What are the ramifications of including an earnout provision when structuring a Section 453 installment sale for a business?

Question

Tyler Smith · Accepted Answer

Including an earnout provision in a business sale structured as a Section 453 installment sale introduces complexities, primarily surrounding how the contingent payments from the earnout are recognized for tax purposes. Under Section 453, a contingent payment sale is one where the total selling price cannot be determined by the close of the taxable year of the sale.

**Maximum Selling Price:** If a maximum selling price can be determined, that amount is generally used to calculate the gross profit percentage. As payments are received, a portion is treated as gain. If later it becomes clear that the maximum won't be reached, the gross profit percentage is recalculated.

**No Maximum Selling Price:** If there's no maximum selling price but the payment period is fixed, the basis is generally recovered ratably over the payment period. Any payments received in excess of the basis allocated to that year are treated as gain. If the payment period is also indefinite, the IRS regulations provide specific rules, often leading to the basis being recovered over 15 years, or until payments cease.

**Interest Imputation:** It's crucial to remember that earnout payments, particularly those extending beyond a year, may be subject to imputed interest rules (Section 483 or 1274) if the contract doesn't specify adequate stated interest. This means a portion of each earnout payment will be recharacterized as interest income rather than sales proceeds, impacting the capital gains deferral. Careful drafting of earnout provisions is essential to align with tax objectives.