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January 14, 2024 Practice Point

Four Tax Issues You Aren’t Thinking About in Installment Sale Transactions

Elizabeth Stieff and Chris Davidson

Oftentimes, buyers want to acquire a business with a note payable over a period of years rather than simply paying 100% of the purchase price up-front in cash. This structure allows the buyer to pay for the target over time and often fund all or a portion of the purchase price with cash proceeds from the target itself (or, as it is commonly called, seller take-back financing). Even when a buyer pays a portion of the purchase price up front, the buyer may pay the remainder via a note, hold back a portion of the purchase price as security for indemnification obligations (i.e., as an escrow) and/or contractually agree to make future payments based on the target’s post-closing economic performance (i.e., an earnout).

In these note, escrow and/or earnout situations, the seller is treated as having sold property in an installment sale. An installment sale is simply a sale of property where the seller receives at least one payment after the tax year of the closing. Some sales of property are wholly ineligible for installment sale treatment (for example, sales of inventory, dispositions by dealers, sales of depreciable property between related persons, and sales of publicly traded property). Even if a sale qualifies for installment sale treatment, certain items cannot be reported under the installment method (for example, any recapture income items). If the sale qualifies for installment method treatment, each payment received by the seller is divided into three parts: (1) a non-taxable recovery of the seller’s basis; (2) a taxable realization of the seller’s gain; and (3) interest.

Unless the seller opts out, the seller is required to report gain from an eligible installment sale on the installment method. The installment method generally allows a seller to match recognition of taxable gain with receipt of payments under the note. This treatment usually is beneficial for the seller, as it enables the seller to defer recognition of a portion of the seller’s gain unless and until payments are received. There are, however, a few additional issues advisers should consider when representing a seller in an installment sale transaction.

A. Allocation of the Types of Consideration

When a transaction is structured as an actual or deemed sale of assets, the purchase agreement usually provides that the parties will allocate the consideration (including any contingent consideration) among the assets sold in accordance with the detailed provisions of section 1060 and the related regulations. The Code generally applies the residual method requiring buyers and sellers to allocate a business’s assets into seven different classes. The consideration is allocated first to Class I assets, to the extent of the fair market value of the Class I assets, then to Class II assets, to the extent of the fair market value of the Class II assets, and so on through the classes. Any consideration remaining after allocation to the Class VI assets is allocated to Class VII, which captures goodwill and going concern value. For purposes of the examples below, be aware that accounts receivable are Class II assets and goodwill is a Class VII asset.

Although there are detailed provisions regarding the allocation of consideration among the assets, there is no explicit statement on allocating the various forms of consideration (i.e., up-front cash and an installment note). There are two potential methods: the proportional method and the specific asset method. A simple example illustrates the difference between these methods.

Facts: Assume there are 2 assets sold: (1) $1,000 of zero basis accounts receivable for services rendered; and (2) zero basis goodwill. The purchase price is $1,000 up-front cash and an installment note with a principal amount of $5,000.

Proportional Method: There is $6,000 of consideration to allocate. First, the parties must allocate the total consideration among the assets under the residual method, resulting in $1,000 allocated to accounts receivable and $5,000 allocated to goodwill. Then the parties must allocate a pro rata portion of each type of consideration to each asset sold. The $1,000 up-front cash is allocated $166.67 to accounts receivable (which are allocated $1,000 of the total $6,000 consideration, so are allocated 1/6th of the $1,000 cash) and $833.33 to goodwill (which is allocated $5,000 of the total $6,000 consideration, so is allocated 5/6th of the $1,000 cash). The $5,000 note is similarly allocated, so there is an allocation of the note of $833.33 for accounts receivable and an allocation of the note of $4,166.67 for goodwill. Gain from the sale of the accounts receivable cannot be reported on the installment sale method. Accordingly, seller recognizes $1,000 of gain (from both cash and note) on the accounts receivable at closing. Seller also recognizes $833.33 of gain on the goodwill at closing, because seller has received $833.33 of cash and a $4,166.67 installment obligation for the goodwill. As a result, seller has $1,000 of ordinary income and $833.33 of capital gain in the year of the sale. When the installment note is paid, seller will recognize the remaining $4,166.67 of gain.

Specific Asset Method: The Service blessed the use of the specific asset method in the asset sale context, so long as the parties agree to use that method. Language in the purchase agreement to this effect should preserve the seller’s right to use the specific asset method.

