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COLUMNS I Tax Practice & Procedure
Accounting for Sales with
Contingent Obligations
Methods and Considerations
By Stephen A. Josey
ypically, the sale of a capital asset held by an individual licly traded stock cannot be reported using the installment
is a straightforward affair from a tax accounting per- method, and instead must be reported using the closed trans-
Tspective. Under the most common scenario, the buyer action method per IRC section 453(k). A taxpayer who is eli-
will offer a one-time cash payment to the seller in exchange gible to report transactions using the installment method is
for the subject property, and the seller will report the gain or required to account under this method unless he elects out of
loss on the property and, if there is a gain, pay tax on the gain the method on his tax return for the year in which the trans-
subject to the applicable rate [Internal Revenue Code (IRC) action occurs [IRC section 453(d)].
sections 1, 1001]. If there is a loss, the seller can claim that
loss against other capital gains, potentially apply a portion of
the loss to offset ordinary income, and if any loss remains,
carry that loss forward to future-year returns [IRC sections
1211(b), 1212(b)(1)].
What happens, however, when a sale contract provides for
the possibility of payments outside of the year of the sale?
Buyers and sellers are increasingly incorporating such terms
in sale contracts, as these provisions offer a level of risk mit-
igation for the buyer by deferring payments and tying them
to conditional outcomes, while also providing potential upsides
to sellers if the sale proves lucrative for the buyer.
For example, a contract may provide for a partial cash pay-
ment from the buyer to the seller in the year of the sale, but
also provide that the buyer shall pay the seller a future per-
centage of earnings derived from the asset for a set number
of years. Alternatively, a buyer and seller may agree to a pay-
ment structure whereby proceeds will become payable upon
the realizations of certain milestones related to the purchased
asset. How do taxpayers account for and report the sale of a
capital asset when the amount ultimately payable is unknown
in the year of the transaction?
This article will discuss the three methods—installment,
closed transaction, and open transaction—available to taxpayers
for reporting sales that involve contingent consideration poten-
tially payable outside the year of the sale. Each of the methods While the installment method is most often thought of as
described below has its own benefits and pitfalls that taxpayers applying to sales that involve set payments over a period of
and tax professionals should examine before electing a partic- several years, it also applies to asset sales where there is a pos-
ular approach. sibility (not just a guarantee) of payment outside of the tax
year of the transaction.
The Installment Method The regulations accompanying IRC section 453 explain how
The installment method is the default method for reporting various sale scenarios involving contingent consideration should
sales involving future-year contingent consideration (IRC sec- be accounted for under the installment method. For example,
tion 453), subject to certain exceptions—namely, sales of pub- if a “maximum selling price” can be determined (i.e., there is
MAY 2020 / THE CPA JOURNAL 53