Last week, the IRS issued PLR 202645014, which permits a taxpayer to use an alternate method of basis recovery in a contingent installment sale. Unfortunately, as is the case with many PLRs, all the numbers have been redacted and the magnitude of the alternate basis allocation is not apparent. However, the method of alternate basis recovery is worthy of mention.
Reg. §15a.453-1(c) governs the manner in which a taxpayer’s basis is allocated to payments received and to be received in a contingent payment sale. The rules are designed appropriately to distinguish contingent payment sales for which a maximum selling price is determinable, sales for which a maximum selling price is not determinable but the time period over which payments will be received is determinable, and sales for which neither a maximum selling price nor a definite payment term is determinable. Where a maximum selling price is determinable, basis is allocated among the payments based on the maximum selling price (i.e., basis is allocated as if the maximum purchase price were being paid). Where the maximum selling price is not determinable, but the time period over which the payments can be made is ascertainable, basis is allocated in equal amounts over the time period, except that, in general, no loss can be recognized until the final year in which a payment is to be received (and any loss in an earlier year, if there are payments that are less than the allocable basis, is carried over as additional basis in the following year). Where none of the above is ascertainable, basis is allocated equally over 15 years (and, in general, no loss is allowed until year 15).
Reg. §15a.453-1(c)(7)(ii) contains special rules where the foregoing “will substantially and inappropriately defer recovery of basis,” under which a taxpayer can request a private letter ruling for a different allocation method. However, to obtain a ruling, a taxpayer must demonstrate that (A) the alternative method is a reasonable method of ratably recovering basis and (B) the anticipated rate of basis recovery is at least twice the rate that would apply under the otherwise applicable basis recovery rules discussed above. The taxpayer in the PLR satisfied both requirements because it was entitled to a fixed payment at closing and an uncapped earn-out based on EBITDA over the ensuing four-year period. Consequently, the otherwise applicable basis recovery rules would have required basis to be recovered in equal annual increments. The taxpayer was able to demonstrate that based on historical EBITDA and estimates of future earnings the taxpayer would recognize a disproportionately large gain in the year of the downpayment and a disproportionately large loss at the end of the earn-out period. As a result, the IRS ruled that basis could be recovered based on an estimate of the aggregate payments to be received.
Given that the earn-out payments were uncapped, it is interesting that the taxpayer did not seek to apply the “open transaction” doctrine whereby all basis is recovered before any gain is recognized. (Or perhaps the taxpayer did make such a request and was turned down, which led to a basis recovery request based on the estimated payments to be received.) This doctrine emanates from the Supreme Court decision in Burnet v. Logan, 283 U.S. 404 (1931). Reg. § 15a.453-1(d)(2)(iii) reflects the IRS’s narrow view of the open transaction doctrine:
Only in those rare and extraordinary cases involving sales for a contingent payment obligation in which the fair market value of the obligation…cannot reasonably be ascertained will the taxpayer be entitled to assert that the transaction is “open.”
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