Tax Consequences of Contingent Payment Transactions (Portfolio 566)

Tax Management Portfolio, Tax Consequences of Contingent Payment Transactions, No. 566, focuses on the transfer of a business for consideration contingent on the future performance of the business. To view this Portfolio, visit Bloomberg Tax for a free trial.

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Description

Tax Management Portfolio, Tax Consequences of Contingent Payment Transactions, No. 566, focuses on the transfer of a business for consideration contingent on the future performance of the business. Part II explores taxable sales, which generally are governed by the installment sale rules, unless the seller elects out of the installment method. If the seller elects out of the installment method, the sale is generally taxed as a closed transaction or, in rare cases, as an open transaction. Part III examines reorganizations and §351 transactions where the primary consideration is buyer stock, but a portion of that stock is placed in escrow or is reserved for issuance until a later date. Part IV examines transfers of certain intangible property for consideration contingent on the future productivity of the transferred property, as well as §367(d)(2) transactions. Part V examines the impact of contingent payments in the context of transfers of a business where a former owner is also an employee of the buyer, transfers of a business where a seller retains a contingent interest in the transferred property or receives a contingent proprietary interest in the buyer, and leases and licenses. Part V also addresses contingent value rights (“CVRs”). Finally, Part VI considers various reporting issues. In addition to providing an analysis of the law, this Portfolio contains numerous examples applying the law to specific fact patterns.

Tax Management Portfolios on related topics include:

  • 535 T.M., Time Value of Money: OID and Imputed Interest    
  • 558 T.M., Intellectual Property: Exploitation and Disposition    
  • 565 T.M., Installment Sales    
  • 770 T.M., Structuring Corporate Acquisitions — Tax Aspects

Professor Kwall thanks the following students for excellent research assistance: Katherine Brown, Paolo Santonocito, Alexandra Vozza, Jonathan Whitacre, and Katherine Wilbur.

The Portfolio may be cited as Kwall and Schally, 566 T.M., Tax Consequences of Contingent Payment Transactions.

 

Authors

Jeffrey L. Kwall, Esq.

Jeffrey L. Kwall, B.A., Bucknell University (summa cum laude, 1977); M.B.A., The Wharton School (1981); J.D., University of Pennsylvania Law School (cum laude, 1981); Professor, Loyola University Chicago School of Law (1984–Present); Of Counsel, Schwartz & Freeman and Michael Best & Friedrich (1984–2005); member, American Bar Association, Section of Taxation, Committee on Corporate Tax; member and former chair, Chicago Bar Association, Federal Taxation Committee.

Timothy G. Schally, Esq.

Timothy G. Schally, B.S., Marquette University (cum laude, 1981); J.D., University of Wisconsin Law School (cum laude, 1985); Partner and Chair of the Taxation Group, Michael Best & Friedrich LLP (1985–Present); member and former chair, Taxation Section, Wisconsin Bar Association.


