Failed earn-out milestones fix loss on installment stock sale

Plain-English summary

A limited liability company converted secured notes into stock and sold its majority interest in a company through a merger. The sale included contingent earn-out payments, so the seller initially reported the transaction under the § 453 installment method. Later events reduced the maximum selling price, and the target failed to meet any earn-out milestones before the measurement period expired. That failure fixed the maximum remaining payment at less than the seller's represented stock basis, turning the transaction into a loss. The IRS ruled that the seller could deduct under § 165 the amount by which its unrecovered basis at the end of the prior year exceeded the maximum remaining payment. The IRS did not determine the seller's stock basis or its basis-calculation method.

Ruling snapshot

• Question: When and to what extent could the seller claim a loss after contingent earn-out milestones failed on an installment stock sale?
• Outcome: Approved, limited to unrecovered basis exceeding the maximum remaining payment
• Key authorities: IRC §§ 165 and 453; Treas. Reg. §§ 1.165-1 and 1.1011-1

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201451004 Third Party Communication: None
Release Date: 12/19/2014 Date of Communication: Not Applicable
Index Number: 165.00-00, 453.00-00
Person To Contact:
--------------------------------------------- ----------------------------------
--------------------- ID No. ------------------
------------------------------------ Telephone Number:
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Refer Reply To:
---------------------------------------- CC:ITA:B01
PLR-109117-14
Date:
September 03, 2014

Taxpayer = ------------------------------------------------------------------------
State = --------------
B = --------------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------------
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Date1 = ----------------------------
Date2 = ------------------------
Company = ------------------------------------
C = -------------------------------------------
D = ---------------------------------------------------------------------------
E = ----------------
Year1 = -------
Date3 = ----------------------------
F = --------------------------------------------------------------------------------------------
----------------
Buyer = ----------------------
G = ----------------------------------------------
H = --------
J = --------------
K = ------------------
Date4 = ---------------------------
L = ------------------------------------------
Year4 = -------
M = --------------------------------------------------------------
N = ----------------
P = ------------
Q = --------
Year2 = -------
R = ----------------
PLR-109117-14 2

S = --------------
T = ------------
Year3 = -------
V = --------------
W = --------------

Dear ----------------------:

This letter responds to your letter dated February 3, 2014, and subsequent
correspondence, on behalf of Taxpayer, requesting a ruling on the proper application of
§§ 165 and 453 of the Internal Revenue Code to Taxpayer’s transaction.

RULING REQUESTED

Taxpayer will be permitted to claim a loss deduction under § 165 with respect to
Taxpayer’s sale of its interest in Company for the taxable year ended Date4, except
to the extent of L.

FACTS

Taxpayer is a State limited liability company engaged in the business of B. From Date1
through Date2, Taxpayer invested in Company by issuing secured convertible
promissory notes and satisfying the principal and interest of those promissory notes
through the issuance of new secured convertible promissory notes of similar terms
charging interest of C, and convertible into D.

By the middle of Year1, Taxpayer, as majority-in-interest of the lenders, decided that
Company needed to be sold in order to recoup its investment. Taxpayer directed
Company’s management to initiate the sale process.

On Date3, Company, F, and Buyer entered into G, whereby Company would merge into
a subsidiary of Buyer. Immediately prior to the merger, Taxpayer converted its
outstanding promissory notes into equity in Company. After the conversion, Taxpayer
owned H% of Company. Pursuant to G, Buyer paid $J at closing, with several amounts
due after closing, including, among other items, a maximum earn-out of $K to be paid
based on several milestones Company was to achieve by the end of Year3, and L, to be
paid in Year4, provided M.

On its Year1 federal income tax return, Taxpayer reported the sale of Company on the
installment method under § 453 as a contingent payment sale. Based on the terms of
G, Taxpayer determined its share of the stated maximum selling price to be $N.
Taxpayer received $P proceeds in Year1, and reported $Q in income under the
installment method for Year1.
PLR-109117-14 3

In Year2, events occurred that reduced the maximum selling price to $R. Taxpayer
received $S in Year2, and reported $T in income under the installment method in Year2.

In Year3, the earn-out period expired before Company achieved any milestones,
reducing the maximum selling price again to $V. Taxpayer represents that $V is less
than its basis in the stock it sold, and thus the transaction is now a loss transaction
rather than a gain transaction. Taxpayer did not receive any proceeds in Year3.

In Year4, Taxpayer expects to receive $W, its share of L, provided M.

LAW AND ANALYSIS

Section 453(a) provides that income from an installment sale shall be taken into account
under the installment method.

Section 453(c) provides that the term “installment method” means a method under
which the income recognized for any taxable year from a disposition is that proportion of
the payments received in that year which the gross profit percentage (realized or to be
realized when payment is completed) bears to the total contract price.

Section 165(a) provides that there shall be allowed as a deduction any loss sustained
during the taxable year and not compensated by insurance or otherwise.

Section 1.165-1(c) provides that the amount of the loss allowable as a deduction under
§ 165(a) shall not exceed the amount prescribed by § 1.1011-1 as the adjusted basis for
determining the loss from the sale or other disposition of the property involved.

Section 1.165-1(d)(1) provides that a loss shall be allowed as a deduction under § 165
only for the taxable year which the loss is sustained. For this purpose, a loss shall be
treated as sustained during the taxable year in which the loss occurs as evidenced by
closed and completed transactions and fixed by identifiable events occurring in such
taxable year.

Taxpayer correctly reported the sale of Company on the installment method under
§ 453 in Year1 and Year2. In Year3, however, the failure to achieve the earn-out
milestones meant that the maximum amount paid or to be paid under G, $V, was less
than Taxpayer’s basis in the stock it sold, as represented by Taxpayer, resulting in a
loss.

The taxable year during which Taxpayer sustained a loss is governed by § 165. In
Year3, identifiable events occurred that established that the maximum remaining
amount Taxpayer could receive under the terms of G was $W. Accordingly, Taxpayer
sustained a loss under § 165 during the taxable year ended Date4 to the extent its
PLR-109117-14 4

unrecovered basis at the end of Year2 exceeded $W, the maximum remaining amount it
could receive as a result of L.

CONCLUSION

Taxpayer may claim a loss deduction under § 165 with respect to Taxpayer’s sale of
its interest in Company in the taxable year ended Date4, to the extent its
unrecovered basis at the end of Year2 exceeds $W, the maximum remaining
amount it is entitled to receive under G as a result of L.

CAVEATS

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter. Specifically, we express or imply no opinion regarding the Taxpayer’s basis
in its stock in Company, its unrecovered basis at the end of Year2, or the method the
Taxpayer used to determine its basis.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

                                   Sincerely,


                                   Andrew M. Irving
                                   Senior Counsel, Branch 1
                                   Office of Associate Chief Counsel
                                   (Income Tax & Accounting)