When buying or selling an asset with significant uncertainty about its current value, there are often sound theoretical and practical business reasons for incorporating this uncertainty into the asset’s selling price. This incorporation of uncertainty often takes the form of price adjustments after the sale date based on some future economic event or events. A study of over 900 taxable corporate acquisitions found that taxpayers structured about 20% of taxable acquisitions to include contingent payments. 1 In addition, the study’s empirical evidence indicates that sellers with higher marginal tax rates are more likely to desire contingent payments in the contract. These price contingencies raise tax issues that practitioners must address when planning and reporting such transactions.
Contingent consideration is not consideration with an uncertain future value. Instead, a transaction includes contingent consideration when the quantity of the consideration transferred depends on an uncertain condition, situation, or set of circumstances that future events will ultimately resolve. Taxpayers can use contingent consideration as payment in a sale transaction or as compensation for services performed.
Not all uncertainties inherent in the accounting process give rise to contingencies. For instance, estimates required in allocating the cost of a depreciable asset over its useful life or estimates used in determining the accrued liabilities are not contingencies because there is nothing uncertain about the fact that those assets or liabilities have been incurred. An example of contingent consideration as payment in a property transaction is an earn-out component of selling price in a corporate acquisition where the selling price equals $100,000 plus one-quarter of the target firm’s operating cashflow for the next two years. An example of contingent consideration as payment for services performed is the compensation of an executive with shares of restricted stock. Typically, the restriction is that the stock vests with the employee over time, provided that the employee remains employed by the employer. In both of these examples, the amount or transfer of the contingent consideration depends on future events (i.e., the target firm’s future performance and the continued employment of the executive).
The first part of this article discusses the tax and financial reporting consequences of contingent consideration used as payment in property transactions, particularly corporate acquisitions. The second part examines the tax and financial reporting consequences of incorporating contingent payments as compensation for services performed by employees.
Contingent Consideration in Property Transactions
Including contingent payments in a property or service purchase agreement can benefit buyers and sellers from both tax and nontax perspectives. Contingent payments may allow for a better risk-sharing arrangement between buyer and seller. For example, if an acquiring firm is unwilling to purchase a target firm because of uncertainties about the target firm’s value, the seller can provide a future earnings-based payout after the sale date based on the future performance of the target firm. This contingent payment effectively transfers some risk from the buyer to the seller of the target firm.
Another advantage of including a contingent element in the sales price involves the tax consequences of the sale. As discussed later in this section, price contingencies can sometimes allow the seller to defer some or all of the gain and resulting tax on a sales transaction.
Despite these advantages, not all sales transactions include contingent payments because they also impose nontax costs on buyers and sellers. Buyers must wait until the contingency lapses to determine the actual payment amount. There are also contracting and monitoring costs associated with the resolution of the contingent portion of the sales price. For example, an earnings-based contingent payout in a corporate acquisition can result in additional audit and accounting costs to verify the target firm’s earnings number.
Statement of Financial Accounting Standards (FAS) No. 141R, Business Combinations, addresses the financial accounting and reporting for contingent consideration in a corporate acquisition. GAAP defines contingent consideration as “an obligation of the acquirer to transfer additional assets or equity interests to the former owners of an acquiree as part of the exchange for control of the acquiree if specified future events occur or conditions are met.” 2 In general, the acquirer will recognize the acquisition date fair value of contingent consideration as part of the consideration transferred in exchange for the acquiree. 3 International Financial Reporting Standards (IFRS) also require that contingent consideration be measured at fair value at the time of the business combination. 4 This recognition principle is equivalent to the “closed transaction” approach discussed later in this section.
GAAP and IFRS are also consistent in the subsequent accounting for a contingent consideration. Changes to contingent consideration resulting from events after the acquisition date are to be recognized in profit or loss. If the amount of contingent consideration changes as a result of a postacquisition event (such as meeting an earnings target), accounting for the change in consideration depends on whether the additional consideration is an equity instrument, cash, or other assets paid or owed. If it is equity, the original amount is not remeasured and the subsequent settlement is accounted for within equity. If the additional consideration is cash or other assets paid or owed, the changed amount is recognized in profit or loss. If the amount of consideration changes because of new information about the fair value of the amount of consideration at acquisition date (rather than because of a postacquisition event), retrospective restatement is required. 5
The tax issues relating to contingent consideration in a property transaction include (1) whether contingent consideration triggers a taxable transaction on the sale date and (2) when gains are recognized if there are contingent payments. Current tax law uses three general approaches to tax these transactions:
- Closed transaction: Taxpayers treat the transaction as completed despite the existence of the contingency;
- Open transaction: Sellers recognize the gain when basis is recovered; and
- Installment sales: Sellers recognize the income proportionately as the taxpayer receives the consideration from the sale.