Table of Contents

Detailed Analysis
I. Introduction
A. Scope of Portfolio
B. Reasons for Using Contingent Payments
C. Conceptual Issues
II. Taxable Sales
A. Overview
1. Fixed Payment Sales
a. Single Payment at Time of Sale
b. Payment(s) Beyond Year of Sale
2. Contingent Payment Sales
3. Imputed Interest: OID and Section 483 Rules
B. Installment Sale Treatment: Fixed Payment Sales
C. Installment Sale Treatment: Contingent Payment Sales
1. Stated Maximum Selling Price
2. Fixed Term
3. Neither Stated Maximum Selling Price Nor Fixed Term
4. Income Forecast Method
5. Letter Ruling Relief
a. Taxpayer Requests Alternative Method of Basis Recovery for First Tax Year
(1) Stated Maximum Selling Price
(2) Fixed Term
b. Taxpayer Requests Alternative Method of Basis Recovery for Subsequent Tax Year
c. IRS Requests Alternative Method of Basis Recovery
6. Allocation of Gain/Loss
a. Fixed Payment Sale
b. Contingent Payment Sale
7. Characterization
8. Imputed Interest
a. OID Contingent Payment Rules for “Debt Instruments”
(1) Debt Instruments Issued for Money or Publicly Traded Property
(2) Debt Instruments Issued for Nonpublicly Traded Property
b. §483 Contingent Payment Rules for Sales Excluded from OID Rules
9. Interest Charge on Deferred Tax
a. Fixed Payment Sale
b. Contingent Payment Sale
10. §338(h)(10) and §336(e) Transactions
a. Fixed Payment Sale
b. Contingent Payment Sale
11. Sale of Partnership Interest
12. Treatment of Buyer
a. Allocation of Fixed Payments Among Acquired Assets
b. Impact of Contingent Payments on Basis
c. Timing and Deductibility of Imputed Interest
D. Election Out of the Installment Method: Closed Transaction
1. Consequences at Time of Sale
a. Quantifying Seller's Amount Realized
(1) Fixed Deferred Payments
(2) Contingent Deferred Payments
b. Allocation of Seller's Amount Realized Among Transferred Assets
c. Calculation and Characterization of Seller's Gains and Losses
d. Buyer's Basis in Acquired Assets
2. Consequences of Deferred Contingent Payments
a. Imputed Interest
b. Calculation and Timing of Gain or Loss
(1) Gain Situation — Total Principal Payments Exceed Amount Realized
(2) Loss Situation — Amount Realized Exceeds Total Principal Payments
c. Characterization of Deferred Gain or Loss
(1) Buyer's Obligation Constitutes a Debt Instrument
(2) Buyer's Obligation Constitutes a Contract Right
(a) Sale or Exchange
(b) Capital Asset
d. Impact of Gain or Loss on Buyer
E. Election Out of the Installment Method: Open Transaction
1. Background
2. Consequences at Time of Sale
a. Quantifying Seller's Amount Realized
b. Allocation of Seller's Amount Realized Among Transferred Assets
c. Calculation and Characterization of Seller's Gains and Losses
d. Buyer's Basis in Acquired Assets
3. Consequences of Deferred Contingent Payments
a. Imputed Interest
b. Calculation and Timing of Gain or Loss
(1) Gain Situation
(2) Loss Situation
c. Characterization of Deferred Gain or Loss
d. Impact of Gain or Loss on Buyer
F. Cash Escrow Arrangements
1. Introduction
2. Time of Sale
a. Consequences to Seller
(1) Escrow Is Property of the Buyer
(a) Installment Sale Treatment
(b) Installment Method Does Not Apply
(2) Escrow Is Property of the Seller
b. Consequences to Buyer
(1) Escrow Is Property of the Buyer
(2) Escrow Is Property of the Seller
3. Taxation of Earnings on Escrow
4. Termination of Escrow
a. Consequences to Seller
(1) Payments to the Seller
(2) Payments to the Buyer
b. Consequences to Buyer
(1) Payments to the Seller
(2) Payments to the Buyer
5. Sample Escrow Agreement
G. Impact of Contingent Liabilities
1. Introduction
2. Distinguishing Liability of the Seller from Liability of the Buyer
3. Seller Liability
a. Consequences to Seller
b. Consequences to Buyer
4. Buyer Liability
a. Consequences to Seller
b. Consequences to Buyer
III. Reorganizations and §351 Transactions
A. Introduction
B. Escrow and Contingent Stock Arrangements
1. “Other Property” Under §356 and §351
a. Introduction
b. Carlberg and Hamrick
c. Rev. Proc. 84-42
2. Imputed Interest
a. Escrowed Shares
b. Contingent Shares
3. Tax Basis and Holding Period in Buyer Stock
a. Escrowed Shares
b. Contingent Shares
4. Income Tax Consequences of Return of Shares from Escrow to Buyer
a. Return of Shares to Buyer Based on Value of Shares when Returned; or a Right to Substitute Exists
b. Return of Shares to Buyer Based on Value of Shares at Closing; No Right to Substitute
5. Continuity of Shareholder Proprietary Interest
a. The Continuity Doctrine — In General
b. Escrowed or Contingent Stock — The Problem
c. Escrowed Stock — Analysis and Planning
d. Contingent Stock — Analysis and Planning
6. Miscellaneous Issues
a. §305(b)
b. “Midstream” Acquisitions
C. Contingent Payments of Boot
1. Background: §356
a. Amount of Gain
b. Character of Gain
2. Notes and Contingent Consideration
a. Target Shareholder Receives Acquiring Corporation Stock and Note
(1) Gain and Qualification for Installment Reporting
(2) Basis
b. Target Shareholder Receives Acquiring Corporation Stock, Cash and Notes
c. Target Shareholder Receives Acquiring Corporation Stock, Note, and an Earn-Out Right to Additional Acquiring Corporation Shares
D. Adjustable Conversion Ratio Preferred Stock
IV. Transfers of Certain Intangible Property
A. Introduction
B. Patents (§1235)
1. Scope
2. Treatment of Transferors
3. Treatment of Transferees
C. Franchises, Trademarks and Trade Names (§1253)
1. Treatment of Transferors
2. Treatment of Transferees
D. Transfer by U.S. Person to Foreign Corporation (§367(d)(2))
1. In General
2. §367(d) Transactions Involving Boot or Assumption of Liabilities
V. Alternative Arrangements
A. Earn-Out as Compensation
1. Introduction
2. Basic Principles
3. Examples
B. Earn-Out as Lease or License
1. Introduction
2. Significance
3. Impact of Contingent Payments on Classification of Transaction
C. Co-Ownership
1. Earn-Out as Retained Interest in Seller
2. Earn-Out as Newly Acquired Proprietary Interest
D. Contingent Value Rights
1. Introduction
2. Tax Treatment of CVRs
a. Installment Method
b. Open Transaction
(1) Consequences if Open Transaction Treatment Applies
(2) Availability of Open Transaction Treatment
c. Closed Transaction
(1) Receipt of the CVR
(2) Payments Received Pursuant to the CVR
(3) Debt Instrument
(4) Contract Right
(5) Deferred Payment Contract Sale
VI. Reporting Issues
A. Form 8594 (§§1060 and 338)
B. Form 6252 (§453)
C. Election Out of Installment Method
1. In General
2. Late Elections Out of the Installment Method
3. Revoking an Election Out of the Installment Method
D. Contingent Payment Real Estate Transactions (Reg. §1.6045-4(i)(3))

Working Papers

Table of Worksheets
Worksheet 1 Flow Chart of Alternatives for Taxable Sales With Contingent Payments
Worksheet 2 Summary of Basis Allocation Rules for Contingent Payment Transactions Qualifying for Installment Method Reporting
Worksheet 3 Sample Escrow Agreement with Tax Provisions
Worksheet 4 Selected Transactions Involving Contingent Value Rights (“CVRs”)
Worksheet 5 Preamble and Proposed §468B Regulations on Contingent At Closing Escrows