Tax News
In PLR 201111002 the Service Approves an Alternative Method for Basis Recovery in a No-Cap Earnout
May 27, 2011
Administrative Actions
Earnouts are very common in private equity and venture capital deals. The fund could be exposed to the earnout as a seller or a buyer of a portfolio company. An earnout is basically a contingent installment sale whereby some future payments depends on the profitability of the portfolio company. If the fund is a seller, one of the threshold questions is whether to report under the Section 453 installment method or whether to elect out of it. Often it is advantageous to report under the installment method.  However, reporting under the method could present certain traps for the unwary such as the Section 453A interest rule for obligations over $5MM and the imputed interest rules of Reg. 15a.453-1(c)(2)(ii) and Section 483. The above PLR illustrates another trap for the unwary.  In a no-cap earnout that has a fixed payment period, as in the ruling, the seller must recover basis in equal installments over the earnout period. Well, that usually works out fine if earnout payments are actually made and the business performs to the expectation of the parties.  However, if the business underperforms, it is very likely that basis may be deferred inappropriately.

To remedy this issue, Section 15a.453-1(c)(7)(ii) provides that the taxpayer may use an alternative method of basis recovery if the taxpayer is able to demonstrate prior to the due date of the return including extensions for the taxable year in which the first payment is received, that application of the normal basis recovery rule will substantially and inappropriately defer recovery of basis. To demonstrate that application of the normal basis recovery rule will substantially and inappropriately defer recovery of basis, the taxpayer must show (A) that the alternative method is a reasonable method of ratably recovering basis and, (B) that, under that method, it is reasonable to conclude that over time the taxpayer likely will recover basis at a rate twice as fast as the rate at which basis would have been recovered under the otherwise applicable normal basis recovery rule. The taxpayer must receive a ruling from the IRS before using an alternative method of basis recovery.

In this PLR the taxpayer did exactly that.  The sold business experienced a significant downturn and there was no expectation for future earnout payments. Under the normal basis recovery rules the taxpayer had to recover basis over 4 years which obviously was disadvantageous considering that there were no expected earnout payments. The taxpayer applied for a ruling seeking a determination that the normal basis recovery caused an inappropriate deferral of basis. The taxpayer proposed an alternative method of basis recovery, whereby it allocated the same ratio of basis to each installment payment as that installment payment bears to the estimated amount of aggregate payments to be received by the taxpayer during the four years in which payments could be received. Because the taxpayer did not anticipate receiving any earnout payments, it reasoned that it should be able to allocate all tax basis to year 1 and 2.  The Service agreed.

Private equity and venture capital funds should keep in mind the procedure in Section 15a.453-1(c)(7)(ii). Asking for the IRS’ permission to adopt an alternative method could result in tax savings in deals that did not turn out as expected. The ruling is attached below.

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Tags: "15a.453-1(c)(7)(ii)" "contingent payment sales", earn-out, earnouts