JOURNAL ARTICLE REVIEW GRADING RUBRIC

Name of Jeziel Nicah L. Bantayaon / AC5A

Reviewer/
Section
Journal United States: Contingent Payment Installment Sales—A Seller’s Dilemma
Article
Title
Author Jeffrey K. Ekeberg and Jeffrey C. Wagner

http://www.mondaq.com/unitedstates/x/318114/M+A+Private%20equity/Contingent+Payment+Installment+SalesA+Sellers+Dilemma
Source

Criteria Notes/Comments Point Points

Value Earned
Format and Writing Style
 Required format is adopted: Arial 11, Double
spacing, and 1” margin on each side
 Length requirement met (600-700 words) 20
 Writing style consistent with graduate level
expectations
Article Selection
 Article is carefully selected (articles contains
good research points and is relevant to the
accountancy profession) 15
 Article is applicable to topics already discussed
during classroom lectures
 Article is current (no more than 10 years old)
Article Summary and Citations
 Article is well-summarized and explained
15
 Appropriate quotations and citations are made
to help the reader understand the article
Explanation & Critique
 Explains and critiques the methods, sources,
findings, conclusions and/or analysis present in
the article
 Critique is well-supported by facts and accepted 25
theory rather than opinion
 Evaluation of the article and its findings are
based on professional criticism supported by
theory
Application
 Application explains connections to and impact
on the reviewer’s future profession 25
 Application presented is viable for classroom
discussion

Total 100
Summary

The installment method is an option for certain sellers to defer reporting taxable gain

until payments are received in connection with the sale of certain types of property. A seller

may elect out of the installment method and recognize gain in the year of the sale in an amount

equal to the excess of (i) the total consideration received, including the full fair market value of

any installment obligation received (including the fair market value of the right to receive any

contingent payments), over (ii) the seller's basis in the property sold. If a seller elects out of the

installment method and does not receive the full amount estimated as the fair market value of

the installment obligation (including any right to receive contingent payments), the seller is not

permitted to recompute the amount of income recognized in the year of sale. Instead, the seller

may only take a loss (generally, a capital loss) when it is ultimately determined that the

installment obligation is worthless.

The installment method generally provides that each payment received by the seller in a

taxable year subsequent to the sale year is comprised of three parts: a partial return of the

seller's basis in the property sold, a portion of the gain recognized on the sale and interest.

When a seller reports a transaction on the installment method, the timing of the basis recovery

is dependent upon the terms of the deferred consideration. When either the selling price of the

property or the time period over which the deferred payments are to be received is fixed, the

seller generally recovers its basis in the property sold ratably and reports the associated income

in the year in which the payments are received. The rules are significantly more complex,

however, when both the timing and the amount of any deferred payments is not known.

Contingent Payment Installment Sales

If a seller can compute the maximum possible amount that could be received in an installment

sale (e.g., when an earnout is capped at a fixed dollar amount), the seller is required to compute
the taxable gain when a payment is received based upon an assumption that the seller will

actually receive the maximum possible amount under the agreement. If less than the stated

maximum selling price is received, this method defers the seller's recovery of basis, as

compared to a scenario where the full payment schedule is known.

If there is no stated maximum selling price but the time period during which payments will be

received is fixed (e.g., when an uncapped earnout is scheduled to be paid following each of the

three fiscal years following closing), a seller may only recover the basis in the property sold in

equal annual increments during the scheduled time period of payments. In a typical situation

where the payments received by the seller are front loaded, this method can result in a

significant acceleration of taxable gain.

Finally, if there is no stated maximum selling price nor a fixed time period during which

payments will be received (e.g., when an uncapped earnout is contingent on the achievement of

certain milestones rather than payable during a fixed time period), the seller may only recover

basis in the property sold in equal, annual increments over 15 years. Once again, when the

payments received by the seller are front loaded, this method of basis recovery may result in a

significant acceleration of taxable gain.

Takeaway—Choosing a Method

A seller who accepts contingent consideration should carefully consider the manner in which the

seller intends to report the transaction for tax purposes. If the seller elects out of the installment

method and takes into income any deferred consideration in the year of sale, the seller must be

prepared to report as income the fair market value of any right to receive contingent payments.

By electing out of the installment method, however, the seller will not be subject to the interest

charge provisions. If the amount reported as income with respect to the contingent

consideration is not ultimately received, the seller should understand that the only recourse may
be to report a capital loss when the installment obligation is ultimately determined to be

worthless.

