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Business for Sale Florida

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									           Sale of a Business With an Earnout:
                  The OID and Installment Sale
          Implications of Contingent Liabilities

                             Tax Section, The Florida Bar
                               Tuesday, March 18, 2008
                                      Hosted by
                               Greenberg Traurig, P.A.
                                 1221 Brickell Avenue
                                    Miami, Florida



                                                   Jerry Hesch
Prof. Elliott Manning                              Greenberg Traurig, P.A.
Faculty Chair                                      Miami, Florida
Graduate Program in Taxation                       Adjunct Professor
University of Miami School of Law                  University of Miami School of Law
Coral Gables, Florida                              Coral Gables, Florida

                                                                                       1
        Installment Sale Examples
The purpose of this progression of examples
is to add one element at a time, using the
same basic facts for each example. For
each example, the Seller’s amount realized,
basis and capital gain remain the same.
And, the Buyer’s cost basis for the asset is
generally the same in all of the examples.


                                               2
             Basic principles

• The Seller’s amount realized includes:
   – Cash received;
   – Value of installment note received; and
   – All of the Seller’s liabilities taken over by the
     buyer.
   – Liability Defined: Reg. § 1.752-1(a)(4),
     adopts the ―tax benefit‖ theory.


                                                         3
             Basic principles (continued)
Reg. § 1.752-1(a)(4) Liability defined. – (i) In general.


An obligation is a liability for purposes of § 752 and Reg. §1.752-1 only,
    when,

and to the extent that incurring the obligation,

         (A) Creates or increases the basis of any of the obligor's assets
     (including cash);

        (B) Gives rise to an immediate deduction to the obligor; or

         (C) Gives rise to an expense that is not deductible in computing
     the obligor's taxable income and is not properly chargeable
     to capital.


                                                                             4
          Basic principles (continued)
2. The Buyer’s tax cost (basis) includes:
   a. Cash paid;
   b. Seller’s liabilities taken over by the Buyer;
      and
   c. The Buyer’s new liability incurred when the
      buyer issues an installment note.
      (All fixed liabilities the Buyer incurs as part of the acquisition
      of an asset are part of the Buyer’s basis)




                                                                           5
           Example 1
(a)   Value              $250,000



      Basis (tax cost)   $150,000
      Capital Gain       $100,000
      Mortgage            None
      Equity             $250,000




                                    6
      Example 1 (continued)
(b) Sale on October 1, 2007
   Down payment      $ 50,000
   Installment note $200,000

   Note terms: $50,000 every 12 months (for four
   years) plus 6% annual interest on unpaid
   balance

   Buyer’s tax cost: $250,000

                                                   7
        Example 1 (continued)

(c) Amount realized                $250,000
                                                   Cash         Note
    Less: Basis                     150,000
                                                  $50,000   + $200,000
    Capital gain                   $100,000

                             Gross profit          $100,000
(d)   Gross profit ratio =                    =                = 40%
                             Contract price        $250,000




                                                                         8
              Example 1 (continued)
(e)
                Payment                Principal Payment
       Date     Received   Interest   Basis     Gain (40%)
      10-1-07   $50,000     None      $30,000    $20,000
      9-30-08    62,000    12,000      30,000     20,000
      9-30-09    59,000     9,000      30,000     20,000
      9-30-10    56,000     6,000      30,000     20,000
      9-30-11    53,000     3,000      30,000     20,000

      Total                                     $100,000




                                                             9
          Example 2
(a)   Value              $250,000
      Basis (tax cost)   $150,000
      Capital Gain       $100,000
      Mortgage           $100,000
      Equity             $150,000




                                    10
      Example 2 (continued)
(b) Sale on October 1, 2007
   Down payment       $60,000
   Installment note   $90,000

   Note terms: $30,000 every 12 months (for
   three years), plus 6% annual interest on
   unpaid balance
   Buyer also assumes $100,000 mortgage
   indebtedness
   Buyer’s tax cost: $250,000
                                              11
          Example 2 (continued)
(c) Amount realized              $250,000
                                                 Cash              Note           Liability
    Less: Basis                   150,000
                                               $60,000      +    $90,000    +    100,000
    Capital gain                 $100,000


      Gross         Gross profit               Gross profit                     100,000
(d)   profit   =   Contract price    =   Sale price less liabilities   =
      ratio                                                                250,000-100,000

                   100,000
               =             =      67-2/3%
                   150,000




                                                                                              12
              Example 2 (continued)
(e)             Payment                 Principal Payment
       Date     Received   Interest   Basis     Gain (67-2/3%)
      10-1-07   $60,000     None      $20,000      $40,000
      9-30-08    35,400     5,400      10,000       20,000
      9-30-09    33,600     3,600      10,000       20,000
      9-30-10    31,800     1,800      10,000       20,000

      Total                                       $100,000




                                                                 13
      Example 2 (continued)
The formula for the ―gross profit ratio‖ treats
all liabilities first as a return of basis.

