# Ruling Outlines Proper Treatment of Earn-Out When Sale Eventually Determined to Be a Loss Event Due to Failure to Meet Earn-Out Milestones

When a taxpayer sells a business the sales price often is both payable over time and, rather than being a fixed amount, ends up being a number based on the performance of the acquired business. The latter is most often referred to as an “earn-out” provision and most often extends over a period of years.

In PLR 201451004 the situation above was complicated by the fact that while the seller (who sold stock of a subsidiary) originally expected to have a gain on the disposition, in year three it was determined that none of the earn-out targets would be met, resulting in proceeds of sale that would be less than the taxpayer’s basis in the stock sold.

When the sale took place the taxpayer treated it as an installment sale. To be treated as an installment sale under IRC §453 generally there must both be payments received in more than one tax year and there must be a gain on sale. As always, the gain computed is the excess of the selling price over the taxpayer’s basis.

When contingent installment payments are involved (as they will be in an earn-out situation) the seller computes his/her selling price as the maximum amount possible under the contract if such a maximum exists, as it did in this case. [Reg. §15a.453-1(c)(2)] Based on that computation, the taxpayer determined there was a gain on sale.

Using that maximum selling price, the taxpayer reported gain in the first year using the following formula:

In the second year events that had occurred made it impossible to achieve the original maximum selling price. Under Reg. 15a.453-1(c)(2)(iii) (see Example 5) the taxpayer recomputes the new revised maximum selling price and a new gross profit percentage. The taxpayer first computes the remaining unrecognized gain using the following formula:

The new gross profit percentage then becomes:

This percentage was then used to report the principal received in Year 2.

In Year 3 events occurred that insured, in fact, none of the earn-out milestones would be met. Thus, the actual sales price would be the minimum selling price in the original agreement, which was less than the taxpayer’s basis in the stock. The remaining unpaid balance would be paid in Year 4.

The PLR determined that the taxpayer should recognize a loss in Year 3. Year 3 was the year in which the identifiable events occurred that established the true amount that would be received under the agreement. [Reg. §1.165-1(d)(1)]

The loss under IRC §165 would be computed as follows:

Note that a loss would be triggered at the point where the remaining maximum amount to be received under the agreement would exceed the remaining basis. That would be true even if the amount might be further reduced in later years—in that case an additional loss would be triggered in later years based on the reduction of the maximum price.

As well, note that the regulation cited above requires this recognition occur in the year when the identifiable events occur—thus on exam an agent may question whether, in fact, the loss related to an earlier (likely closed for claims for refund) year, making it very important to document each year the taxpayer’s rationale for the computation of the current maximum price remaining on the installment note.