If, on the other hand, the seller decides to report the transaction on the installment method, the

fair market value of the right to receive the contingent payments does not need to be

determined. The seller must instead evaluate the application of the interest charge provisions.

If the seller does not apply an interest charge with respect to the contingent consideration, the

IRS could challenge that position. If the seller takes a more conservative approach and uses

the look-back method to apply the interest charge provisions, the IRS should be less likely to

challenge the approach because it has acknowledged the reasonableness of the look-back

method in informal guidance. Nevertheless, the seller should be aware that there is no

precedential guidance authorizing the look-back method.

As sellers agree to accept contingent consideration, they should be aware of the options

available to report any income associated with the sale and ensure that, regardless of the

manner in which they intend to report the transaction for income tax purposes, the structure

does not give rise to any unanticipated tax risk. There may be alternative structures for the

transaction that result in greater certainty as to the present value of the seller's after-tax

proceeds.

Reaction

Though the article stated above is a bit lengthy, it only expresses the thought about

installment sales, contingent payment installment sales, and its related interest charges. As

applied using the U.S. GAAP and other international standards, on an installment sale, each

collection on a contract is regarded as representing both a return of cost and a realization of

gross profit in the ratio in which these two factors are found in the original sales price. It
emphasizes on collection rather than sale and recognizes income in the periods of collection

rather than in the period of sale.

Likewise, I assent to the fact that the installment basis of accounting is justified on the

basis that when there is no reasonable basis for estimating the degree of collectability, revenue

should not be recognized until cash is collected. This results to a higher risk of loss from

uncollectible accounts as compared to ordinary sales since payment is spread over a relatively

long period of time.

The determination of revenue recognized on a particular period is important for taxing

authorities to compute the correct amount of taxable gain. This is a crucial stage for sellers as

they report the associated income in the year in which payments are received. I learned that

everything became more complex, as both the timing and the amount of any deferred payments

is not known.

As regards to contingent payment installment sales, if the seller can compute the

maximum possible amount that could be received in an installment sale, the seller is required to

compute the taxable gain when a payment is received based upon an assumption that the seller

will actually receive the maximum possible amount under the agreement. If less than the stated

maximum selling price is received, this method defers the seller's recovery of basis. If there is

no stated maximum selling price but the time period during which payments will be received is

fixed, a seller may only recover the basis in the property sold in equal annual increments during

the scheduled time period of payments. In a typical situation where the payments received by

the seller are front loaded, this method can result in a significant acceleration of taxable gain.

Finally, if there is no stated maximum selling price nor a fixed time period during which

payments will be received, the seller may only recover basis in the property sold in equal,

annual increments over 15 years. Once again, when the payments received by the seller are
front loaded, this method of basis recovery may result in a significant acceleration of taxable

gain.

Application

As a student aiming to be a CPA, I learned from the article review of significance of

having adequate knowledge and understanding of the revenue recognition of installment sales. I

gained insights of the complexities encountered and shoulder by the accountant as it assist

management on the proper reporting of income both for the internal user and for the taxing

authorities.

Moreover, it has given me the privilege to get a glimpse of how a foreign country deals

with the common problems that it encounter as regards to receiving installment payments and

how it accounts and thought over this matter. With this, I know that this will be of big help in my

studies and on my journey towards the corporate world.

United States: Contingent Payment Installment Sales—A Seller’s Dilemma

Jeffrey K. Ekeberg and Jeffrey C. Wagner

http://www.mondaq.com/unitedstates/x/318114/M+A+Private%20equity/Contingent+Paym

ent+Installment+SalesA+Sellers+Dilemma

Parties have increasingly looked to earnouts or contingent payments to bridge any gap in value

between the buyer and seller and to incentivize target owners who continue to work in the

business post-closing. Subject to certain exceptions, if these earnouts or contingent payments

are to be received in a taxable year after the sale year, they are viewed as a form of deferred

consideration, which may be eligible to be reported for U.S. federal income tax purposes on the

"installment method." We address how the tax rules treat contingent payment sales that are

reported on the installment method and highlight a few important considerations for sellers as

they analyze whether to elect out of the installment method or otherwise take affirmative actions

to structure the deal to avoid application of the installment method.