A basis of $150,000 less the $100,000
mortgage, leaves $50,000 of basis
remaining to be recovered as the installment
note principal payments are received.


                                                  14
           Example 3

(a)   Value              $250,000
      Basis (tax cost)   $150,000
      Capital Gain       $100,000
      Mortgage           $170,000
      Equity             $ 80,000




                                    15
       Example 3 (continued)
(b) Sale on October 1, 2007
   Down payment       $20,000
   Installment note   $60,000
   Note terms: $30,000 every 12 months (for two
   years), plus 6% annual interest on unpaid
   balance
   Buyer also assumes $170,000 mortgage
   indebtedness
   Buyer’s tax cost: $250,000

                                                  16
      Example 3 (continued)

(c) Amount realized       $250,000
                                              Cash            Note             Liability
    Less: Basis            150,000
                                             $20,000 + $60,000 +              $170,000
    Capital gain          $100,000


      Gross         Gross profit                          Gross profit
(d)   profit   =   Contract price    =       Sale price less liabilities up to basis
      ratio

                       100,000                  100,000
               =                         =
                   250,000-150,000              100,000


               =   100%

                                                                                           17
      Example 3 (continued)

The first $150,000 of liabilities is a return of the seller’s
$150,000 basis. In addition, there is a fictional payment
of the sale price at the date of sale of an amount equal
to the excess of the liabilities over basis.

                $170,000 > $150,000
                       = $20,000




                                                                18
              Example 3 (continued)
(e)                                       Principal Payment
                   Payment
        Date       Received   Interest   Basis    Gain (100%)
       10-1-07     $20,000     None       —         $20,000
      (down)
      10-1-07       20,000     None       —          20,000
      (fictional
      payment)
      9-30-08       33,600     3,600      —          30,000
      9-30-09       31,800     1,800      —          30,000


      Total                                        $100,000




                                                                19
         Example 4

(a)   Value              $250,000
      Basis (tax cost)   $150,000
      Capital Gain       $100,000
      Mortgage           $141,000
      Equity             $109,000




                                    20
                 Example 4 (continued)
(b) Sale on October 1, 2007

      Proration of property taxes:
            January to Sept (9 months)     $ 9,000
            Oct to Dec (3 months)          $ 3,000
      Down payment                         $40,000
      Installment note                     $60,000

      Note terms:      $20,000 every 12 months (for three years), plus 6%
                       annual interest on unpaid balance

      Buyer agrees to pay all property taxes for the 2007 year when due. The
      property taxes for Jan. – Dec. 2007 are $12,000, and they are due on
      December 31, 2007.




                                                                               21
         Example 4 (continued)
(c) Amount realized         $250,000
    Less: Basis              150,000
    Capital gain            $100,000
                                     Mortgage             Property Tax
       Cash          Note             Liability             Liability
      $40,000   +   $60,000   +      $141,000        +       $9,000


       Gross          Gross profit                             Gross profit
(d)    profit   =    Contract price      =        Sale price less liabilities up to basis
       ratio

                         100,000
                =                            =      100%
                    250,000-150,000

                                                                                            22
      Example 4 (continued)
(e) The seller’s liability for $9,000 of property taxes is
    taken over by the buyer. Thus, the cash to close was
    reduced by $9,000.

    (i)   The Commercial Security Bank case treated this
          $9,000 reduction as if the buyer paid an additional
          $9,000 of cash at closing and the seller then gave the
          $9,000 back to the buyer as payment for the seller’s
          property tax liability for the 9 months during the 2007
          year that the seller owned the property.
          Seller is deemed to pay the $9,000 at the date of the
          sale and deducts $9,000 on 10-1-2007 as a property
          tax payment.

                                                                    23
    Example 4 (continued)
(ii) When Buyer pays $12,000 of property
     taxes on 12/31/07, Buyer only deducts
     $3,000. The other $9,000 is a non-
     deductible payment of the liability the
     Buyer assumed.
(iii)Buyer’s tax cost is $250,000.




