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Guidance from the IRS allowed one partnership involved in a sale tied to earn-outs to use an alternative method of basis recovery to accelerate tax benefits.
Robert Willens, CFO.com | US
January 18, 2011
The global financial crisis was part of the reason the Internal Revenue Service allowed an investment advisory firm to use an alternative method of basis recovery to speed up its recovery. Described in a private letter ruling released last September, the guidance, which concerns a contingent payment installment sale — or earn-out — is relevant for corporate taxpayers involved in such deals today.
In the letter ruling, the IRS explains that a domestic partnership (an investment adviser), dubbed PS for purposes of this example, entered into an agreement to sell its business and certain assets ("the acquired assets") to another corporation (the buyer). Under the terms of the purchase agreement, the buyer agreed to assume certain liabilities and pay PS a contingent purchase price. The contingent purchase price consisted of three earn-out payments. The payment for each earn-out period equaled "Y%" of "net client revenues" with respect to the earn-out period, and there was no ceiling on the earn-out payments.
An earn-out is an incentive offered to key employees of a target company to entice them to stay with the acquired company and drive value. Essentially, if the target company hits profit goals set by the buyer, the individuals get a piece of the profit. PS was an investment adviser and its earnings, therefore, were a function of "assets under management."
In the IRS letter, PS was paid an earn-out payment of "$d" for the second year of the payment. However, for the third year of the earn-out period, PS's earn-out payment was only "$h," a lesser amount. This lower earn-out was a result of two market factors: the decline in the securities market and the loss of a significant number of customers. In addition, PS noted there would be no earn-out payment in the fifth year (pertaining to the year 4 earn-out period) because of the loss of customers and the "financial crisis."
But PS was not satisfied with tax implications, and argued that the normal basis recovery rule (with respect to the installment sale of the acquired assets) would "substantially and inappropriately" defer recovery of its basis. Accordingly, PS requested that the IRS allow the partnership to use an alternative method of basis recovery. Under the alternative method, PS proposed to allocate "$d" of basis to year 3, the remaining basis dollars to year 4, and zero to year 5. The IRS granted PS's request (see LTR 201002006, September 29, 2009).
Contingent Payment Rules
Based on the tax code's Regulation Section 15a.453-1(c)(1), a contingent payment sale is defined as a sale or other disposition of property in which the aggregate selling price cannot be determined by the close of the taxable year in which such sale or disposition occurs. The transaction in the letter ruling constitutes a contingent payment sale. Unless the taxpayer makes an affirmative election, contingent payment sales must be reported using the installment method.
Further, Regulation Section 15a.453A-1(c)(3)(i) says that when a stated maximum selling price cannot be determined as of the close of the taxable year in which a sale occurs (the case here), but the maximum period over which payments may be received under the contingent sale price arrangement is fixed (again, the case here), the basis is allocated to the taxable years in which payments may be received in equal annual increments.
In addition, Regulation Section 15a.453-1(c)(7)(ii) provides that the taxpayer may use an alternative method of basis recovery if the taxpayer is able to demonstrate that application of the normal basis recovery rule would substantially and inappropriately defer recovery of basis. In such a case, the taxpayer must show two things:
— the alternative method of basis recovery is a "reasonable" method and
— it is reasonable to conclude that, over time, the taxpayer likely will recover basis at a rate twice as fast as the rate at which basis would be recovered under the normal method of recovery.
In making this determination, the taxpayer may rely upon contemporaneous or immediate past relevant sales, profit, or other factual data that are subject to verification. Ordinarily, the taxpayer is not permitted to rely on projections. However, in some circumstances, a reasonable projection may be acceptable based upon a specific event that has already occurred. This exception covered PS's case.
Thus, the IRS ruling concludes that PS has convincingly shown, based upon the decline in the value of its assets under management (the partnership was an investment adviser), the loss of significant customers, and the financial crisis, that it is reasonable to assume it will not receive an earn-out payment in year 5. Accordingly, PS may use its alternative method of basis recovery and, in the process, recover its basis much more rapidly (at least two times more rapidly) than it would have had it been forced to use the normal method of basis recovery.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.