The Installment Method

The installment method is an option for certain sellers to defer reporting taxable gain until

payments are received in connection with the sale of certain types of property. A seller may

elect out of the installment method and recognize gain in the year of the sale in an amount

equal to the excess of (i) the total consideration received, including the full fair market value of

any installment obligation received (including the fair market value of the right to receive any

contingent payments), over (ii) the seller's basis in the property sold. If a seller elects out of the

installment method and does not receive the full amount estimated as the fair market value of
the installment obligation (including any right to receive contingent payments), the seller is not

permitted to recompute the amount of income recognized in the year of sale. Instead, the seller

may only take a loss (generally, a capital loss) when it is ultimately determined that the

installment obligation is worthless.

The installment method generally provides that each payment received by the seller in a taxable

year subsequent to the sale year is comprised of three parts: a partial return of the seller's

basis in the property sold, a portion of the gain recognized on the sale and interest. When a

seller reports a transaction on the installment method, the timing of the basis recovery is

dependent upon the terms of the deferred consideration. When either the selling price of the

property or the time period over which the deferred payments are to be received is fixed, the

seller generally recovers its basis in the property sold ratably and reports the associated income

in the year in which the payments are received. The rules are significantly more complex,

however, when both the timing and the amount of any deferred payments is not known.

Contingent Payment Installment Sales

If a seller can compute the maximum possible amount that could be received in an installment

sale (e.g., when an earnout is capped at a fixed dollar amount), the seller is required to compute

the taxable gain when a payment is received based upon an assumption that the seller will

actually receive the maximum possible amount under the agreement. If less than the stated

maximum selling price is received, this method defers the seller's recovery of basis, as

compared to a scenario where the full payment schedule is known.

If there is no stated maximum selling price but the time period during which payments will be

received is fixed (e.g., when an uncapped earnout is scheduled to be paid following each of the

three fiscal years following closing), a seller may only recover the basis in the property sold in

equal annual increments during the scheduled time period of payments. In a typical situation
where the payments received by the seller are front loaded, this method can result in a

significant acceleration of taxable gain.

Finally, if there is no stated maximum selling price nor a fixed time period during which

payments will be received (e.g., when an uncapped earnout is contingent on the achievement of

certain milestones rather than payable during a fixed time period), the seller may only recover

basis in the property sold in equal, annual increments over 15 years. Once again, when the

payments received by the seller are front loaded, this method of basis recovery may result in a

significant acceleration of taxable gain.

If the gain recognized with respect to a particular sale pursuant to the application of these rules

will distort the seller's income over time, the seller may seek a ruling from the Internal Revenue

Service (IRS) to permit an alternative means of basis recovery or apply an "income forecast"

method, with respect to the sales of certain types of property (e.g., mineral property, motion

picture film, television film or taped television show).

Interest Charge on Installment Obligations in Excess of $5 Million

If, at the end of a particular taxable year, a seller holds installment obligations that, in the

aggregate, exceed $5 million, the seller is required to pay an additional tax akin to an interest

charge on the tax liability deferred as a result of the installment method. If an installment

obligation is not contingent, interest is generally payable at the federal short-term rate (currently

0.32 percent) plus 3 percent on the product of (i) the maximum capital gains rate in effect for the

seller and (ii) the amount of gain deferred with respect to the portion of the installment obligation

that exceeds $5 million. Thus, if a seller sold property with a basis $800,000 in exchange for an

$8 million installment obligation, for each taxable year during which such installment obligation

remained outstanding, the seller would be required to pay interest on the product of (i)

maximum capital gains rate applicable to the seller, currently 20 percent for individuals and 35
percent for corporations, and (ii) $2.7 million (three-eighths of the total $7.2 million gain).

Depending on how the deferred consideration is structured, this interest charge can significantly

reduce the present value of the seller's net after-tax cash proceeds.

Interest Charge on Contingent Payment Installment Obligations

When the installment obligation does not provide for the payment of a fixed amount, the

application of this interest charge is not clear. The Internal Revenue Code directs the U.S.

Secretary of the Treasury (Secretary) to prescribe regulations as may be necessary to carry out

the interest charge provisions in the case of contingent payments. However, the Secretary has

not yet proposed or promulgated any such regulations in the 26 years that have passed since

the provisions were enacted.