                                               24
           Example 4 (continued)
(iv)             Payment                Principal Payment
         Date    Received   Interest   Basis    Gain (100%)
       10-1-07   $40,000      —        None       $40,000
       9-30-08    23,600     3,600     None        20,000
       9-30-09    22,400     2,400     None        20,000
       9-30-10    21,200     1,200     none        20,000


       Total                                     $100,000




                                                              25
                 Example 5

(a)   Value                             $250,000
      Basis (tax cost)                  $160,000
      Capital Gain                      $ 90,000
      Fixed liability to pay            $ 50,000
      environmental clean-up expenses
      (both the obligation and the
      amount are established)
      Equity                            $200,000



                                                   26
      Example 5 (continued)
(b) Sale on October 1, 2007
    Buyer will pay clean-up expenses $ 50,000
    Down payment                  $ 50,000
    Installment note              $150,000

    Note terms:$30,000 every 12 months (for
    five years) plus 6% annual interest on unpaid
    balance


                                                    27
      Example 5 (continued)

(c)   Amount realized         $250,000                                      Fixed
      Less: Basis              160,000           Cash         Note         Liability
      Capital gain             $ 90,000         $50,000   + $150,000   +   $50,000




         Gross                  90,000
(d)                   =
       profit ratio       250,000 less 50,000

                           90,000
                      =
                           200,000

                      =     45%


                                                                                       28
          Example 5 (continued)

(e)(i) Since Seller is deemed to have paid the $50,000
       of environmental remediation costs at the time of
       the sale, the Seller can deduct the $50,000
       expense (assuming it is in the nature of
       maintenance and repairs).
  (ii)    Buyer’s basis is $250,000.
  (iii)   Buyer cannot take a deduction when Buyer pays the
          $50,000 of clean-up costs.



                                                              29
               Example 5 (continued)
(iv)             Payment                Principal Payment
         Date    Received   Interest   Basis     Gain (45%)
       10-1-07    $50,000    None      27,500     $22,500
       9-30-08     39,000    9,000     16,500      13,500
       9-30-09     37,200    7,200     16,500      13,500
       9-30-10     35,400    5,400     16,500      13,500
       9-30-11     33,600    3,600     16,500      13,500
       9-30-12     31,800    1,800     16,500      13,500


       Total                                      $90,000




                                                              30
      Example 6 -- Contingent Liability

(a)   Value                                 $250,000
      Basis (tax cost)                      $150,000
      Potential Capital Gain                $ 100,000
      There is a liability to pay
      environmental remediation costs
      estimated to be $50,000. The
      liability is contingent even though
      the obligation exists because the
      amount is uncertain.                   $ 50,000


                                                        31
       Example 6 (continued)
Contingent liabilities are not taken into
account for Federal income tax purposes as
long as they remain uncertain.

If there is an obligation, but the amount is
uncertain, it is still a contingent liability for
income tax purposes.


                                                    32
      Example 6 (continued)
(b) Seller and Buyer estimate remediation
  costs to be $50,000.
  So, Buyer agrees to pay only $200,000
  cash. Buyer will pay all of these clean-up
  costs in the future.




                                               33
         Example 6 (continued)
(b) Sale on October 1, 2007.
         Sale contract states that Buyer takes property ―as is.‖
         Legal impact: Buyer cannot be reimbursed by Seller
   if clean-up costs exceed $50,000. Seller is not entitled to
   additional payments if clean-up costs less than $50,000.
         Tax impact: Since there is no limit in the sale
   contract on how much the Buyer is responsible, we have
   a contingent liability with no maximum amount. Since the
   sale contract does not address how many years the
   Buyer has undertaken this responsibility, we have a
   contingent liability with no maximum term.
         Reg. §15A.453-1(c)(4) provides that if the seller’s
   legal obligation is shifted to the buyer under these
   circumstances, we have a contingent payment installment
   sale with neither a maximum term nor a maximum
   amount (i.e., Seller recovers basis over an arbitrary 15-
   year period, commencing with date of sale).
                                                                   34
      Example 6 (continued)

(c) Amount realized         $200,000             Cash
                                               $200,000
    Less: Basis              150,000
    Capital gain            $ 50,000

      For Federal income tax purposes both the seller and the buyer do not take
      contingent liabilities into account. Buyer’s basis is $200,000 at this time.

