Installment Sale - Electing Out and Contingent Payments

Electing Out and Contingent Payments

One of the primary reasons that sellers elect out of the installment method is the harsh treatment of contingencies in the regulations accompanying IRC 453. Contingent payments are common in some types of installment sales, where, for example, payments are based on the actual rather than the expected profitability of the item sold (typically some percentage of the future profits). Where the contract calls for contingent payments, the regulations recognize three possibilities.

First, the contingent payments may be subject to a stated maximum selling price, e.g., "5% of future profits up to a maximum of $1,000,000." In this case, the regulations require the seller to calculate the profit ratio by assuming that the maximum will actually be reached. As compared to a situation where the maximum in fact is not reached, this requirement has the effect of increasing the profit ratio and thus the gain reportable for each year, deferring recovery of basis. Any deficiency between the actual amounts received and the stated maximum selling price will result in unrecovered basis, for which no loss may be reported until there is no more right to future payments.

Second, if there is no maximum selling price, the contingent payments may be subject to a finite duration, e.g., "5% of future profits for ten years." In this case, the regulations require the basis to be apportioned ratably over the years in which payment can be received. Basis that is not used in one year is carried over to the next year. Especially if the item sold declines in profitability over the stated finite duration, it is possible that there will be unrecovered basis at the end of the period, for which no loss may be reported until that final year.

Finally, there may be neither a maximum selling price nor a finite duration. In this case, the first step is to consider whether there is a sale at all; the transaction may in fact be for rent or royalties, since beneficial ownership arguably remains with the seller. However, if there is in fact a sale, there are two possibilities. First, the transaction may be subject to the judicial "open transaction doctrine" of Burnet v. Logan. Almost no sales are subject to this doctrine because it is applicable only to unusual and rare sales that are wholly speculative and impossible to value. If the open transaction doctrine applies, the taxpayer may completely recover basis before reporting any gain. This is by far the best tax treatment for the transaction, but it is likely to be attacked by the IRS and in most circumstances would not be sustained.

More likely, a contingent sale in the third category would be a closed transaction. This is the worst case scenario. In this case, basis is allocated ratably over a fifteen-year period, but unused basis is not simply carried forward into the next year; instead unused basis is re-allocated over the balance of the 15-year term. No loss may be reported until the final year.

In all three of these scenarios, there is the possibility that there will be unrecovered basis on the back end of the transaction resulting in a capital loss. If, for example, the seller is an individual who is retiring off of the proceeds of the sale, the capital loss on the back end would be almost worthless (except to the nominal extent usable against ordinary income).

The alternative is to elect out of the installment method. In that case, the seller reports the fixed amounts (taking original issue discount into account for future fixed payments) plus the fair market value of the right to contingent payments. The taxpayer pays tax up front in the year of the sale on this total amount realized. The taxpayer then has a basis in the right to contingent payments equal to the amount reported as fair market value. The good news here is that the seller gets a little piece of the open transaction doctrine, and may fully recover basis in the contingent piece of the sale before reporting any additional contingent payments in future years. Where the profit ratio would have been high anyway and the fair market value of the contingent payments are low, the taxpayer may experience favorable consequences by effectively paying a little more tax up front and in return getting the first crop of contingent payments tax-free, while eliminating the risk of an unusable future capital loss.

Whether or not the seller elects out, the total net gain or loss reported will be the same, but timing and characterization can vary widely.