Alternative installment basis method avoids deferred recovery

Plain-English summary

An S corporation shareholder received an initial merger payment and rights to three later payments determined by the buyer's stock price. When that stock price declined, allocating basis equally over the four-year installment period would have produced a disproportionately large first-year gain and a large loss in the final year. The shareholder proposed allocating basis to each installment according to its proportion of estimated total proceeds. The IRS determined that the method was reasonable and would recover basis more than twice as fast as the normal rule. It approved the alternative basis recovery method.

Ruling snapshot

• Question: May the shareholder use proportional basis recovery for the contingent installment payments received in the merger?
• Outcome: Approved
• Key authorities: IRC § 453; Temp. Treas. Reg. § 15A.453-1(c)(7)(ii)

Full text (IRS public release)

Internal Revenue Service                        Department of the Treasury
                                                Washington, DC 20224

Number: 201626010
Release Date: 6/24/2016
Index Number: 453.09-01
                                                Person To Contact:
---------------                                 ----------------------, ID No. ----------------
--------------------                            Telephone Number:
--------------------------------                --------------------
                                                Refer Reply To:
                                                CC:ITA:B05
                                                PLR-134943-15
                                                Date:
                                                March 17, 2016

TY: ------
Taxpayer: ---------------
Year 1: ------
Year 2: ------
Year 3: ------
Year 4: ------
Company A: --------------------------
Company B: ------------------
e%: ----------
$f:     ----------------
$g:     --------------
$h:     ---------
$i:     -------
$j:     -------------
$k:     ----------
$l:     ----------
$m: --------------
$n:     --------------
$o:     --------------
$p:     --------------

Dear ---------------:

This is in reply to the Taxpayer’s request for a ruling requesting permission to use an
alternative method of basis recovery under § 15a.453-1(c)(7)(ii) of the Temporary
Regulations under the Installment Sales Revision Act of 1981 to report payments from a
contingent payment sale. In accordance with § 15a.453-1(c)(7)(ii), the Taxpayer filed its
ruling request prior to the due date (including extensions) of its Year 1 tax return.

FACTS

PLR-134943-15                                 2

The Taxpayer uses a cash basis method of accounting and a calendar tax year. He is
the beneficial owner of approximately e% of Company A, an S corporation, on a fully-
diluted basis after considering fully vested option holders of the company. In Year 1,
Company A entered into a merger with Company B, a publically-traded corporation,
whereby Company A would become the wholly-owned indirect subsidiary of Company
B. Consideration, in the form of cash and Company B shares, was paid to Company A
shareholders in an initial amount of $f payable in Year 1, and then three deferred
payments payable on the successive anniversaries of the merger closing in Year 2,
Year 3, and Year 4.

The deferred payments are each an amount equal to $g multiplied by a fraction with a
numerator equal to the average of the closing market prices of Company B shares over
the previous five trading days and a denominator equal to $h, the approximate share
price of Company B at the time of the merger. The first deferred payment also included
adjustments consisting of certain post-merger true-ups.

By the time of the first deferred payment, in Year 2, share prices for Company B had
declined to $i. Based on this share price, the first deferred payment was $j. The
Taxpayer estimates that its share of the deferred payments, after accounting for
remaining transaction costs, will be:

                 Year 2                  Year 3                  Year 4
          $k                      $l                     $l

In total, the Taxpayer estimates, based on the Year 2 share price, that Taxpayer’s share
of the purchase price it will receive in exchange for Taxpayer’s ownership interest in
Company A will be $m. Further, Taxpayer’s tax basis in its ownership interest at the
time of sale was $n.

The Taxpayer requests a ruling that it be permitted to use an alternative method of
basis recovery (as described below) under § 15A.453-1(c)(7)(ii) to report payments from
the contingent payment sale of Taxpayer’s ownership interest in Company A to
Company B because the normal basis recovery rule set forth in § 15A.453-1(c)(3)(i) will
substantially and inappropriately defer recovery of basis based on Company B’s share
price. Pursuant to § 15A.453-1(c)(7)(ii), Taxpayer asserts that its proposed alternative
method of basis recovery is a reasonable method of ratably recovering basis, and that
over time Taxpayer likely will recover basis at a rate at least twice as fast as the rate at
which basis would have been recovered under the otherwise applicable normal basis
recovery rule.