(d)   Clean-up costs paid by Buyer

         Date              Amount
        10-1-08           $37,000
        10-1-09             12,000
        10-1-10              1,000
      Total               $50,000
                                                                                     35
                Example 6 (continued)
(e)       Seller’s income tax treatment

                               Fictional                                                   Principal     Deduction for
                 Payment       Payment         Interest      Principal      Principal     Capital Gain     Clean-up
      Date       Received      Received        Portion*       Portion     Basis portion     portion         Costs
10-1-07          $200,000          --             --         $200,000       $10,000        $190,000            --



10-1-08             --          $37,000         1,762          35,238        10,000          25,238        <35,238>



10-1-09             --           12,000         1,116          10,884        10,000             884        <10,884>



10-1-10             --            1,000           136             864        120,000       <119,136>       <   864>




Note: The artificial $119,136 capital loss reported in 2010 cannot be carried back to offset any of the artificial
      capital gain reported in 2007.

The Buyer can only take a deduction for its interest costs each year.



* Interest is imputed using the 5.0% long-term AFR for October, 2007.


                                                                                                                         36
• Installment Method and Contingent Liabilities
   – Income tax computations are more complex when the transferred
     liability is contingent.
   – There are 4 basic arrangements that give rise to contingent liabilities
     for income tax purposes:
      1. Earnouts
          – The parties to a sale agree on a minimum value, but allow for
            the payment of additional amounts based on the future
            profitability or the future performance of the business.
              » For example, the purchaser must pay a specified
                percentage of future earnings in excess of a agreed-to
                threshold amount.
          – Protects the purchaser from overpaying for the business
            because the post sale performance determines the final sales
            price.
          – Prevents the seller from being short-changed if the business
            performs as the seller expects.
                                                                               37
• Contingent Liabilities
  – Types
     2. Holdbacks
         – The parties agree to hold back a portion of the purchase
           price to cover expected and unexpected future liabilities of
           the business.
            » Occurs particularly when future liabilities cannot be
              determined or reasonably estimated.
         – The purchaser is entitled to receive all or a portion of the
           amount held back at some point in the future if the actual
           liabilities are less that than the amount held back.
            » Essentially leaves seller financially responsible for the
              payment of the undetermined future obligation.

                                                                          38
• Contingent Liabilities
  – Types
     3. Reduction in Sales Price
         – A variation of a holdback - the parties make a
           reasonable estimate of the future liability and reduce
           the sale proceeds by the estimated amount.
         – The buyer is responsible for the payment of the future
           obligation.
             » Bears the economic risk if the actual liability
               exceeds the estimate.
             » Obtains the economic benefit if the actual amount
               paid is less than the amount of the estimate.


                                                                    39
• Contingent Liabilities
  – Types
     4. Escrows
        – An amount is placed in escrow for payment to the
          seller upon the occurrence of a certain event.
            » Examples: Passing a final inspection, obtaining
              a building or zoning permit, etc.
        – Although the amount is held back, it differs from a
          ―hold back‖ since the money is not intended to
          cover future liabilities.
        – While the amount held in escrow is fixed and
          certain, the occurrence of the triggering event is
          not.
                                                                40
• Contingent Liabilities
   – The IRS generally excludes contingent liabilities transferred from
     the seller to the purchaser from the seller’s amount realized and
     the purchaser’s basis until they become fixed (i.e. the sale is held
     ―open‖).
       • Thus, contingent liabilities for non-publicly traded property are
         generally ignored for income tax purposes until a payment is
         made or the amount become fixed (a contingent payment).
   – The types of items that give rise to contingent liabilities are
     frequently covered by representation, warranty or indemnity
     provisions in contracts of sale or exchange. To the extent the
     purchaser is protected by such provisions, the contingent liability
     has not been effectively transferred.
   – Similarly, to the extent the purchaser indemnifies the seller against
     liabilities that are not formally transferred, the liability has been
     effectively transferred to the purchaser.

