Deferred payment sales are typically subject to the installment method unless the taxpayer affirmatively elects out. There are three traps that one can fall into with the installment method.
1. With certain types of sellers like S corporations, a tax free distribution can be made to the extent of basis in the pre-transaction planning stage. This allows cash to come out of the company which increases the profit percentage when the company is sold in the future. Hence, the lawyer should always think about taking pre-transaction distributions to the extent of basis before entering into this type of transaction.
2. If the taxpayer holds installment obligations at the end of a tax year of more than five million dollars, he must pay an interest charge on a portion of the tax liability that is deferred for the year. This rule applies for each selling shareholder, so a selling shareholder is sometimes advised to gift shares to a spouse to reduce the amount of installment obligations each would own. Often, a taxpayer might elect out of installment treatment and recognize as income the value of the installment obligation rather than taking the interest charge. This approach however requires recognition of income on amounts that might not be collected, in which case the taxpayer may end up with a (non-deductible) capital loss on the back end.
3. The third trap when dealing with the installment method has to do with basis allocation. As noted above, the first step is to determine the gross profit percentage and the portion of each payment that is taxable and the portion that is basis recovery. In the case of an earn-out or contingent payment, however, it is uncertain whether the client will collect on those amounts so the determination of a gross profit percentage relies on certain assumptions. First, the regulations require a taxpayer to assume that the maximum amount possible will be paid (i.e. all of the earn-out targets will be achieved) in determining the gross profit percentage. If there is no maximum amount, the regulations assume there is a basis recovery over the maximum term of the earn-out. If there is neither a maximum amount nor maximum term, the regulations assume that the basis will be recovered ratably over 15 years, and the payments in excess of ratable basis recovery are taxed as income.
Intuitively, it would seem that the taxpayer should recover his basis first and then pick up income when and to the extent that the payments exceed basis. This is referred to as “open transaction treatment” and applies only in rare and extraordinary circumstances. If circumstances justify open transaction treatment, the parties might have a partnership for tax purposes instead of a sale. If it is a partnership, a different tax regime applies.
The seller should also keep in mind that there is always an interest element when there is a deferred payment. In other words, part of the payments will be taxed as ordinary income. Fortunately, the applicable federal rate is currently very low.
For more information on mergers and acsuisitions, and the tax aspects of purchases and sales of businesses, see RoyseLaw Mergers and Acquisitions, RoyseLaw Tax, Recent M&A Transactions, and blog posts at Royse University M&A, and Royse University Tax. Additional materials on mergers and acquisitions can be found at our blog posts at Franchise Tax Board Audits Sale of S Corp in 338(h)(10) Transaction, Corporate Reporting of Transactions Affecting Basis, M&A Trends and Qualified Small Business Stock. See M&A slides at SlideShare.