LAW AND ANALYSIS

Section 453(a) of the Code provides as a general rule that income from an installment
sale shall be taken into account under the installment method for federal income tax

PLR-134943-15                                3

purposes. Section 453(b)(1) defines the term “installment sale” to mean a disposition of
property if at least one payment is to be received after the close of the taxable year in
which the disposition occurs. The term “installment method” is defined in section 453(c)
as a method under which the income recognized for any taxable year from a disposition
is that proportion of the payments received in that year which the gross profit (realized
or to be realized when the payment is completed) bears to the total contract price.

Section 453(j)(2) provides that the Secretary of the Treasury shall prescribe regulations
providing for ratable basis recovery in transaction where the gross profit or the total
contract price (or both) cannot be readily ascertained.

Section 15A.453-1(c)(1) of the Temporary Income Tax Regulations defines a
“contingent payment sale” 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 other disposition occurs. Unless a taxpayer makes an election under §
15A.453-1(d)(3), contingent payment sales are to be reported on the installment
method.

Section 15A.453-1(c)(2)(i)(A) provides that a contingent payment sale will be treated as
having a maximum selling price if, under the terms of the agreement, the maximum
amount of sales proceeds that may be received by the taxpayer can be determined as
of the end of the taxable year in which the sale or other disposition occurs. Generally,
the taxpayer’s basis shall be allocated to payments received and to be received by
treating the stated maximum selling price as the selling price for purposes of § 15A.453-
1(b). If, however, application of the foregoing rules in a particular case would
substantially and inappropriately accelerate or defer recovery of the taxpayer’s basis, a
special rule will apply.

The Taxpayer has made an installment sale for a fixed period but for a contingent sales
price. Accordingly, Taxpayer is subject to the rules of § 15A.453-1(c)(3)(i). That section
provides generally that when a stated maximum selling price cannot be determined as
of the close of the taxable year in which the sale or other disposition occurs, but the
maximum period over which payments may be received under the contingent sale price
agreement is fixed, the taxpayer’s basis shall be allocated to the taxable years in which
payments are to be received in equal annual increments.

Additionally, § 15A.453-1(c)(3)(i) provides generally that if in any taxable year no
payment is received or the payment received is less than the basis allocated to that
year, no loss shall be allowed unless the taxable year is the final payment year under
the agreement. When no loss is allowed, the unrecovered portion of basis allocated to
the taxable year is carried forward to the next succeeding taxable year.

PLR-134943-15                                 4

Section 15A.453-1(c)(3)(i) further provides that a special rule under section 15A.453-
1(c)(7) will apply if application of the foregoing general rules would substantially and
inappropriately accelerate or defer recovery of the taxpayer’s basis in a particular case.

Section 15A.453-1(c)(7)(i) provides that the normal basis recovery rules set forth in §
15A.453-1(c)(3) may, with respect to a particular contingent payment sale, substantially
and inappropriately defer recovery of the taxpayer’s basis.

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, prior to the due date of the return
including extensions for the taxable year in which the first payment is received, that
application of the normal basis recovery rule will substantially and inappropriately defer
recovery of basis. To demonstrate that application of the normal basis recovery rule will
substantially and inappropriately defer recover of basis, the taxpayer must show (A) that
the alternative method is a reasonable method of ratably recovering basis, and (B) that,
under that method, 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 have been
recovered under the otherwise applicable normal basis recovery rule. The taxpayer
must receive a ruling from the Internal Revenue Service before using an alternative
method of basis recovery.

Section 15a.453-1(c)(7)(ii) further provides that the taxpayer must file the request for a
ruling prior to the due date for the return including extensions. In demonstrating that
application of the normal basis recovery rule would substantially and inappropriately
defer recovery of the taxpayer's basis, the taxpayer in appropriate circumstances may
rely upon contemporaneous or immediate past relevant sales, profit, or other factual
data that are subject to verification. The taxpayer ordinarily is not permitted to rely upon
projections of future productivity, receipts, profits, or the like. However, in special
circumstances a reasonable projection may be acceptable based upon a specific event
that has already occurred.

