Greenberg Traurig Alert
New Installment Sale Rules Hit Accrual Taxpayers: GT Prepared to Launch
By James F. Miller and
Harry J. Friedman, Greenberg
Traurig, Miami Office
View or download the PDF version of this Alert
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.