                                                                             41
• Contingent Liabilities
   – Original Issue Discount (―OID‖) Implications
       • Contingent Payments
          – When a future payment is made in the discharge of a contingent
            liability, a portion of such payment is interest because it is deemed
            a deferred payment related to the prior sale.
          – Determining the Interest Portion of Each Payment
              » Contingent bond method - Divides the debt instrument into two
                parts:
                (1) a noncontingent component consisting of all noncontingent
                    payments on the debt instrument; and
                (2) a contingent component consisting of all contingent
                payments.
                The noncontingent component is treated as a separate debt
                instrument and is taxed under the general OID rules. The
                following will focus on the treatment of the contingent payments.
                                                                                    42
• Contingent Liabilities
  – OID Implications
      • Contingent Payments - Determining the Interest Portion
          – The interest portion of the contingent payment for both the seller and
            the purchaser is determined by discounting the payment back to the
            date of sale using the AFR in effect at the time of the sale.
             » The purchaser’s interest deduction is subject to any applicable
               deduction limitation (e.g., § 163(d), §469, §465, §267).
             » The interest portion of the contingent payment or the fixed amount is
               reported when it is paid or fixed respectively.
          – The remaining amount of the contingent payment is principal. This
            remaining amount is (1) an additional amount realized for the seller and
            (2) added to basis for the purchaser.
          – This method treats a lesser portion of the early contingent payments as
            interest, when compared to computing the interest on the entire stated
            price and deducting it as payments are made (as used for
            noncontingent payments)
                                                                                       43
• Contingent Liabilities
   – OID Implications
      • Example 7:
          – Seller owns all the stock in a closely-held business, with a
            basis of $210,000.
          – The installment sale of the stock is eligible for reporting under
            the installment method.
          – Purchaser agrees to pay $240,000 in cash for the business,
            plus an amount determined by earnout, payable at the end of 3
            years.
          – The short-term, semiannual AFR on the date of sale is 4.15%
            (10/07).
          – Exactly 3 years after the sale, Purchaser pays an earnout
            amount of $4,000.


                                                                                44
• Contingent Liabilities
   – OID Implications                Year        4.15% interest earned   Ending Balance

       • Example 7 continued:         0                 $0.00              $3,540.64
                                      1                $146.94             $3,687.58
                                      2                $153.04             $3,840.62
                                      3                $159.38              $4,000



                                                       $459.36


  – This chart shows the use of a 3-year earnout at 4.15% short-term
    AFR (since the earnout is for three years) and $4,000 is paid at the
    end of Year 3.
  – This chart clearly illustrates how the annual interest is computed.
  – But, all $459.36 of interest is reported in year 3 (the year it becomes
    fixed).
  – So, additional selling price is $3,540.64.


                                                                                          45
• Contingent Liabilities
   – OID Implications
       • Example 7
           – The contingent liability is not taken into account in the year of sale.
           – At the time of the sale, the Seller's amount realized and the
             Purchaser’s initial basis is $240,000.
           – When the $4,000 earnout is paid 3 years later, it is treated as a
             separate OID debt instrument, with a portion treated as interest.
              » At the 4.15% AFR for 3 years, $459 is interest and the
                remaining $3,541 is treated as an additional payment of
                principal for the business.
           – In year 3, Purchaser increases the basis in the business by $3,541
             and deducts $459 of interest, subject to any applicable limitations.
           – In year 3, Seller reports an additional payment of the selling price
             of $3,541 and $459 of interest income.


                                                                                       46
• Contingent Liabilities
   – OID vs. Installment Method
       • Recall Example 7 Facts:
          – Seller owns all the stock in a closely-held business, with a
            basis of $210,000.
          – The sale of the stock is eligible for installment sale treatment.
          – Purchaser agrees to pay $240,000 in cash for the business,
            plus an amount determined by earnout, payable at the end of
            3 years.
          – The short-term, semiannual AFR on the date of sale is 4.15%.
          – Exactly 3 years after the sale, Purchaser pays an earnout
            amount of $4,000.



                                                                                47
• Contingent Liabilities
   – OID vs. Installment Method
       • Example 7 – Installment Method Results
           – Because the earnout is limited by time (3 years) and not by price,
             the maximum term approach applies to determine basis recovery:
              » The seller’s entire basis must be amortized over a 3 year
                period: $210,000 / 3 = $70,000 per year.
           – Year 1: The seller’s capital gain on the receipt of $240,000 would
             be $170,000 ($240,000 - $70,000).
           – Year 2: The seller receives no payments, so no capital gain or loss
             is reported (seller carries forward the unused $70,000 of basis to
             year 3).
           – Year 3: Upon the receipt of $3,541 in principal (determine under
             OID), the seller would report a $136,459 capital loss (($70,000 x 2)
             - $3,541), which can only be carried forward, not back.

