The tax bill recently enacted by Congress includes a provision which prohibits the use of the installment method of accounting for dispositions of property by taxpayers using the accrual method of accounting. Under the installment method, if a seller of property receives a note providing for installment payments to be paid in subsequent years, the seller generally is entitled to report any gain from the sale on a pro rata basis as installment payments are received each year. As a result of this new amendment, sellers that are on the accrual method of accounting (i.e., all public corporations, most private corporations, and many partnerships and limited liability companies), will not be entitled to use the installment method. Instead they will be required to include all of the gain from the sale as if the total amounts due under the installment note had been received in the year of sale.
The new rule should lead accrual basis taxpayers to carefully plan sales of significant assets and ascertain that they receive or otherwise have in reserve sufficient cash to pay the resulting federal and state income tax liabilities. This concern is demonstrated by the following example.
Corporation T utilizes the accrual method of accounting. It owns assets with an aggregate value of $2,000,000 and an aggregate tax basis of $500,000. P is interested in buying T.s assets. On December 31, 2000, T sells all of its assets to P in exchange for $250,000 in cash and an installment note with a face amount of $1,750,000 payable in level amounts (including principal and interest) on December 31st over each of the next three years. T has a taxable gain in the year 2000 of $1,500,000 ($2,000,000 amount realized less $500,000 tax basis). Assuming a combined federal and state effective tax rate of 40%, the sale triggers taxes of $600,000. T does not receive sufficient cash to pay the tax liability in full and may be forced to borrow money to pay the remainder of the tax.
Individuals and other cash method taxpayers may continue to use the installment method, subject to current rules. Accordingly, individual shareholders of a corporation that utilizes the accrual method will still be able to use the installment method of reporting when selling stock of the corporation. However, a stock sale may result in lower sale proceeds for the seller because the buyer will not obtain an increased tax basis in the corporation.s assets. If the corporation were to sell assets, the buyer would obtain a .stepped-up. basis in the assets, including goodwill and other intangibles. The prohibition against using the installment method could apply in the case of a sale by individuals of stock of a subchapter S corporation for which an election is made under section 338(h)(10) to treat the transaction as a deemed sale of assets.
As applied to partnerships that utilize the accrual method, the new amendment will encourage sellers who are individuals to sell partnership interests, rather than assets, on installment. The buyer of partnership interests may obtain an increased basis in the partnership.s assets. However, there is a risk in some circumstances that the IRS could treat the transaction as a sale of assets by the partnership and deny the use of the installment method.
This new prohibition will also affect the treatment of .earnouts. . payments based on the earnings of the sold entity. The seller may want to take the position that the earnout is so contingent that it is not accruable in the year of receipt and is subject to .open. transaction treatment -- that is, gain is not reported until the contingent payments actually received exceed the tax basis of the sold property. However, the IRS takes the position that the .open. transaction doctrine applies only in .rare and extraordinary. cases and that contingent notes generally must be valued in the year of receipt. Additionally, the buyer may want the seller to value the earnout in the year of sale in order to protect the buyer.s step-up in tax basis in the purchased assets.
New entities may want to consider the new rule in determining whether to adopt the cash or accrual method of accounting. Existing entities may also want to consider changing to the cash method if permitted.
There may be more legislative developments in this area, as lobbyists have complained that the new prohibition on the use of the installment method should not apply in the case of a once-in-a-lifetime sale of assets by a closely-held business.
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The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require and further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative.