How does Section 453 handle contingent payment arrangements, like earnouts, in a business sale?

Question

Tyler Smith · Accepted Answer

Section 453 provides specific rules for installment sales where the total selling price cannot be determined at the time of sale, commonly known as contingent payment sales or earnouts. Under these arrangements, a portion of the purchase price is tied to future performance metrics, such as revenue or EBITDA milestones. For tax purposes, the IRS generally allows taxpayers to recover their basis ratably over a period of 15 years if the maximum selling price is unascertainable, or over the shortest period over which payments could be received if the payment schedule is uncertain but a maximum price is known.

If there's a stated maximum selling price, that price is used to determine the gross profit percentage, which dictates how much of each payment is taxable. However, if no maximum selling price can be determined, the seller's basis is generally recovered in equal annual installments over 15 years. If payments received in a year are less than the allocated basis for that year, the unrecovered basis is carried forward. Conversely, if the payments exceed the allocated basis, the excess is taxable. This method can lead to basis recovery issues if the earnout period is shorter than 15 years or if the earnout fails to materialize. Careful structuring and understanding of these rules are crucial to optimize tax deferral and avoid unexpected tax liabilities, especially as earnouts are increasingly common in business acquisitions.