There is $6,000 of consideration to allocate. Under the residual method, $1,000 is allocated to the accounts receivable and $5,000 is allocated to goodwill. The up-front cash is 1/6th of the total consideration. Up-front cash is allocated entirely to the accounts receivable under the specific allocation method. Because the up-front cash equals the fair market value of the accounts receivable, the entire $5,000 of the note is allocated to goodwill. Accordingly, on the receipt of the cash, seller recognizes $1,000 of income on the accounts receivable at closing. The seller recognizes no gain on the goodwill at closing because the cash is allocated to the accounts receivable. As a result, seller has $1,000 ordinary income and $0 capital gain in the year of the sale. When the installment note is paid, seller will recognize the remaining $5,000 of gain. The specific asset method therefore allows the seller to avoid the acceleration of $833.33 of capital gain that results under the proportional method.

As noted above, practitioners have generally interpreted Rev. Rul. 68-13 to require language in the purchase agreement providing for the use of the specific asset method. An example of the language follows:

The parties agree that for all income tax purposes they shall allocate (i) the cash portion of the tax consideration (excluding any note payments, escrow payments, or earn-out payments) to the portion of the assets that do not qualify for installment sale reporting pursuant to section 453 of the Code, and (ii) any note payments, escrow payments, earn-out payments, and any other tax consideration remaining after application of clause (i) to the portion of the assets that qualify for installment sale reporting pursuant to section 453 of the Code

B. One-Day Note

Use of a one-day note in an installment sale by, or with respect to, an S corporation may provide federal and state tax benefits. So long as there is a limit on the deductibility of state income taxes for federal income tax purposes, however, sellers should use this approach with caution.

Federal Tax Benefits: Generally, when an S corporation distributes an asset to its shareholders, the S corporation recognizes gain as if the S corporation had sold the asset. This gain flows through to the shareholders, increasing their basis. Basis is then reduced by the distributed asset’s fair market value. Disposition of an installment obligation typically triggers recognition of any deferred gain; however, section 453B(h) provides that if an installment obligation is distributed to shareholders in a complete corporate liquidation (including a deemed liquidation under section 338(h)(10)), an S corporation is not required to recognize any deferred gain. The shareholders apportion their stock basis among the assets received and determine whether any gain is recognized with respect to each asset.

For example, assume a shareholder owns 100% of an S corporation. Shareholder has a $0 basis in her stock; S corporation has a $0 basis in its sole goodwill asset. Shareholder sells all of her stock in a section 338(h)(10) transaction for $600,000: $100,000 is paid at closing and $500,000 is payable with an installment note. S corporation recognizes $100,000 of gain at closing, which flows through to the shareholder and increases her stock basis to $100,000. Shareholder receives the $100,000 cash and the $500,000 installment obligation. Shareholder allocates her $100,000 of basis pro rata among the cash (i.e., $16,666.67) and installment obligation ($83,333.33). Shareholder recognizes an additional $83,333.33 of gain on the cash distribution ($100,000 of cash less $16,666.67 allocable basis) and $0 of gain on the distribution of the installment obligation. Shareholder recognizes the remaining $416,666.67 of gain as payments are made under the installment obligation. The aggregate taxable income recognized by the S corporation and the shareholder in the year of the closing is $183,333.33. The aggregate taxable income recognized once all installment sale payments are received is $600,000.

The above result seems inconsistent with the principles of the installment method. If the shareholder gets $100,000 of cash at closing and $500,000 in the future, one would expect the shareholder to recognize, at most, $100,000 of gain in the year of the closing and $500,000 of gain in the future. Use of the one-day note can resolve this timing issue.

For example, assume that the shareholder receives a $600,000 note at closing, with $100,000 payable one day after closing and $500,000 payable in subsequent tax years. No gain is recognized by the S corporation because it has not received any cash (only installment obligations); no gain is recognized by the shareholder on receipt of the installment obligations. When the one-day note is paid the day after closing, the shareholder has $100,000 of gain, which is recognized immediately. The remaining $500,000 of gain is recognized by the shareholder as payments are received. By deferring receipt of the closing cash by one day, the shareholder has better matched the recognition of gain with the receipt of payments.