A tax benefit arises when the seller can defer recognizing some or all of the gain by including contingent consideration for the property sold. This tax savings relates directly to the deferral period (i.e., the length of time of the contingency) and the seller’s marginal tax rate.
Closed transaction approach: Under the closed transaction approach, Sec. 1001 considers transactions concluded on the sale date, and the amount realized includes the expected fair value of all assets received, including contingent consideration. This approach requires no follow-up process to recognize gain from the sale of property when the contingency is resolved. However, sellers will recognize additional gain or loss if future events require contingent consideration that differs from that expected on the sale date.
Open transaction approach: Historically, the IRS has preferred the closed transaction approach because it does not defer recognition of gain. However, the courts have selectively allowed an open transaction approach when the contingent consideration is speculative and its ultimate realization is highly uncertain. In these transactions, sellers recognize taxable gain only when basis is recovered fully, and sellers treat the sale as closed only when future events resolve the contingency (i.e., when the final price is known with certainty).
Note that this treatment defers some or all of the realized gain (depending on the extent to which the seller recovers its basis), even though only a portion of the sales price is contingent on future events. Accordingly, taxpayers historically have tried to apply the open transaction approach to defer gain, and Congress and the IRS have resisted these efforts.
Installment sale approach: In response to taxpayer and IRS litigation involving sales with contingent consideration, Congress and Treasury restrict taxpayers’ ability to keep property transactions open. Sec. 453 and Regs. Sec. 15A.453-1(c) generally require taxpayers to use the installment sales method of accounting for sales with a contingent portion of the selling price, providing a legislative/regulatory “solution” to the closed-open dilemma. However, the installment approach is not available in all situations, including sales of inventory and sales of stock or securities traded on an established securities market.
The installment approach uses a mechanical procedure that matches the timing of taxable gain to the timing of the associated cashflow. The gain realized each tax year equals the cash received during the year multiplied by the ratio of realized gain to contract price. Taxpayers can elect out of the installment sales method or apply the open transaction doctrine. However, Regs. Sec. 15A.453-1(d)(2)(iii) makes it clear that these instances should be rare, and the IRS scrutinizes these transactions carefully. The courts have been more liberal in allowing taxpayers to use the open transaction method, so taxpayers must carefully consider the advantages of keeping the sales transaction open against the risk and expected cost of IRS intervention.
A simplified example illustrates how each of these approaches works.
Example 1: Taxpayer X owns 100% of T Corp. His basis in T is $90,000. On January 1, 2010, X sells T for $100,000 plus another payment on January 1, 2011, contingent on T’s future performance. The additional payment equals one-quarter of T’s 2010 operating cashflow. The expected value of this future payment is $50,000 [¼ × $200,000 (T’s operating cashflow for 2010)], but the contingent payment could be $10,000 higher or lower, based on the estimates used. (See the exhibit.)
Note that the parties to the transaction must estimate the total sales price under the closed transaction and installment sales approaches, which can be difficult in acquisitions involving contingent consideration. The open transaction approach avoids this and instead defers gain until the seller recovers its basis. Loss is deductible only after there is no likelihood of further recovery.
Example 1 illustrates a situation in which the amount of the contingent payment (and therefore the selling price) has no maximum limit and the payment period is not fixed. However, it is not uncommon for buyers and sellers to negotiate a maximum contingent payment. In addition, some situations dictate an unknown payment period. In these situations, Regs. Sec. 15A.453-1(c) establishes rules for determining the contract price used in the installment sales gain calculation.
Installment Sales Approach
Determinable Maximum Selling Price and Unknown Payment Period
Regs. Sec. 15A.453-1(c)(2) discusses the first special case. When the sales agreement provides for a maximum contingent payment from the buyer and an unknown or variable payment period, sellers must compute the contract price assuming that they will receive the maximum selling price. When the seller receives cash payments, he or she uses this assumed contract price to determine the gross profit percentage on the sale and the resulting gain recognized. This method overstates gain if the seller ultimately fails to receive the maximum contract price.
Example 2: X owns 100% of T. His basis in T is $90,000. On January 1, 2010, X sells T for $100,000 plus one-quarter of T’s future operating cashflow, not to exceed $70,000. The expected value of this contingent payment is $50,000.
