A seller closing a deal in 2020 with a material amount of deferred consideration — whether funds in escrow, fixed payments over time or a contingent earn-out based on the sold company’s post-close performance — may want to consider electing out of the installment method as a way to lock in gains at 2020 capital gain rates.
Gain and Installment Treatment
A seller who sells stock held for more than 12 months is taxed on gains at long-term capital gain rates, currently 20%. If part of the consideration will not be received until a subsequent year, then installment treatment automatically applies, unless the seller elects out of the installment method. Calculation of gain is complicated. Generally, a seller offsets a certain percentage of the basis in the stock sold against each expected payment — depending on many factors, including whether such payments are contingent or have a cap — resulting in taxable gain each year. That future gain is taxed at the long-term capital gain rate that applies in the year of payment, not the rate that applied when the stock was sold. Therefore, if an earn-out is paid in 2021 and 2022, the long-term capital gain rate in those years will apply to the gain, as if the stock was sold in those years.
Seeing Into the Future
Installment sale treatment is the default. A seller may elect out of the installment method, however, and choose to recognize all of the gain in the year of sale, applying the long-term capital gain rate in that year. Payments on the installments are, of course, not taxed a second time (but see the discussion of fair market value below).
The rules on making the election allow a seller to see a little way into the future before committing to the year of taxation. The election must be made on or before the due date (including extensions) for filing the seller’s return for the taxable year of sale. A seller generally will have, then, until October 15 of the year following the sale to decide. Note, however, all taxes for the year of sale are due April 15, so a seller will still need to make adequate deposits by then or risk substantial penalties.
Conditional or protective elections, however, are not allowed. Late elections are not allowed without IRS consent. A seller may not revoke an election without IRS consent.
The Risks of the Future
If a seller elects out, and the future payments are fixed (e.g., a fixed amount each year in the two years following sale), the seller will recognize gain based on the full purchase price in year of sale. In practice, this calculation is straightforward: Gain equals the entire amount payable, whenever paid, less basis (except that if the deferred payments do not bear interest, a portion of them will be recharacterized for federal income tax purposes as interest income, which will accrue over the period of the deferred payments).
If future payments are contingent (e.g., on performance of the company after sale), then a seller recognizes gain in the same way, based on the fair market value of the earn-out. A seller will need to determine that fair market value.
This project should be approached with caution. Consider:
- What is the likelihood of payment based on the metrics? What is the credit quality of the payor? What is the interest rate environment?
- What other parts of the transaction are dependent on that value? Could underestimating or overestimating the value undermine a position taken in the transaction for regulatory, litigation, contractual or other purposes? What is the accounting position of the buyer on the value?
- Will a position taken on fair market value now cause regret in a future dispute about that earn-out?
- Given the ability to make the election in October of the year following sale, does the seller already have sufficient data to estimate the earn-out?
- What supporting material does the seller have if the IRS disagrees with the value?
In all cases, recall that if the IRS reviews the fair market value, it will likely be after all the payments are made so that the IRS will have the benefit of hindsight. The IRS may be inclined to question a determination of an earn-out’s fair market value at the time of the sale that turns out to be a great deal less than what is ultimately received. When the IRS reviews it, the IRS knows the outcome. When a seller decides how much gain to recognize in the year of sale, the seller does not know the outcome.
If payments eventually exceed the amount taken into account in computing gain in the year of sale, those payments should largely be taxed at the long-term capital gain rate, though the one that applies when the payment is received.
If payments eventually are less, or the buyer defaults on the obligation, the seller will recognize a capital loss in the year the payment would have been received (subject to rules on when disputed losses may be taken). While a seller may ask the IRS to revoke the election, there is high risk the IRS would not do so, or the years affected would not still be open for the seller. A seller should certainly not plan on being able to revoke the election.
These rules are relatively flexible and should give 2020 sellers some ability to see into 2021 and 2022 before a decision on 2020 is made (and again taxes for 2020 are due before the election must be made). Sellers should consider carefully the nontax consequences of estimating contingent earn-outs.
Installment treatment is not allowed on every sale (in particular, it is not allowed on a sale of publicly traded securities), so a seller should consult a tax adviser to determine correct reporting. We have assumed the deferred payments are not transferrable, tradeable or otherwise liquid. Also consider the consequences of the Medicare investment tax and estate planning. Interest, implied or otherwise, on earn-out payments and other deferred payments is treated differently and not addressed here.