State Tax Benefits: When a shareholder receives a note in liquidation of an S corporation, the payments on the installment obligation are treated as payments in exchange for the shareholder’s stock; therefore, gain on the receipt of payments on the installment obligation generally is sourced to the shareholder’s state of residence. By contrast, gain recognized at the S corporation level on the sale (or deemed sale) of assets is sourced based on state sourcing rules, which generally look to where the S corporation does business. Accordingly, if a shareholder owns equity in a business that operates in a high-tax jurisdiction but lives in a low-tax jurisdiction, this planning strategy could move gain from the S corporation to the shareholder, shifting gain into the low-tax jurisdiction. Care should be taken with implementing this solution, as certain states have enacted legislation to combat this planning strategy or otherwise have advised that the state will not respect the one-day note in this instance.

Limitation on the Deductibility of State Taxes: Although it seems that the one-day note would always provide at least a federal tax benefit to the S corporation shareholders, this may not be the case in a post-TCJA world. Under the TCJA, the deduction for state taxes paid by an individual is limited to $10,000. A number of states have enacted workarounds for this limitation, which generally allow a pass-through entity to make an election (commonly referred to as a PTE election) to pay tax at the entity level on behalf of an owner. This PTE election shifts the tax payment to the entity level. Because the taxes are now an entity-level expense, the deduction for these taxes is not subject to the $10,000 limit: these taxes can be deducted in full. The shareholder gets a credit on its state tax return for the taxes paid on its behalf by the entity. Thus, depending on the type of assets in the target and the state tax filing position of the target and its owners, it may actually be better to recognize gain at the entity level so that state income taxes are deductible rather than shift income to the shareholders. The benefits of the one-day note are only available because the gain is shifted from the S corporation to its shareholders; accordingly, if the one-day note structure is being considered to shift gain (particularly if the sole purpose is to address the basis recovery issue described above), be aware that the shift potentially limits the deductibility of state income taxes paid with respect to the same gain.

For example, an S corporation sells its sole asset, goodwill, to a buyer. There is no asset or stock basis, and a purchase price of $600,000 (payable $100,000 in the year of closing and $500,000 in a subsequent year). Let’s assume that the S corporation operates in only one state and the shareholder lives in the same state where the state income tax rate is 10%. In the one-day note structure, $100,000 is not paid at closing, but is paid via a one-day note, which is distributed in liquidation of the S corporation. As a result, no gain is recognized by the S corporation. Accordingly, the entire $600,000 of gain is subject to tax in the shareholder’s state of residence (assuming the relevant states respect this structure). The shareholder will pay $10,000 of state income tax in the year of the closing, which will be deductible. Assuming the remainder of the note is payable in 2 years, the shareholder will pay $50,000 of state tax in that year; only $10,000 will be deductible. The shareholder has total federal gain of $600,000 and a federal deduction of $20,000 for state taxes paid, for net federal gain of $580,000.

By contrast, assume the S corporation sells the asset for cash at closing plus an installment sale note. In the year of the closing, S corporation has $100,000 of gain and makes a PTE election. S corporation pays $10,000 of tax on behalf of the shareholder, all of which is deductible. In 2 years when the note is paid, the S corporation has $500,000 of gain and pays state tax on behalf of the shareholders of $50,000: because of the PTE election, all of the state tax is deductible at the entity level. The shareholder has total federal gain of $600,000 and a federal deduction of $60,000 for state taxes paid, for net federal gain of $540,000.

Of course, this scenario eliminates any potential state tax savings from use of a one-day note if the S corporation operates in states other than the shareholder’s state of residence. A seller in this scenario should run the numbers under the various scenarios to ensure the transaction is structured in a way that is most tax-advantageous to the seller.

C. Opting Out

Sellers usually want to report gain on the installment method because it allows them to match tax consequences with the receipt of cash, but they can opt out of installment sale reporting. In that case, the seller must recognize gain in the year of sale equal to the difference between the cash and the fair market value of the installment obligation and the seller’s basis in the asset sold. Why would a seller want to opt out and accelerate gain?

1. The seller has a significant basis in the asset sold, and the installment obligation is contingent

For example, assume a seller owns stock of a corporation with a basis of $1,000. The purchase price for the stock is $1,000 at closing, and the seller also is entitled to contingent consideration up to a maximum of $5,000 payable the year after closing if certain economic hurdles are met. If the seller utilizes the installment method, seller allocates basis among the closing and future payments assuming the maximum contingent consideration is paid. Seller has $833.33 of gain at closing ($1,000-$166.67 of allocable basis). The remaining $833.33 of basis is allocated to the contingent installment obligation. The economic hurdles are not met, and the seller receives no additional consideration. Seller has a $833.33 capital loss once seller determines no additional consideration will be paid. Assuming seller is a non-corporate taxpayer, this loss cannot be carried back.