In this case, X computes his gross profit percentage using an assumed sales price of $170,000. This implies a gross profit percentage of about 47% [($170,000 – $90,000) ÷ $170,000]. Thus, 47% of every dollar received from the sale is taxable gross profit. The taxpayer will recognize a residual amount of gross profit with the final payment if that payment shows that the 47% gross profit rate is too high.
No Maximum Selling Price but Fixed Payment Period
Regs. Sec. 15A.453-1(c)(3) discusses a second special case involving contingent payments in which the buyer and seller negotiate no maximum selling price but set a fixed payment period. The regulations require the seller to compute the installment sales gain by allocating the seller’s basis equally to each year. The taxpayer then computes gain each year as actual cash received minus the allocated basis.
Example 3: X owns 100% of T. His basis in T is $90,000. On January 1, 2010, X sells T for $100,000 plus one-quarter of T’s operating cashflow at the end of the sale year and the following year. The expected value of this future payment is $50,000 [(¼ × $100,000 (T’s operating cashflow for the first year)) + (¼ × $100,000 (T’s operating cashflow for the second year))].
In this case, X computes his gross profit as actual cash received each year minus one-half of his basis in T stock. In 2010, if T’s operating cashflow is $100,000, gross profit will be $80,000 [($100,000 + $25,000 contingent payment) – (½ × $90,000)]. Similarly, if 2011 operating cashflow is $100,000, year 2011 gross profit will be a loss of $20,000 [$25,000 – (½ × $90,000)].
Under this method, the seller generally cannot recognize a loss until the final installment period, even if no payment is made in a period before the final period or the payment amount is less than the amount allocated as basis for that period. In that case, the amount by which the basis exceeds the payment amount is added to the basis used to compute the gain for the next installment period.
No Maximum Selling Price or Fixed Payment Period
Regs. Sec. 15A.453-1(c)(4) discusses a third special case involving contingent payments in which the buyer and seller negotiate neither a maximum payment nor a fixed payment period. The general rule in this case requires the seller to recover basis (including selling expenses) in equal annual increments over a period of 15 years commencing with the date of sale. However, if in any tax year the seller receives no payment or receives an amount of payment (exclusive of interest) that is less than basis allocated to the year, no loss is allowed unless it is otherwise determined, in accordance with the timing rules generally applicable to worthless debts, that the future payment obligation under the agreement has become worthless; instead, the excess basis is reallocated in level amounts over the balance of the 15-year term.6
However, if the seller is able to show to the satisfaction of the IRS that the nature of the contingency precludes a reasonable basis for determining gross profit, the seller may elect out of Sec. 453 and apply the open transaction doctrine (see the open transaction example above). However, the regulations state that the IRS will scrutinize such transactions closely for appropriateness of using the open transaction approach to recognize gross profit.
Example 4: X owns 100% of T. His basis in T is $90,000. On January 1, 2010, X sells T for $100,000 plus one-quarter of T’s net cashflow of the year when net cashflow reaches $200,000. X expects the value of this future payment to be at least $50,000.
In this case, X may consider applying the open transaction doctrine and keep the transaction open until he recovers his basis or future events resolve the uncertainty, whichever happens sooner.
The IRS imposes additional requirements when buyers issue contingent stock to acquire a target firm in a tax-deferred reorganization under Sec. 368. Among other requirements, Rev. Proc. 77-37 7 requires a business purpose for the contingent stock and a contingency period of five years or less, and the initial distribution of shares paid for the target must include at least 50% of the maximum total shares of each class of stock issued. Failure to meet these additional requirements will generally preclude the parties from obtaining a favorable letter ruling from the IRS regarding the proposed tax-deferred reorganization.
Contingent Consideration in Compensation Agreements
A typical form of contingent consideration in a compensation arrangement is employer-restricted stock; the restriction usually involves forfeiture of the stock upon early termination of employment. The financial accounting and reporting for such contingent consideration is that the employer expenses the additional consideration when future events resolve the contingency. 8
Consistent with the financial accounting treatment, in 1969 Congress adopted an open transaction approach to contingent property offered as compensation for services performed in Sec. 83. Under Sec. 83, an employee receiving property as compensation does not recognize income on the receipt of the property until the property is transferable or is not subject to a substantial risk of forfeiture, whichever occurs first. The thrust of this treatment with respect to restricted stock is that the employee recognizes compensation income (and the employer takes the corresponding deduction) when the restrictions on the employee with respect to the stock lapse or when, considering all relevant facts and circumstances, the employee has unrestricted access to the stock.
Alternatively, Sec. 83(b) allows employees to elect to close the transaction at the time they receive the restricted property. This election is particularly useful for limiting the amount of compensation recognized when the value of the restricted stock is close to the price paid by the employee to acquire the stock.
