because sellers must now pay the tax on the gain immediately. In response to protest, Congress is making efforts to reinstate the installment sale tax treatment for small businesses. Until the prohibition is repealed, however, small businesses and their advisors must plan sales in order to pay the immediate tax liability that could result. Editor: Edwin B. Morris, CPA Rosenberg, Neuwirth & Kuchner

Editor:
Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

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