Page 2 - Accounting for Sales with Contingent Obligations: Methods and Considerations

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COLUMNS I Tax Practice & Procedure

a set dollar limit on potential future-year have several drawbacks. First, taxpayers for such taxable year” [IRC section
payments), the taxpayer should report the whose basis in their property is high, rel- 453A(c)(3)]. While the statute, codified
sale proceeds earned in the year of the ative to the amount of proceeds to be in 1987, includes a provision instructing
transaction, but the taxpayer’s basis in realized in the year of the transaction, the Treasury Secretary to issue regula-
the asset should be apportioned so that will not be able to fully recover their tions “to carry out the provisions of this
it is recovered over time on the assump- basis in the year of the transaction. This subsection including regulations provid-
tion that all contingencies will be realized can be especially problematic where ing for the application of this subsection
[Treasury Regulations section 15a.453- potential future payments are high, but in the case of contingent payments” [IRC
1(c)(2)]. A separate set of rules governs expected realization is low. Under such section 453(A)(c)(6)], no regulations
contingent sales where the maximum a scenario, the recovery of a large portion have been promulgated to date. As a
selling price is unknown, but where there of the taxpayer’s basis will be delayed result, significant uncertainty exists as to
is a set date by which all payments will (possibly indefinitely), even though it is whether individuals holding rights to
be made [Treasury Regulations section unlikely that the taxpayer will actually contingent payments are liable for the
15a.453-1(c)(2)]. Sales where both the receive future proceeds. interest payments under IRC section
maximum selling price and the timeline 453A, and if they are, how such interest
for payment are indeterminable are sub- payments should be calculated. [See, e.g.,
ject to yet another set of rules [Treasury While the installment IRS CCA 201121020 (May 27, 2011):
Regulations section 15a.453-1(c)(4)]. The “In the absence of regulations under
common principle that drives the rules method is the most Section 453A(c)(6), the Service allows
governing these transactions is that the taxpayers to use a reasonable method of
taxpayer should only be required to favorable accounting calculating the deferred tax and interest
account for cash proceeds in the year that on the deferred tax liability with respect
they are realized, while recovery of basis method for many to contingent payment installment obli-
in the sold property should be spread out gations.”]
over time to account for the potential for taxpayers, because it Finally, the installment method may
additional consideration. lead to unfavorable outcomes for taxpay-
Under the installment method, unless allows for the deferral of ers whose sales qualify for other exclu-

the sale contract provides for the pay- recognition of proceeds sions and benefits under the tax code.
ment of interest, a portion of the pay- For instance, a taxpayer who sells qual-
ments earned in future tax years (assum- until the year that they ified small business stock that meets the
ing the contingencies are realized) will requirements under IRC section 1202,
be treated as imputed interest income are realized, it does have but where the aggregate potential gain
[Treasury Regulations section 15a.453- under the sales contract exceeds the
1(c)(2); see also IRC section 483]. To several drawbacks. allowable maximum income exclusion
the extent the taxpayer does not realize under that provision, will not be permit-
contingency payments (e.g., because ted to claim the full amount of the exclu-
milestones were not met), the taxpayer’s Another major pitfall associated with sion in the year of the transaction, and
deferred basis will be treated as a capital the installment method is the deferred instead will be required to apportion the
loss in the year when the right to the con- interest payment described in IRC sec- exclusion over time if the installment
tingent payments expire [IRC section tion 453A, which is applicable to tax- method is elected. (See 2019 Instructions
453A(b)(2)(B)]. Unfortunately, in situa- payers whose future payments have a for Schedule D.)
tions where the right to contingent pay- “face amount” exceeding $5 million
ments is not time- or dollar-limited, a [IRC section 453A(b)(2)(B)]. Pursuant The Closed Transaction Method
taxpayer may be forever precluded from to that provision, taxpayers are required For those sellers looking for an alter-
claiming a capital loss for unrecovered to pay interest on their “deferred tax lia- native accounting method, taxpayers may
basis. bility,” which is defined as “the amount elect to treat a sale with contingent obli-
While the installment method is the of gain with respect to an obligation gations as a closed transaction, which
most favorable accounting method for which has not been recognized as of the falls under IRC section 1001. Pursuant
many taxpayers, because it allows for the close of such taxable year, multiplied by to that provision, the gain from the sale
deferral of recognition of proceeds until the maximum rate of tax in effect under or other disposition of property “shall be
the year that they are realized, it does section 1 or 11, whichever is appropriate, the excess of the amount realized there-

54 MAY 2020 / THE CPA JOURNAL