By contrast, assume seller opts out of the installment sale method and determines that the contingent consideration has a fair market value of $0. In this scenario, seller has $0 of gain at closing. Seller’s valuation of the contingent consideration must be reasonable and represent fair market value; however, if the contingent consideration is highly speculative, opting out of the installment sale method may better match seller’s recognition of gain.

2. The installment sale is subject to the section 453A(a)(1) interest charge, and the benefit of deferral is not worth the cost

On certain large installment sales, section 453A(a)(1) requires the seller to pay an interest charge on its deferred tax liability for the privilege of deferring installment gain. This interest charge is generally applicable to all installment sales for more than $150,000 made during the taxable year if, at the end of the year, the seller holds installment obligations from such sales during the year with aggregate face amounts exceeding $5,000,000. Interest payable on the deferred tax liability is computed by multiplying the underpayment rate in effect under section 6621(a)(2) on the last day of the year, the tax deferred (computed at the highest marginal rate), and the ratio of obligations in excess of $5,000,000 to the total installment obligations held by the taxpayer. Generally, the underpayment rate is the federal short-term rate plus 3%. This interest charge is non-deductible and is not credited against future taxes due.

A seller should consider whether the benefit of the deferral is worth this additional cost. For example, assume a seller owns stock of a corporation with a basis of $10,000,000. The purchase price for the stock is $10,000,000 at closing and a $50,000,000 note payable in 2 years. The short-term applicable federal rate for December 2023 is 5.26%. The current capital gains rate is 20% and the $50,000,000 payable is the seller’s sole installment obligation. In the year of the closing, seller reports $8,333,333.33 of gain and pays $1,666,666.67 of tax. In addition, seller must pay the interest charge. First, the taxpayer determines the applicable percentage, which is 90% here: (i) $45,000,000 (the excess note over the $5,000,000 floor)/$50,000,000 (the taxpayer’s total installment obligations). The deferred tax liability is $8,333,333.33: (i) the $41,666,666.67 of gain left to be recognized ($60,000,000 purchase price less $10,000,000 basis less $8,333,333.33 of gain recognized in Y1) times (ii) 20%, the maximum federal capital gains rate. The underpayment rate of 8.26% (i.e., 5.26% short-term applicable federal rate plus 3%) applies to the applicable percentage (90%) multiplied by the deferred tax liability ($8,333,333.33). Accordingly, the interest charge is $688,333.33. Seller pays the interest charge of $688,333.33 in Y2 as well. In Y3, the note is paid in full, and the seller recognizes the remaining $41,666,666.67 of gain and pays tax of $8,333,333.33. Ultimately, seller has paid tax of $10,000,000 and interest charges of $1,376,666.66.

By contrast, if seller had opted out of the installment sale method, seller would have paid $10,000,000 in tax in Y1. When the $50,000,000 of future consideration is received, the seller does not pay additional tax on the $50,000,000 received. The seller likewise is not subject to the interest charge. In this scenario, the seller must consider whether the deferral of $8,333,333.33 of tax by two years was worth the interest payment of $1,376,666.66.

In determining whether to opt out of the installment sale method, the seller also should consider the creditworthiness of the buyer. If the seller opts out of the installment sale method and the buyer fails to pay the future consideration, the seller recognizes gain on the face amount of the installment obligation in the year of the sale and has a capital loss in the year the buyer defaults on the installment obligation. By contrast, if the seller had utilized the installment sale method, the seller would have recognized gain only to the extent of payments received. In such a scenario, the seller is likely in a better economic position having paid the interest charge and less up-front tax rather than having avoided the interest charge by paying the tax up-front and generating a capital loss (which the seller may not be in a position to utilize) in a subsequent year.

3. The seller thinks income tax rates will go up in subsequent years and wants to accelerate gain

In a scenario where income tax rates and interest rates are expected to rise, a seller may be better off opting out of the installment sale method to get the benefit of the current income tax rate while minimizing gain subject to higher future rates and avoiding the section 453A(a)(1) interest charge entirely. This option likely will depend on the economics of the installment obligation, the likelihood of rate increases, and whether seller is economically able to accelerate payment of the tax liability.

