A Partly Contingent Purchase Price

A Partly Contingent Purchase Price

June 11, 2014

A partly contingent purchase price creates tax complications.

Many developers sell projects that are still under development for cash at closing plus additional payments that are contingent on reaching various milestones.

The developer usually reports its gain under the installment method, meaning the gain is reported over time as payments are received.

IRS regulations require the gain be calculated each year by taking the maximum purchase price the developer might receive and subtracting his basis in the project to determine the fraction of the purchase price that would be gain. The developer then reports that fraction of each actual payment from the buyer as gain.

However, if the maximum purchase price is unclear by the end of the year in which the sale occurs, then the developer is supposed simply to spread its basis in the project ratably over the period that the purchase price will be paid. Thus, for example, if the purchase price might be paid over five years, the developer would subtract 20% of its basis in the project each year from what the buyer pays it that year.

One taxpayer who sold a company got the IRS to rule that it could use a different method for determining how much of each payment was gain. The ruling is Private Letter Ruling 201417006. The IRS made the ruling public in late April.

The buyer agreed to pay cash at closing, assume liabilities and make additional payments over the next seven years tied to growth in company revenues.

Since the ultimate purchase price the seller might pay was too uncertain, but the seller knew it might receive payments for up to seven years, it was required to spread its basis in the company shares it sold ratably over seven years. This would have led to a large gain in year one and a large loss in year seven based on projections the seller made assuming the company would continue to grow at the same rate it had in the past.

Instead, the IRS let the seller allocate part of its basis to each year over the seven-year period in the same pattern as the seller expected to receive contingent payments.

IRS regulations allow the seller to use a different method for allocating basis if it can show that he will probably recover basis at least twice as fast under the alternative and the method is reasonable. The seller must receive IRS approval to use the method by asking for a private ruling.

by Keith Martin