                                                                                    48
• Contingent Liabilities
   – OID vs. Installment Method
       • Example 7 – Installment Method Results
          – The net capital gain reported is only $33,541 ($170,000 -
            $136,459).
             » However, the recovery of basis method imposed by
               installment method treatment of this type of contingent
               payment sale creates a substantial artificial capital gain
               in year 1 and an artificial capital loss in year 3 of
               $136,459, which cannot be used to offset the year 1 gain.
          – The required ratable allocation of the seller’s entire basis
            over the 3 year earnout effectively causes his basis recovery
            to be determined solely by the contingent portion of the sale
            proceeds.


                                                                            49
• Contingent Liabilities
   – OID vs. Installment Method
      • Alternative Basis Recovery - Maximum Price
          – Converting a contingent payment sale from a maximum term to
            a maximum price approach may avoid the artificial tax
            distortion described above (e.g., placing a cap on the amount
            of the earnout in addition to the payment term).
          – Recall that under the installment method, the income and basis
            portion of an installment payment is determined by multiplying
            it by the gross profits ratio (gross profits / contract price).
             » For purposes of the maximum price approach, it is assumed
               that the seller will receive (1) the maximum price and (2) all
               contingent payments on the earliest possible date.
          – With this approach, a significantly larger portion of the selling
            price received in the first year can be treated as a tax-free
            return of basis.                                                    50
• Contingent Liabilities
   – OID vs. Installment Method
      • Example 8: Same facts as Example 7, except the parties estimate that
        the maximum earnout will be $10,000.
      • Results:
          – Year 1: For purposes of gross profits, the seller treats both the $240,000
            cash payment and the $10,000 earnout as received at closing.
          – The gross profits ratio is 16%
             » $40,000 (gross profits = $250,000 sales price - $210,000 basis)
               $250,000 (contract price = $250,000 sales price - $0 qualified debt)
          – Seller reports $38,400 of gain (16% of $240,000) in year 1. [recovers
            $201,600 Basis]
          – Seller reports a $4,859 capital loss year 3 [$8,400 remaining basis minus
            $3,541 principal payment].
      • Even though the net capital gain is the same $33,541 as above, the
        approach reduces the artificial gain and loss created under the
        maximum term approach.

                                                                                         51
• Contingent Liabilities
   – No Installment Method of Accounting Reporting
       • Another way to avoid the initial reporting of artificial gain and the
         later reporting of artificial loss potentially imposed by application of
         the installment method is to elect out of installment sale treatment.
       • A seller who elects out of the installment method must report all
         the gain realized on a deferred payment sale at the time of the
         sale.
          – The contingent liability is treated as a liability for Federal
            income tax purposes at the time of sale even though it remains
            contingent.
          – Accordingly, a reasonable valuation of the contingent liability
            must be made in order to determine the amount realized on the
            sale.
          – The purchaser, however, cannot include this as part of his
            basis because it remains contingent.
                                                                                    52
• Contingent Liabilities
   – No Installment Method of Accounting Reporting
       • Example 9: Same facts as Example 8, except that the 3 year
         earnout is estimated at $4,000, with a present discounted value
         of $3,541.
       • Results: Year of Sale:
          – The sales price and the seller’s amount realized equal
            $243,541 ($240,000 cash payment + $3,541 estimated
            earnout).
          – Seller realizes and recognizes gain for the year of the sale in
            the amount of $33,541 ($243,541 sales price - $210,000
            basis).
       • Note that If the actual amount received under the earnout is
         greater or lower than the estimated amount, the difference, as
         adjusted for the OID portion, is additional capital gain or loss,
         reported when the earnout amounts are paid or become fixed.
                                                                              53
       Contingent Liability and Like-Kind Exchange
 A                             Real Estate                           B
140                             Gross Value                         160

 60                           Adjusted Basis                        125

+80                            Potential Gain                       + 35

 35                            Fixed Liability                       60

 5                          Contingent Liability                    none

100          Equity (take the contingent liability into account)    100

           ** However, the contingent liability is not taken into
           account for income tax purposes.


None                          Boot Received                          25

-35                       Decrease in Liabilities                   - 60

+ 60             Increase in Liabilities (not contingent)           + 35

None                         Gain Recognized                         25
 Contingent Liability and Like-Kind Exchange - Continued

                  Basis in Property Received -- §1031(d)
            A                                           B
  $60,000   Adjusted Basis                           $125,000 Adjusted Basis
 + 25,000   Net increase in fixed                   + 25,000 Gain recognized
            liabilities                             - 25,000 boot received
  $85,000                                            $125,000

Taxpayer A                                   Taxpayer B
Prior Potential Gain $80,000                 Prior Potential Gain $35,000
Gain Recognized                     $0       Gain Recognized         $25,000
Unrealized Gain           $75,000            Unrealized Gain         $15,000
                                             ($140,000 minus $125,000)

When B pays the contingent                   When B pays the contingent liability,
liability, A must decrease basis by          B can increase basis by $5,000.
$5,000.