Assuming that contingent payment installment obligations are subject to the interest charge

provisions (despite the fact that no regulations have been issued) a seller could assert that the

formula to compute the amount of the interest charge yields zero because the face amount of a

wholly contingent installment obligation is undefined. The IRS, however, has asserted that even

without any regulations, contingent payment installment sales are subject to the interest charge

provisions. In support of its position, the IRS has argued that failing to apply the interest charge

provisions to contingent payment installment obligations would result in sellers who elect out of

the installment method and are required to value and report contingent payments in the year of

sale paying more tax than sellers who use the installment method to defer their tax liability.

Informal IRS Guidance on Contingent Payment Installment Obligations

Although the IRS has been clear in its position that the interest charge provisions should apply

to contingent installment obligations, it has been much less clear in defining how the provisions

should apply. In the absence of regulations, the IRS has asserted that sellers may use any
reasonable method of calculating the deferred tax and interest on the deferred tax liability with

respect to contingent payment installment obligations.

In informal guidance, the IRS has indicated that sellers may report (and pay on a current basis)

the interest charge based on an assumption that the maximum amount will be received under

the installment obligation. Alternatively, sellers may simply wait and use the amounts actually

received to calculate the actual amount of tax deferred and use that amount as the basis upon

which the interest is computed and paid (the look-back method). Paying the interest charge on

a current basis, while assuming that the full amount of any contingent consideration will be

received, accelerates payments to the IRS when cash may not be available from the sale and

could also result in interest being paid on amounts never received. This could significantly

reduce the present value of the after-tax proceeds to the seller; hence, the remainder of this

discussion focuses upon the application of the look-back method.

Application of the look-back method should account for the benefit of the $5 million threshold

amount that is excluded from the interest charge provisions. Because the total "face amount" of

a contingent payment installment obligation cannot be determined for purposes of determining

the amount by which the face amount of the installment obligation exceeds $5 million, the IRS

suggested that a seller treat the first $5 million of payments received after the year of sale as

exempt from the interest charge provisions. The tax liability attributable to the gain on payments

received in the year(s) subsequent to the year of sale in excess of $5 million is subject to the

interest charge.

With respect to these subsequent payments, the deferred tax liability is determined by

multiplying the portion of the payments received that represents gain (the total amount of the

payments received less any imputed interest and the amount of the basis in the property sold

that is allocable to the taxable year) by the maximum capital gains rate applicable to the seller.
This deferred tax liability is then multiplied by the relevant rate in effect for the month with or

within which the taxable year ends to obtain the amount of interest due. Additional interest on

the interest is calculated for the period beginning on the due date of the seller's return for the

taxable year in which the sale occurred and ending on the due date for the seller's return for the

taxable year immediately preceding the taxable year in which the relevant principal payment

was received (the interest period).

Although arguably this method for applying the interest charge provisions to contingent payment

installment obligations is reasonable, it has only been discussed by the IRS in informal non-

precedential guidance. As a result, sellers should be wary as they consider applying it to their

own circumstances because there is nothing that binds the IRS to this method.

Takeaway—Choosing a Method

A seller who accepts contingent consideration should carefully consider the manner in which the

seller intends to report the transaction for tax purposes. If the seller elects out of the installment

method and takes into income any deferred consideration in the year of sale, the seller must be

prepared to report as income the fair market value of any right to receive contingent payments.

By electing out of the installment method, however, the seller will not be subject to the interest

charge provisions. If the amount reported as income with respect to the contingent

consideration is not ultimately received, the seller should understand that the only recourse may

be to report a capital loss when the installment obligation is ultimately determined to be

worthless.

If, on the other hand, the seller decides to report the transaction on the installment method, the

fair market value of the right to receive the contingent payments does not need to be

determined. The seller must instead evaluate the application of the interest charge provisions.

If the seller does not apply an interest charge with respect to the contingent consideration, the
IRS could challenge that position. If the seller takes a more conservative approach and uses

the look-back method to apply the interest charge provisions, the IRS should be less likely to

challenge the approach because it has acknowledged the reasonableness of the look-back

method in informal guidance. Nevertheless, the seller should be aware that there is no

precedential guidance authorizing the look-back method.

As sellers agree to accept contingent consideration, they should be aware of the options

available to report any income associated with the sale and ensure that, regardless of the

manner in which they intend to report the transaction for income tax purposes, the structure

does not give rise to any unanticipated tax risk. There may be alternative structures for the

transaction that result in greater certainty as to the present value of the seller's after-tax

proceeds.