Overview of Sec. 83
Sec. 83 applies when employers transfer property for services performed by employees or independent contractors, even if there are other reasons for the employee or contractor to receive the consideration. In addition, Sec. 83 applies to the portion of the consideration paid that requires a condition to be met (i.e., a restriction) such that the employee or contractor has a substantial risk of forfeiture.
Under Sec. 83, a transaction is not considered complete and remains open until the consideration is substantially vested. 9 “Substantially vested” means that the employee faces no substantial risk of forfeiture or that he or she can transfer the property to another person. 10 There is no taxable event until there is no longer a substantial risk of forfeiture. A facts-and-circumstances approach is used to determine whether a substantial risk of forfeiture exists. It exists when continued ownership of the consideration depends on (1) the future performance of substantial services, (2) not performing substantial services, or (3) some other employment-related condition. 11 Important considerations include the nature, regularity, and time spent on the services performed as well as the employer’s tendency to enforce the restriction in prior instances.
The value of the contingent consideration equals the fair market value of the consideration transferred at the time the transaction is closed less the amount paid for the consideration. In determining this value, the parties ignore any temporary restrictions 12 but reduce the value for the effect of permanent restrictions. 13 Thus, one could consider reducing the value of the consideration if the employer has a right to repurchase the property if the employee later sells it. Between the transfer date and the date that the restriction lapses, the transaction is deemed incomplete, and tax law considers the employer, not the employee, as the owner of the transferred consideration.
The employee may elect, within 30 days of the consideration transfer, to close the transaction on the transfer date and include the contingent income in his or her current-year taxable income. 14 This election essentially treats the transaction as if there are no substantial restrictions on the consideration on the transfer date. If the employee makes this election, the tax law treats the property as owned by the employee on the transfer date; therefore, any subsequent income from this property is taxed to the receiving employee.
Employees who pay full value for restricted stock grants should normally elect Sec. 83(b) treatment for the grants. This will ensure zero compensation and capital gain treatment for the entire stock gain when the employee sells the restricted stock at a later date. This election will also start the employee’s holding period on the stock grant date instead of on the date the restrictions lapse. Failure to elect Sec. 83(b) treatment can result in much of the stock gain being taxed as compensation and any remaining gain as short-term capital gain. However, Regs. Sec. 1.83-2(a) imposes a potential cost on taxpayers making the election because they generally cannot revoke the election or amend their tax returns if forced to later forfeit the restricted property.
The following example illustrates the tax treatment of compensating employees with restricted stock.
Example 5—Open transaction approach under Sec. 83(a): Employee Y performs services for employer A Corp. On January 1, 2008, A sells 100 shares of its stock to Y for $5/share when the stock is worth $20/share. Y agrees to forfeit the shares if she leaves A’s employment before January 1, 2010. A and Y expect the price of A stock to rise to $30/share by January 1, 2010. Y intends to sell A stock on December 30, 2010, for an expected price of $35/share. Y also expects to have a 30% ordinary tax rate and a 15% capital gain tax rate for the foreseeable future. Both Y and A are calendar-year taxpayers.
Under the open transaction approach of Sec. 83(a), Y’s compensation income is $0 and A’s corporate deduction is $0 for years 2008 and 2009. On January 1, 2010, the restrictions lapse, so for the 2010 tax year Y has compensation income of $2,500 [($30/share × 100 shares) – ($5/share × 100 shares)], and A has a compensation deduction of the same amount. In addition, Y reports a short-term capital gain of $500 [($35/share × 100 shares) – $3,000], which is based on the holding period of January 1, 2010–December 30, 2010, and the stock basis of $3,000 [($5/share × 100 shares) + $2,500].
An analysis of Y’s cashflows (using an assumed 10% discount rate) shows that Y has a cash outflow of $500 ($5/share × 100 shares) on January 1, 2008, for the acquisition cost, resulting in a present value of $500. On January 1, 2010, Y has another cash outflow of $750 for the tax on the compensation income ($2,500 × 30%), resulting in a present value of about $620.
On December 30, 2010, Y receives $3,500 ($35/share × 100 shares) from selling stock and pays $150 ($500 × 30%) tax for short-term capital gain, resulting in a net cash inflow of $3,350 and a present value of $2,517. Overall, Y’s net present value of cashflow is $1,397 (–$500 – $620 + $2,517).
Example 6—Closed transaction approach if employee elects Sec. 83(b): The facts are the same as in Example 5, except Y elects Sec. 83(b) treatment.
