Calculating gain with contingent purchase price
A contingent purchase price in an installment sale makes calculation of the seller’s gain complicated.
All the rulings were issued to shareholders in an S corporation who sold their shares to a C corporation so that the S corporation became a subsidiary of the C corporation. The consideration was a mix of cash and shares in the C corporation.
The purchase price was paid in four annual installments. However, the installments were adjusted based on change in the value of the C corporation shares in the five trading days before each installment payment.
The US tax code lets anyone selling property for payments over time report his gain over the period the sales price is received. This approach is automatic. However, a taxpayer who prefers to report his full gain up front can elect on his tax return to do so. Paying taxes over time will require payment of an interest charge on the deferred tax liability.
The gain is normally considered earned over time in the same ratio the sales price is received.
However, this is not easy to calculate when the sales price is contingent on future events.
In that case, if there is a maximum sales price, then the seller uses it to spread out the gain.
If there is no maximum price, but there is a fixed period for the installment payments, then the seller subtracts his basis from the installment payments ratably over the fixed period, but no loss is allowed in that case until the end. Thus, for example, if the basis ratably allocated to year two exceeds the installment payment that year, then the year-two loss is rolled into year three and used to offset the installment payment in year three.
Alternatively, the taxpayer can ask the IRS for permission to recover the basis on a different schedule. The alternative approach must be reasonable. The seller must get an IRS private letter ruling. It must apply for the ruling before the due date, including extensions, of the tax return on which first installment will be reported. The IRS will only approve an alternative method if the seller can show it will allow recovery of the basis at least twice as fast.
In this case, the IRS allowed the sellers to match the pattern that the sales proceeds were expected at inception to be received.