It goes without saying that when a taxpayer disposes of property in a taxable sale or exchange, the gain realized on the sale will be subject to tax. Depending upon the nature of the asset disposed of, the gain may be taxable at ordinary or at capital gain rates.
It is also generally understood that if the property is sold for one or more deferred payments—payments of purchase price that are made after the year in the which the disposition occurs—the taxpayer’s recognition of the gain realized on the sale may be deferred, under the installment method, until such time as the payments are actually received (regardless of the seller’s method of accounting).
In many cases, these deferred payments are evidenced by a promissory note. The note will be payable over a term of years, may be secured by the property sold, and may be guaranteed by another person (typically, the buyer’s parent corporation). Generally, it will bear a rate of interest that may or not be payable currently. The interest is taxed as ordinary income (up to a rate of 43.4% for individuals), while the principal is usually taxed as capital gain (up to a rate of 23.8% for individuals).
In other cases, the deferred payments of purchase price are not accompanied by a payment of stated interest (though in the case of an escrow account, the earnings thereon will typically follow the “principal”). Taxpayers are often surprised to see that, in these situations, the IRS will treat part of the purchase price (part of the principal, if you will) as interest for tax purposes. In other words, they are surprised to see that what otherwise would have been taxed to them as capital gain purchase price is, instead, treated as ordinary interest income. This interest is referred to as “imputed interest.”
Their surprise sometimes turns to shock when interest is imputed despite the fact that the sales price is not only deferred, but is, in fact, contingent on future events. They are incredulous that interest would be imputed under such circumstances. After all, they say, the reason for a contingent purchase price arrangement was because the parties could not agree upon the total sale price as of the sale date. This will often be the case in the sale of a closely held business; for example, parties will often provide for adjustments to, and subsequent payments of, purchase price based upon an earn-out because they cannot agree on the level of performance that the business will attain during the years immediately following the sale. How then, they say, can interest be imputed when the payment was not even determinable at the sale? This shock is exacerbated when a well-advised buyer issues an information return to the seller reflecting the seller’s receipt of ordinary interest income (the payment of which may be deductible by the buyer).
The IRS Considers Contingent Payments
The IRS considered a complex contingent payment arrangement in a recent ruling. In accordance with a merger agreement, Acquiring merged with and into Target (“Merger”), with Target as the surviving corporation (a stock sale). Before the Merger, Acquiring was a wholly-owned subsidiary of Taxpayer. Pursuant to the merger agreement, Target became a wholly-owned subsidiary of Taxpayer, and the equity interests of its members (“Record Date Members”) were cancelled and automatically converted into the right to receive consideration representing a portion of the purchase price.
Taxpayer agreed to pay Purchase Price to the Record Date Members. The Purchase Price was payable over five years. The Purchase Price would be adjusted upward or downward (based upon certain performance criteria) on each of five adjustment dates (“Adjustment Dates”), producing five adjusted purchase prices (“Adjusted Purchase Prices”).
Each Record Date Member would receive a percentage of each of the five Adjusted Purchase Prices (“Future Payments”) annually on or before five corresponding payment dates (“Payment Dates”).
Simple interest would be computed on Adjustment Date 5 as if it had accrued on the five unpaid balances of the final Adjusted Purchase Price determined immediately before the five Future Payments. The Interest would be computed as if it had accrued over five computation periods (one for each Payment Date at five variable annual rates (one for each computation period) with each rate based on the ten-year United States Treasury bond rate. The Interest would be paid in a balloon payment as part of the fifth Future Payment on or before Payment Date 5.
The IRS stated that, in the case of any payment under any contract for the sale or exchange of property that provides for one or more payments due more than one year after the date of the sale or exchange, where the contract does not provide for adequate stated interest, there shall be treated as interest that portion of the total unstated interest under the contract which is properly allocable to such payment (so-called “imputed interest”). Thus, the unstated interest is not treated as part of the amount realized from the sale or exchange of property (in the case of the seller), and is not included in the purchaser’s basis in the property acquired in the sale or exchange (though it may be deductible by the purchaser).
As a rule, a contract has adequate stated interest if the contract provides for a stated rate of interest that is at least equal to the “test rate” – generally, based upon the AFR – and the interest is paid or compounded at least annually.
However, because the merger agreement provided for one or more contingent payments, even if it had provided for adequate stated interest, the IRS concluded that the imputed interest rule applied to the merger agreement. Thus, all of the non-contingent payments under the overall contract would be treated as if made under a separate contract (as a separate debt instrument), with the imputed interest being accounted for annually on the basis of the so-called “OID rules.” On the other hand, each contingent payment under the overall contract would be characterized as principal and interest. Specifically, a contingent payment would be treated as a payment of principal in an amount equal to the present value of the payment determined by discounting the payment at the test rate from the date the payment was made to the issue date. The amount of the payment in excess of the amount treated as principal under the preceding sentence would be treated as a payment of interest, and would be taken into account by the seller under its regular method of accounting.
It’s Just Dollars – Plan For It
As we have said many times, every sale transaction is about economics– the seller decides to sell a property because the seller expects to end up with a certain level of net proceeds. Toward that end, the tax liability arising out of the sale must be considered in pricing the transaction. Only in this way can the seller hope to arrive at the desired net economic result.
In considering the tax cost of a transaction, it is imperative that the seller consider the application of the imputed interest rules, especially where the seller is an individual, an S corporation, or a partnership/LLC with individual owners. As to these taxpayers, the 19.6% differential between the capital gain and ordinary income rates can have a significant economic impact that must not be overlooked. While it would appear simple enough to provide for the actual payment of interest in respect of the contingent purchase price, buyers will rarely agree to such interest (and a seller’s attorneys rarely ask for it).
At the end of the day, it’s all about dollars and negotiation – which means there may be a way to reduce the impact.