Contingent Payment Installment Sale: Spreading Tax When the Price Is Not Fixed

How it works, in plain English

Buyers and sellers often bridge a price gap with an earn-out: part of the price depends on how the business or property performs after closing. The regulation calls this a contingent payment sale: the aggregate selling price cannot be determined by the close of the year of sale. Unless you elect out, it is reported on the installment method.

The hard part is basis. With a fixed price you use a gross profit percentage. With an unknown price, Temp. Reg. 15a.453-1(c) gives three tracks:

1. Stated maximum selling price ((c)(2)). If the agreement caps what you can receive, assume every contingency resolves in your favor at the earliest date, and use that maximum as the selling price. If the maximum is later reduced, the gross profit percentage is recomputed going forward.
2. Fixed period ((c)(3)). No cap, but payments can come only over a set number of years. Basis is allocated in equal annual amounts over those years. If a year's payment is less than its basis share, the shortfall carries forward; no loss is allowed until the final payment year or until the right becomes worthless.
3. Neither ((c)(4)). No cap and no end date. The IRS will look hard at whether this is a sale at all or really rent or royalty. If it is a sale, basis is recovered in equal amounts over 15 years.

An income forecast method is available in some cases, and you can ask the IRS for a different allocation if the default would substantially and inappropriately defer basis recovery ((c)(7)).

The interest piece

Each contingent payment is split between principal and interest under Treas. Reg. 1.483-4, using rules similar to Reg. 1.1275-4(c): noncontingent payments are treated as a separate contract, and each contingent payment is discounted back to the sale date at the applicable federal rate, with the discount taxed as ordinary interest. This applies even if the contract states adequate interest. A larger earn-out paid later carries more interest and less capital gain.

Who it fits, and who it does not

• Fits: owners selling an operating business where buyer and seller disagree on the value of future growth; sellers of land with entitlement milestones; sellers of intellectual property paid on future sales.
• Fits: sellers who want some upside after closing and accept that tax follows the cash.
• Does not fit: arrangements where the "note" is really a retained interest, a joint venture or partnership interest, or equity in the buyer. The regulation excludes those from contingent payment sale treatment regardless of a cap or fixed term ((c)(1)).
• Does not fit: sellers who will need a deduction for a shortfall soon. Unrecovered basis waits for the final year.

Worked example (qualitative)

Assumptions: an owner sells a business for cash at closing plus an earn-out equal to a share of revenue for five years, with no cap on the total.

• Because there is no stated maximum but payments stop after five years, the fixed period rule applies: the owner's basis (including selling expenses) not used against the closing cash is spread in equal fifths across the five earn-out years.
• Each year, gain equals that year's earn-out principal minus that year's basis share; a portion of each payment is ordinary interest under Reg. 1.483-4.
• If revenue disappoints in year 2 and the payment is smaller than its basis share, no loss is allowed that year; the unused basis carries to later years, and any final shortfall becomes a loss in year 5.
• If the deal had capped the earn-out, the cap would set the selling price and the gross profit percentage from day one, with a recomputation if the cap later fell.

Numbers depend on the earn-out formula, so the Big Sale Tax Analysis models low, expected and high cases rather than one figure.

IRS stance and audit risk

The contingent payment rules are long-standing regulations and are not a listed transaction or transaction of interest. Audit attention goes to three places: whether the arrangement is a sale or disguised rent, royalty or equity; whether the basis allocation follows the right track; and whether interest was carved out of each payment. Electing out of a contingent sale is allowed, but the obligation is valued at no less than the value of the property sold, and an open transaction is available only in rare and extraordinary cases (15a.453-1(d)(2)(iii)). IRS Publication 537 points contingent sales to the regulation, and related-party sales of depreciable property have their own contingent payment rule in 453(g)(1)(B)(ii). For notes over $5 million, 453A authorizes special interest-charge rules for contingent payments.

Costs and fees

Expect legal drafting for the earn-out formula, definitions of revenue or profit, audit rights, and dispute resolution, plus accounting each year to compute the payment and the tax split. The economic cost is credit and performance risk: the buyer controls the business that drives your payments. Protect yourself with clear accounting definitions, information and audit rights, operating covenants, a security interest or UCC lien on business assets, a personal guarantee from the buyer's owners, and acceleration if the buyer sells the business or breaches the covenants.

How it compares with a fixed-price Section 453 installment sale

A fixed-price installment sale gives a known gross profit percentage, predictable tax and simpler documents. A contingent sale can close a price gap and keep upside, at the cost of uneven basis recovery, more ordinary interest and more dependence on the buyer's choices. Many deals combine both: a fixed note for most of the price and a capped earn-out on top, which keeps basis recovery on the stated maximum track. See also electing out and purchase price allocation.

Hans studies the tax side of exits. The $5,000 Big Sale Tax Analysis models the earn-out against an all-cash price and the other deferral paths.

Frequently asked questions