Using our example above, the seller recognizes all gain in the year of closing and pays total tax of $10,000,000 in Y1. Seller avoids the interest charge under section 453A(a)(1), for a total tax burden of $10,000,000.

By contrast, assume seller reports using the installment method. As calculated above, seller pays tax of $1,666,666.67 in Y1. At the end of Y1 and Y2, the full $50,000,000 of the note is still outstanding; accordingly, the seller must pay the interest charge of $688,333.33 in each of Y1 and Y2. In Y3, when the note is paid, the capital gains tax rate applicable to the seller is 30%. In Y3, the seller recognizes the remaining $41,666,666.67 of gain and pays tax at a 30% tax rate for total tax in Y3 of $12,500,000. Ultimately, seller pays $15,543,333.33 of tax and interest. In this scenario, seller has deferred $8,333,333.33 of tax for two years, but at a cost of an additional $5,543,333.33.

Of course, sellers need to consider the time-value of money. Although seller ultimately pays less tax (and avoids the interest charge) by opting out, seller accelerates the tax liability into the year of the closing. Seller also may not want to use the cash portion of the purchase price to pay federal tax in the year of the closing.

D. Section 1202 Planning

Section 1202 allows a taxpayer other than a corporation to exclude all or part of the taxpayer’s gain on the sale of qualified small business stock (QSBS). The maximum gain eligible for the reduced section 1202 tax rates is the greater of (i) $10,000,000, less the aggregate gain taken into account by the taxpayer under section 1202 in prior years with respect to stock of the same issuer, or (ii) 10 times the shareholder’s basis in issuer stock sold during the relevant taxable year. When a seller sells issuer stock in an installment sale, the entire transaction is treated as a single sale even though the seller receives payments over time. Thus, the $10,000,000 or 10 times basis rule applies to any gain recognized from the sale, whether in the year of the closing or over time. The section 1202 gain exclusion is prorated across the installments to be received. Avoiding installment sale treatment by structuring a transaction as multiple sales may allow a seller to accelerate the benefit of the section 1202 exclusion and, if the seller is relying on basis to calculate the exclusion amount, magnify the benefit of the section 1202 exclusion.

For example, assume seller has a $1,000,000 basis in 100 shares of QSBS. The value of the QSBS is $20,000,000. Buyer proposes an installment sale transaction where buyer will acquire all of seller’s shares for $20,000,000, with $10,000,000 paid in cash and a $10,000,000 note. Seller ultimately will recognize $19,000,000 of gain. The maximum QSBS exclusion on this sale is $10,000,000 (the greater of $10,000,000 or 10 times the basis of the seller’s stock, which is $10,000,000). The excluded amount is applied pro rata, so that $5,000,000 of the exclusion reduces seller’s gain in the year of the sale and $5,000,000 of the exclusion reduces seller’s gain as payments are received under the note.

By contrast, assume seller and buyer agree that buyer will buy 50 shares of seller’s QSBS for $10,000,000 in Y1. The maximum QSBS exclusion is $10,000,000 (the greater of $10,000,000 or 10 times the basis of the stock sold, which is $5,000,000). Seller has $9,500,000 of gain in Y1, all of which is excluded.

In Y2, seller and buyer agree that buyer will buy the remaining 50 shares of seller’s QSBS for $10,000,000. Assuming that this second sale is validly treated as a separate sale, seller is entitled to exclude the greater of (i) $10,000,000, less any prior gain excluded with respect to stock of the same issuer (here, $9,500,000), or $500,000, or (ii) 10 times the basis of the seller’s stock sold in the sale, or $5,000,000. Accordingly, seller has $9,500,000 of gain in Y2, of which $5,000,000 is excluded. Although the two transactions are similar economically, the second results in seller excluding $14,500,000 of gain, while in the first scenario the seller only excludes $10,000,000 of gain.

Of course, this revised structure fundamentally changes the nature of the business deal. The buyer must be comfortable with purchasing a smaller share of the target at the initial closing. There cannot be a binding obligation on the part of the seller to sell its remaining shares to the buyer or the sales will be stepped together. Further, under the revised structure, the seller continues as an owner of the business until the final sale of the seller’s QSBS. If those caveats are acceptable, this does provide a potential alternative to an installment sale that has similar economics for the buyer while maximizing seller’s tax benefits.

    Elizabeth Stieff

    Venable LLP, Baltimore, MD

    Chris Davidson

    Venable LLP, Baltimore, MD

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