Page 3 - Accounting for Sales with Contingent Obligations: Methods and Considerations

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from over the adjusted basis” [IRC sec- ket for identical or similar contingent obli- equal to the fair market value of the con-
tion 1001(a)]. The “amount realized” is gations. Importantly, as noted in the tingent obligations.
the “sum of any money received plus the Treasury Regulations, if the purchase
fair market value of the property (other agreement restricts the seller from trans- The Open Transaction Method
than money) received” [IRC section ferring the right to contingent payments, The final method available, which is
1001(b)]. Accordingly, if electing this this restriction cannot be considered for also often the most favorable for taxpay-
method, the taxpayer will pay tax on the valuation purposes. ers, is the “open transaction” method [see
cash received in the year of the transac- Unlike the installment method, the Burnet v. Logan, 283 U.S. 404 (1931)].
tion plus the fair market value of the con- closed transaction method allows taxpay- It is reserved for those “rare and extraor-
tingent obligations. Taxpayers typically ers to fully recover their basis in the sold dinary cases involving sales for a con-
elect this method by reporting the trans- property in the year of the transaction. tingent payment obligation in which the
action on Form 8949 or Schedule D, but Moreover, unlike the installment method, fair market value of the obligation …
not on Form 6252 [IRS Publication 537, there is no interest payable to the IRS cannot reasonably be ascertained”
Installment Sales (2019)]. [Treasury Regulations section 15a.453-
While the term “fair market value” is 1(d)(2)(iii)].
not defined in the statute, it is widely Under the open transaction method, a
defined in case law and various Treasury taxpayer is taxed on sale proceeds as
Regulations as the price at which a buyer Unlike the installment they are realized, and the basis is imme-
would be willing to purchase the noncash diately recovered rather than deferred.
property in an arm’s-length transaction method, the closed The IRS is aware that taxpayers, if given
[See, e.g., Treasury Regulations section the option, would likely choose the open
25.2512-1; fair market value for purposes transaction method transaction method. To discourage tax-
of gift tax is the “price at which such allows taxpayers to fully payers from electing this method, the
property would change hands between a IRS has issued a warning in its regula-
willing buyer and a willing seller, neither recover their basis in tions that any such transaction will be
being under any compulsion to buy or scrutinized, hinting at an almost certain
to sell, and both having reasonable the sold property in the audit [Treasury Regulations section
knowledge of relevant facts.”] When a 15a.453-1(d)(2)(iii)]. To survive such an
taxpayer elects to use the “closed trans- year of the transaction. audit (or a subsequent court case), tax-
action” method, the “fair market value payers would be advised to retain an
of [the] contingent payment obligation expert who could competently testify to
shall be determined by disregarding any the fact that the contingent obligations
restrictions on transfer imposed by agree- cannot be valued.
ment or under local law” [Treasury for “deferred” payments with a “face
Regulations section 15a.453-1(d)(2)(iii)]. amount” exceeding $5 million. The Choose Carefully
Moreover, the “fair market value of a downsides to the closed method include It is important that taxpayers and their
contingent payment obligation may be the requirement that the taxpayer pay tax advisors consider the nature of the trans-
ascertained from, and in no event shall on the fair market value of the contingent action involving contingent obligations,
be considered to be less than, the fair obligation (assuming the taxpayer realizes the likelihood that the contingent pay-
market value of the property sold (less a gain from the sale), even though such ments will be realized, and the amount
the amount of any other consideration payments may never materialize. This of future-year potential payments when
received in the sale).” method is likely favorable for those tax- choosing the appropriate tax-reporting
Accordingly, if a taxpayer elects this payers with a high basis in the sold prop- method. Because the method of account-
method, it is imperative that she adequately erty but where the contingent payments ing for a transaction is usually irrevoca-
determine the fair market value of the con- are unlikely to be realized. When contin- ble, once a taxpayer makes a method
tingent obligations at the time of the sale gent obligations are unlikely to be met, the election, that method will likely govern
closing. Ideally, this will be done with the fair market value of such obligations will regardless of the eventual outcome of the
assistance and expertise of an appraiser likely be relatively low in the year of the contingent consideration. q
who can value the contingent obligation, transaction. The benefit of fully recovering
or through other independently verifiable basis under such scenarios will often out- Stephen A. Josey, JD, is an associate at
means, such as reference to a public mar- weigh the added costs of reporting a gain Kostelanetz & Fink LLP, New York, N.Y.

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