Based on share prices in Year 2, the Taxpayer expects to receive the following
payments in the years noted below:

                Year 1               Year 2               Year 3               Year 4
          $o                   $k                   $l                   $l


Pursuant to § 15A.453-1(c)(3)(i), when a stated maximum selling price cannot be
determined as of the close of the taxable year in which a sale or other disposition
occurs, but the maximum period over which payments may be received under the
contingent sales price agreement is fixed, the taxpayer's basis (inclusive of selling
expenses) shall be allocated to the taxable years in which payment may be received
under the agreement in equal annual increments. Because in this case the stated

PLR-134943-15                                    5

maximum selling price was not determinable as of the close of Year 1, but the maximum
period over which the payments may be received under the contingent purchase
agreement is fixed (i.e., 4 years), under the normal basis recovery rule, the Taxpayer’s
basis should be allocated to the taxable years in which payment may be received under
the purchase agreement in equal annual increments. The application of this rule,
assuming no change in Company B’s stock price from Year 2, is illustrated in Scenario
1 below:

                               Year 1              Year 2             Year 3            Year 4
 Beginning Basis           -----------------   -----------------   ---------------   ---------------
------------------------
------------------------   -----------------     ------------       ------------      ------------
------------------------
------------------------
                           ---------------     ---------------     ---------------   ---------------
      -------------
  ---------------------    -----------------   ---------------     ---------------         ---
------------------------
                                  ---          ---------------     ---------------   ---------------
    -----------------
------------------------
------------------------        ------               ----               ----             ------
            --


Note, in Year 4, the amount of deferred basis would be $p, which would be recognized
as a loss.

As is demonstrated in Scenario 1 above, application of the normal basis recovery rule
set forth in § 15A.453-1(c)(3)(i), assuming no change in Company B’s stock price, would
substantially and inappropriately defer recovery of basis based on immediate past
relevant share prices resulting in a disproportionately large gain in Year 1 and a
disproportionately large loss in Year 4.

Pursuant to § 15A.453-1(c)(7)(ii), the Taxpayer may use an alternative method of basis
recovery if the Taxpayer can show that (A) the alternative method is a reasonable
method of ratably recovering basis, and (B) under the alternative method, 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 have been recovered under the otherwise
applicable normal basis recovery rule.

Under the Taxpayer’s proposed alternative method, the Taxpayer will allocate the ratio
of basis to each installment payment as that installment payment bears to the estimated
amount of aggregate payments to be received by the Taxpayer during the 4-year term
of the installment obligation. Based on the Year 2 stock price, the basis recovery would
be as reflected in Scenario 2, below:

PLR-134943-15                                        6


Scenario 2 - Alternative Basis Recovery

                             Year 1             Year 2            Year 3           Year 4
Beginning Basis          -----------------   ---------------   ---------------   ------------
----------------------
----------------------
                         -----------------    ------------      ------------     ------------
----------------------
         ------
----------------------
                              ------              ----              ----            ----
       ----------
----------------------
                         -----------------    ------------      ------------     ------------
           ---
 ---------------------   ---------------     ---------------    ------------         ---


As illustrated above, the Taxpayer’s proposed alternative basis recovery method is a
reasonable method of ratably recovering basis, and the Taxpayer will recover basis at a
rate twice as fast as the rate at which basis would have been recovered under the
normal basis recovery rule. Based on the information provided by the Taxpayer, the
proposed alternative basis recovery methodology thus satisfies the requirements of §
15A.453-1(c)(7)(ii).

CONCLUSION

Based on the information provided and the representations made, we conclude that the
Taxpayer’s proposed alternative basis recovery method is a reasonable method of
ratably recovering basis, and that the use of the proposed alternative method of basis
recovery will result in basis recovery at a rate more than twice as fast as the rate at
which basis would be recovered under the normal basis recovery rules. Accordingly, the
Taxpayer’s use of the proposed alternative method of basis recovery is approved.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

PLR-134943-15                                 7


A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                       Sincerely,


                                       William A. Jackson
                                       Branch Chief, Branch 5
                                       (Income Tax & Accounting)


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