Installment Gain on Sale of Assets - 4 year "earn-out"

[NJTax]

Hello - I'm a long time lurker but a first time poster here. Thank you in advance for your help.

My client owns a single member LLC taxed as an S-Corp.

The owner sold the assets of the company in 2016. He received $7M in 2016. He received $2.7M in 2017 then he'll receive approximately $10M in 2019. (Nothing received in 2018.)

When I prepared the 2016 tax return, I recognized the $7M in revenue on Form 4797 and did not treat it as installment sale. Basis was very low so basically it was all taxed at capital gain rates.

In addition, he has a bonus unit grant contract with his employees so about 1/3 of each payment received is paid out to his employees as W-2 wages.

I'm now preparing the 2017 tax return and recognizing the $2.7M he received in 2017.

It appears from some research that there are 2 ways to recognize this gain. The first is as an "open" transaction which is basically what I did by not electing installment gain treatment. (sec 1001)

Regs Sec 15a.453-1)(c)(2) discusses the installment approach. Based on some recent paperwork the seller has sent me, it appears that there was a maximum sales price set at $20M in the contract.

Treating this as an installment sale would have VERY favorable treatment to the IRS and very UNfavorable treatment to the taxpayer. By recognizing so much gain each year AND having to pay out the W-2 wages to his employees, it would really create a cash flow crunch.

I see there is a lot of discussion about the courts being more favorable to the "open" transaction treatment, however, I would really appreciate your thought process on whether I should amend 2016 and handle this as an installment method.

Thank you!

[TaxGuyBill]

Before I add some comments, maybe you can clarify a few things first:

What exactly are the assets that were sold?
You said the Basis was very low. Is the that Adjusted Basis (after depreciation) or is that the Unadjusted Basis (usually original purchase price)?
Was it a specific sales price? I don't understand the "maximum" sales price of $20 Million.
Can you explain how using the Installment sale would be UNfavorable to your client? It should be the other way around. If you only claimed $7 million, it seems like you unofficially reported it using the Installment Method.

[NJTax]

The assets sold were his receivables and fixed assets. Adjusted basis of the fixed assets was very low and they only allocated $50K of the purchase price to the fixed assets.

As for the sales price, the contract states that the the price will be equal to initial payment of $7M, plus a working capital "true Up," plus the "Earn-out Amount."

(c) Notwithstanding the foregoing, in the event that the Final 2016 Adjusted EBITDA
is less than $2,225,000, the Earn-out Amount shall be reduced by multiplying the amount otherwise payable
pursuant to Section 1.8(b) by a fraction, the numerator of which is the Final 2016 Adjusted EBITDA and
the denominator of which is $2,225,000.

(d) Notwithstanding anything to the contrary contained in this Agreement or any
Transaction Document, in no event shall the Earn-out Amount exceed the lesser of (i) $10,000,000 or (ii)
the maximum Earn-out Amount payable following reduction pursuant to Section 1.8(c), if applicable.

(e) Notwithstanding anything to the contrary contained in this Agreement or any
Transaction Document, in no event shall the sum of (i) the Initial Payment, plus (ii) the True-up Amount,
if any, plus (iii) the Earn-out Amount, if any, exceed an aggregate amount of $20,212,500.

[NJTax]

I reviewed the transaction again. The buyer didn't purchase any of the fixed assets so there was an ordinary loss of approximately $80,000 recorded for the remaining basis in 2016.

I did effectively report the gain on an installment basis but I didn't complete Form 6252. I can't go back and amend per the Form 6252 instructions:
"If you filed your original return on time without making the election, you can make the election on an amended return filed no later than 6 months after the due date of your tax return, excluding extensions. Write “Filed pursuant to section 301.9100-2” at the top of the amended return.

Is there anything I should/could do?

[TaxGuyBill]

I think you can still report it using the Installment Method.

The 'default' is to use the Installment Method. As the Instructions (and the Regulation) say, in order to elect OUT of that requirement, you must "report the full amount of the gain on a timely filed return". It is too late to election OUT of the Installment Method, so you can't amend to report the full amount (almost $20 million) 2016. You did not report the full amount (you merely reported it in the wrong place), so you are 'stuck' with using the Installment Method. :-) See also §15.453-1(d)(3)(i).

https://www.law.cornell.edu/cfr/text/26/15a.453-1#d

[NJTax]

Thank you so much for your help.

I'm assuming that I should complete Form 6252 in 2017 and going forward even though I didn't in 2016?

[TaxGuyBill]

Yes, that is what I would do.

[Burke]

I am confused by the information in your post regarding the sale of the fixed assets. In your 2nd post, you said they were sold and $50K was allocated to the purchase price for that category. In your 3rd post, you said the buyer did not purchase the fixed assets, "so there was an $80K loss recorded for the remaining basis in 2016." Can you explain? Were they sold to another party or simply kept? Obviously, there was a profit since you are applying installment gain to the entire sale. (PS: I tried to use the quote feature but it is apparently not working.)