                                                                                     55
          Artificial Bargain Purchased Tax Trap
    X Company is an auto dealership. X Company uses accrual
    method of accounting and LIFO
                  ASSETS                VALUE              CATEGORY
                    Cash               $100,000                  I
                Receivables            $100,000                 III
                  Inventory            $600,000                 IV
                Fixed Assets           $100,000                 V
             Unstated Goodwill         $100,000                 VII
                                      $1,000,000

                                       Liabilities

             Fixed Liabilities                     $ 700,000
             Contingent Liabilities                $ 250,000
                                                   $ 950,000
Owner’s Equity (Taking estimate of
contingent liability into account):                   $50,000


Buyer pays $50,000 cash for all assets and takes the business subject to both
the fixed and contingent liabilities.
Buyer’s basis limited to $750,000.
Buyer cannot take contingent liability as part of basis.

                                                                                56
  Artificial Bargain Purchased Tax Trap - Continued
Buyer’s total basis limited to $750,000
Value of all assets other than goodwill $900,000
But, Buyer limited to allocating only $750,000 to these assets.
Treas. Reg. §1.338-6(b)
      Allocation of $750,000 basis – Residual Method
                         §1060     BASIS      VALUE
          ASSET        CATEGORY   ($1,000)   ($1,000)
           Cash            I        100        100
        Receivables       III       100        100
         Inventory        IV        550        600
        Fixed Assets      V        None        100
         Goodwill         VII      None        100
                                    750       1,000


   When Buyer sells the inventory, Buyer may end up
   reporting an extra $50,000 of ordinary income.


                                                                  57
 Artificial Bargain Purchased Tax Trap - Continued
- When contingent liability is paid by Buyer, then Buyer can
increase the amount paid for the assets of the business by
amount paid (reduced by imputed interest portion).
Assume the principle portion of contingent payment is
$250,000.
- Additional basis can only be added to assets ―in
existence‖ at the time of purchase.
   -Buyer must add to basis of the assets ―in existence‖ at
   time of purchase (inventory) the $50,000 as used LIFO
   (inventory still in existence).
   -So, Buyer will never be able to recoup as a cost of
   goods sold this extra $200,000 of basis.
   -Thus, Buyer adds other $200,000 to Fixed Assets and
   goodwill.
                                                               58
                SHAREHOLDERS IN CORPORATE LIQUIDATIONS
                               Code Sections 453(h), 453B(h)
• When a corporation sells its assets for deferred payments, uses the installment method to defer
the reporting of its gain on the installment sale, and then proceeds to liquidate, normally the
shareholders would not be able to use the installment method to determine the gain on the
liquidation because the purchaser of the corporate assets for an installment note is not the
―purchaser‖ of the stock surrendered in liquidation to the corporation.
• However, Section 453(h) overcomes this technical problem, and specifically allows the use of the
installment method by the shareholders to report their gain realized upon the redemption of their
shares by the corporation, if the corporation’s installment sale of its assets and the liquidation of the
corporation are completed within one (1) year from the adoption of the date of plan of liquidation.
• Further, deferred payments attributable to bulk sales of inventory can qualify, notwithstanding the
general exclusion of inventory from the installment method. When the corporate sale is to a related
party, the exclusion for sales of depreciable property applies.
• The provision only applies to the shareholders, and does not eliminate the corporate acceleration
of gain required under § 453B on the disposition of the installment note by distribution to the
shareholders.
• When the corporation’s installment sale is by an S corporation, in view of the pass-through
income principle, the distribution does not accelerate the gain, but the shareholders characterize
the deferred payments in the same way as the S corporation would.
• But, consider the impact of an election under Section 338(h)(10).


