By Stephen A. Josey
The CPA Journal
May 2020 Edition
Typically, the sale of a capital asset held by an individual is a straightforward affair from a tax accounting perspective. Under the most common scenario, the buyer will offer a one-time cash payment to the seller in exchange for the subject property, and the seller will report the gain or loss on the property and, if there is a gain, pay tax on the gain subject to the applicable rate [Internal Revenue Code (IRC) sections 1, 1001]. If there is a loss, the seller can claim that loss against other capital gains, potentially apply a portion of the loss to offset ordinary income, and if any loss remains, carry that loss forward to future-year returns [IRC sections 1211(b), 1212(b)(1)].
What happens, however, when a sale contract provides for the possibility of payments outside of the year of the sale? Buyers and sellers are increasingly incorporating such terms in sale contracts, as these provisions offer a level of risk mitigation for the buyer by deferring payments and tying them to conditional outcomes, while also providing potential upsides to sellers if the sale proves lucrative for the buyer.
For example, a contract may provide for a partial cash payment from the buyer to the seller in the year of the sale, but also provide that the buyer shall pay the seller a future percentage of earnings derived from the asset for a set number of years. Alternatively, a buyer and seller may agree to a payment structure whereby proceeds will become payable upon the realizations of certain milestones related to the purchased asset. How do taxpayers account for and report the sale of a capital asset when the amount ultimately payable is unknown in the year of the transaction?
This article will discuss the three methods—installment, closed transaction, and open transaction—available to taxpayers for reporting sales that involve contingent consideration potentially payable outside the year of the sale. Each of the methods described below has its own benefits and pitfalls that taxpayers and tax professionals should examine before electing a particular approach.