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New Installment Sale Rules Hit Accrual Taxpayers: GT Prepared to Launch Repeal Effort

January 2000
By James F. Miller and Harry J. Friedman, Greenberg Traurig, Miami Office

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The Tax Relief Extension Act of 1999 sounds like legislation intended only to extend tax benefits. But, hidden in the legislation is a tax law change certain to have a significant impact on the buying and selling of businesses.

The Act modifies provisions of the Internal Revenue Code that permit a seller to use the "installment method" of reporting income in the sale of business assets by certain taxpayers. The installment method applies where a seller receives a promissory note or the payment of all or part of the purchase price is otherwise deferred. Generally, the seller is permitted to defer reporting gain with respect to the deferred payments until the payments are actually received. The seller avoids having to pay taxes until the seller actually has cash. The installment method implicitly adopts a policy that taxation should be deferred if the seller has no proceeds to pay the tax liability.

Prior to the Act, the installment method was available to both accrual and cash method taxpayers with respect to the sale of business assets other than inventory. The Act eliminates the availability of the installment method to many corporate sellers. Under the new law, an accrual-basis taxpayer, other than farming companies and time-share entities, are not permitted to use the installment method in reporting income. If a corporation or partnership using the accrual method (generally required for a business having inventory, corporations, other than S corporations, with gross receipts in excess of $5,000,000, or a partnership that has a C corporation as a partner) sells all of its assets in exchange for a promissory note, it will be required to report, as gross income in the year of the sale, the amount of the note. This result requires a seller to incur a tax liability on proceeds to be received in the future. Sellers facing this dilemma will certainly consider the advantages of receiving cash rather than a deferred payment obligation.

The inability of a seller to defer the tax obligation on deferred sale payments will create even more complex problems in the typical "earnout." Often, the buyer and seller of a business cannot agree on the value of the business. A reasonable solution to this problem is to defer the fixing of the purchase price for a period of time. Typically, the seller will receive a fixed payment at closing and a contingent payment some time after the closing that is dependent on the future earnings of the business. The earnout may have a cap, a maximum amount of additional purchase price; it may be unlimited in amount based on the earnings over a specified period. Depending on how long the parties believe is necessary to establish the value of the business, the final fixing of the purchase price and its payment may be several years after the closing.

Under the Act, a seller who receives this right to future contingent payments may have to establish a value for the contingent obligation and pay taxes in the year of the sale based on the value established. Valuing a contingent obligation will often be difficult; if the value was easy to ascertain, the parties would not be using the contingent earnout to begin with. Alternatively, the seller may, instead of reporting the value of the contingent note, take the position that the right to future payments creates an "open transaction," allowing the seller to report no income until the total payments received exceed the aggregate basis of the assets. In recent years, the IRS has generally taken the position that all contingent payment obligations have to be valued and that open transaction reporting is only permissible in extraordinary circumstances. Conflicts with the IRS over the manner of reporting and the valuation of the note appear inevitable.

Individual taxpayers may also be affected by the denial of installment sale treatment. Sales of businesses by accrual basis S corporations or partnerships in exchange for deferred payments will result in the loss of installment sale treatment for cash-basis shareholders. The requirement that the S corporation or partnership report the gain on the receipt of the installment note results in the recognition of gain by the shareholders or partners, notwithstanding that they are cash basis taxpayers.

Often upon a sale of a stock of an S corporation, the parties agree to make an election under Section 338(h)(10) of the Internal Revenue Code, permitting the parties to treat the transaction as if the S corporation sold all of its assets and distributed the proceeds in complete liquidation. Under recently proposed Treasury Regulations, if the shareholders received a note in exchange for their stock an election is made under Section 338(h)(10), the transaction would be treated as if the note was received by the S corporation in exchange for property and distributed to the shareholders in complete liquidation of the corporation. As a result, the shareholders would not be required to report the gain on the sale of the business’ assets until payments are made under the note. The Section 338(h)(10) election is beneficial in the case of an S corporation because the gain to the shareholders is usually the same regardless of whether stock is sold or a constructive asset acquisition is created. However, an asset sale creates a benefit to the buyer from the basis step-up with respect to the assets. A Section 338(h)(10) election allows for the convenience of a state law stock sale and an asset sale for tax purposes.

A contingent payment obligation arising from an earnout may have a more disastrous impact on an S corporation shareholder. Assuming that the contingent payment obligation is valued for Federal income tax purposes, the S corporation shareholders will be required to report capital gain in the year of the sale. However, if the contingent payments made by the buyer are less that the value assigned to the contingent payment at closing, the shareholder will have a capital loss in a succeeding year. Individual taxpayers are not permitted to carry back capital losses to prior tax years. As a result, the S shareholder will have a significantly adverse tax consequence, a capital gains tax in the closing year and a capital loss in a subsequent that can only be used if the shareholder has future capital gains, it cannot be used to obtain a refund of the taxes paid earlier.

For example, John owns all of the stock of E.com, an S corporation using the accrual method. Bigco wants to buy all the stock of E.com. John and Bigco cannot agree on the value of E.com. They agree that Bigco will pay John 10 times the average annual earnings of E.com over the succeeding three years. Based on the value of internet companies today, the parties value the earnout at $1,000,000. John accepts a contingent installment note. Bigco wants to step up the basis of the assets of E.com so it can depreciate the intangible assets. The parties agree to an election under Section 338(h)(10). E.com reports $1,000,000 of income for the year of the closing and John, as the sole shareholder, pays capital gain taxes of $200,000. At the end of three years, E.com turns out to be not as successful as John thought. He only receives $200,000 from Bigco. Since he has a tax basis in the contingent note of $1,000,000, on the receipt of the payment he has a capital loss of $800,000. However, he can use the capital loss only against future capital gains; he cannot get a refund of the $200,000 in taxes paid in the year of the closing.

The result from the denial of installment sale treatment to accrual basis taxpayers is that businesses will be loath to sell their assets for deferred payment obligations and, instead, require up-front payments of cash by buyers. Negotiating purchase prices, without the alternative of agreeing to an earnout, will be more difficult. Tax laws have a significant impact on the buying and selling businesses. In the future, the importance of tax issues will be even greater.

Congress is just beginning to learn about the severe impact of these recently enacted rules. The National Federation of Independent Business, a trade association in Washington which represents approximately ten percent of all small businesses in the United States, is currently lobbying for repeal. Unless each member of the tax-writing committees in Congress understands fully the nature of the denial of installment sale treatment to accrual basis taxpayers and its impact on business in his or her state or district, the rules stand little chance of being repealed.

Greenberg Traurig, LLP is prepared to launch a repeal effort on behalf of its clients through its Governmental Affairs Group in Washington. An issue of this nature requires a team of experienced tax lawyers and legislative strategists with extensive relationships on Capitol Hill and the Administration. Greenberg Traurig has such a team and will undertake a repeal effort on behalf of interested clients.

If you are interested in an effort to repeal the denial of installment sale treatment to accrual basis taxpayers, please contact James F. Miller, who chairs Greenberg Traurig’s Legislative Group in Washington, at (202) 331-3166, or Harry J. Friedman in our Miami Offices at (305) 579-0711.

 

© 2000 Greenberg Traurig


This GT ALERT is issued for informational purposes only and is not intended to be construed or used as general legal advice. Greenberg Traurig attorneys provide practical, result-oriented strategies and solutions tailored to meet our clients’ individual legal needs.