                                                                                                            59
• Estate Planning
  – Estate Tax Valuation Required - even if not
    valued for income tax purposes.
    • If an individual dies owning an installment obligation
      which includes contingent rights such as an earnout,
      the contingent right to receive a payment must be
      valued for estate tax purposes even though the
      contingent right has not been recognized for income tax
      purposes.

    • In Burnet v. Logan, 283 U.S. 404 (1931), the Supreme
      Court noted that contingent rights were valued for
      estate tax purposes in the estate of the taxpayer’s
      mother. The Supreme Court held that similar
      contingent rights are not recognized while contingent
      for purposes of determining gain under the income tax.    60
• Estate Planning
  – Estate Tax Valuation Required - even if not
    valued for income tax purposes.
    • Contingencies may permit discounts to be claimed
      in valuing an installment obligation in the seller’s
      estate.
    • An installment obligation on which gain has been
      deferred and which is included in the seller’s estate
      constitutes income in respect of a decedent.
      Under Reg. § 1.691(a)-4, the transmission of an
      installment obligation by the seller’s estate does
      not cause an acceleration of income. However,
      the use of an installment obligation to satisfy a
      pecuniary bequest causes acceleration.

                                                              61
• Estate Planning
  – Lifetime Planning
    • Under Section 453B, a seller’s gift of an installment
      obligation to another taxpayer generally causes an
      acceleration of gain, necessitating the valuation
      both for gift and income tax purposes of any
      outstanding contingent right due under the
      obligation. However, acceleration of gain does not
      occur with a transfer to a grantor trust the entire
      income (both ordinary and capital gain) of which is
      taxed to the seller. Under Rev. Rul. 85-13, 1985-1
      C.B. 184, the existence of the trust is not
      recognized for income tax purposes. In essence,
      for income tax purposes, no transfer is considered
      to have taken place.
                                                              62
• Estate Planning
  – Lifetime Planning
    • Contingent rights may permit discounts to be claimed in
      valuing the transferred installment obligation for gift tax
      purposes. Consideration might be given to reducing value
      further by placing the installment obligation in a limited
      partnership or limited liability company.
    • Use of techniques involving grantor trusts such as GRATs
      and sales to defective trusts would generally seem to be
      preferred in lifetime planning with respect to such installment
      obligations.
    • Contingent gifts – If the taxpayer gives all rights to the
      earnout, there likely is not a completed gift – see Burnet v.
      Logan under an ―open transaction‖ theory. However, each
      actual payment is a gift of a separate amount, eligible for the
      annual exclusion.

                                                                        63
• Estate Planning
  – Lifetime Planning
    • With a GRAT, it is generally necessary to pay at least a portion
      of each year’s annuity in kind, necessitating the additional
      valuation of the installment obligation while the installment
      obligation remains outstanding. In addition, if the seller dies
      while the GRAT is in existence, the assets composing the GRAT
      at the time of seller’s death are includible in the seller’s estate.
    • These problems do not exist with a sale to a defective trust.
      Payment of the trust’s promissory note can be deferred until the
      installment obligation is paid in full. If the seller dies while the
      trust’s note is outstanding, the promissory note is included in the
      seller’s estate. The assets of the trust are not.
    • Where there may not be sufficient receipts from the contingent
      obligation, it is better to use a sale rather than a GRAT as the
      sale can be structured to require fewer payments in the early
      years.
                                                                             64
• Estate Planning
  – Lifetime Planning
    • In one respect the GRAT may be superior to the sale to a defective trust
      technique and that is in the ability to use formulas. Reg. § 25.2702-
      3(b)(1)(ii)(B) authorizes the use of a formula to describe the value of a
      donor’s retained annuity interest in a GRAT as a percentage of the
      initial fair market value of the assets composing the GRAT.
         – Such a formula affords protection against an undervalue of assets
            conveyed to a GRAT. If the value transferred to a GRAT of
            property is increased, the use of a formula authorized by Reg.
            Section 25.2702-3(b)(2)(B) causes the annuity payable to the
            grantor to be increased. With a zeroed out GRAT, the gift remains
            zero.
         – The Internal Revenue Service is hostile to formula transfers on
            public policy grounds. Reg. Section 25.2702-3(b)(2)(B) precludes
            the Service from challenging the use of a formula to describe
            payments from a GRAT.
         – Because of the uncertainties with a contingent obligation, the
            GRAT formula may be able to approximate the GRAT payments to
            the amount received each year.
                                                                                  65
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