If Y elects under Sec. 83(b) to close the transaction on the transfer date, she has compensation income of $1,500 [($20/share × 100 shares) – ($5/share × 100 shares)], and A has a compensation deduction of the same amount for the 2008 tax year. The stock basis is $2000 ($500 paid + $1,500 of compensation). For 2009, Y’s compensation income is $0 and A’s corporate deduction is $0. For the 2010 tax year, Y reports a long-term capital gain of $1,500 [($35/share × 100 shares) – $2,000], which is based on the holding period of January 1, 2008–December 30, 2010.
An analysis of Y’s cashflows (again using an assumed 10% discount rate) shows that she pays $500 ($5/share × 100 shares) for the acquisition cost and $450 ($1,500 × 30%) income tax for the compensation income on January 1, 2008, resulting in a total cash outflow and present value of $950. On December 30, 2010, Y receives $3,500 ($35/share × 100 shares) from selling stock and pays $225 ($1,500 × 15%) tax on the long-term capital gain from selling the shares. This results in net cash inflow of $3,275 that has a present value of $2,461. The net present value of all of Y’s cashflows is $1,511 (–$950 + $2,461).
A comparison of the Sec. 83(a) open transaction and Sec. 83(b) closed transaction approaches shows that Y’s net present value of cashflows from the restricted stock increases by $114 ($1,511 – $1,397) if she elects Sec. 83(b) closed transaction treatment. In addition, this election will accelerate the tax deduction for the employer, although the amount of the deduction is less than the deduction under Sec. 83(a).
Open or Closed Transaction Approach with Dividends
For dividends paid on the restricted stock, Sec. 83 requires the employer and employee to treat the employer as the owner of the shares until either the restrictions lapse or the employee makes a Sec. 83(b) election. Before this time, the tax law treats the employee as if he or she had not received dividends but instead received additional compensation from the employer, and the employer has an additional compensation deduction. 15 A Sec. 83(b) election treats the employee as the owner of the stock on the transfer date, resulting in dividend income to the employee and no additional compensation deduction for the employer. 16
This overview of the tax and financial reporting consequences of using contingent consideration in corporate acquisitions and in compensation contracts shows that taxpayers can enjoy both tax and nontax benefits from using contingent consideration in these contracts. Specifically, sellers can defer some or all of the gain from selling target corporations by including contingent payments in the acquisition agreement. This ordinarily results from the use of the installment method of accounting for the gain from this sale. Taxpayers can also elect out of the installment method to report selling the target firm.
When employees are compensated with restricted stock, Sec. 83 offers potentially beneficial tax strategies for employers and employees to negotiate those transactions involving contingent consideration offered as compensation for services performed. Its attractiveness depends on at least three factors: (1) expected change in property value, (2) expected employer and employee tax rates, and (3) expected sale date of property transferred. Practitioners should be aware of the differences in the treatment of restricted stock arrangements under the general rule of Sec. 83(a) and the election to close the transaction under Sec. 83(b).
1 Henning, Shaw, and Stock, 22 J. Am. Tax Ass’n, Supplement: 1–17 (2000).
2 Statement of Financial Accounting Standards (FAS) No. 141R, Business Combinations ¶3f (FASB ASC 805-10-20).
3 FAS No. 141R, ¶¶24 and 41 (FASB ASC 805-30-25-5).
4 International Financial Reporting Standard (IFRS) No. 3, Business Combinations.
5 FAS No. 141R, ¶¶62 and 65 (FASB ASC 805-10-65-1); IFRS No. 3, ¶58.
6 Any basis not recovered at the end of the 15th year is carried forward to the next succeeding year, and to the extent unrecovered thereafter is carried forward from year to year until all basis has been recovered or the future payment obligation is determined to be worthless.
7 Rev. Proc. 77-37, 1977-2 C.B. 568.
8 FAS No. 141, ¶34; APB Opinion No. 16, ¶86.
9 Regs. Sec. 1.83-1(a)(1).
10 Regs. Sec. 1.83-3(b).
11 Regs. Sec. 1.83-3(c).
12 Sec. 83(a)(1).
13 Sec. 83(d)(1).
14 Sec. 83(b).
15 Rev. Proc. 80-11, 1980-1 C.B. 616.
16 Regs. Sec. 1.83-2(a).
Toby Stock is the Robert H. Freeman Professor of Accounting at Ohio University in Athens, OH. Yining Chen is the Mary R. Nixon Professor of Accounting at Western Kentucky University in Bowling Green, KY. For more information about this article, contact Prof. Stock at email@example.com.