Discussion:Purchase Price Adjustment

The Seller would like to amend prior year return to reduce the LTCG and the Buyer would like to adjust goodwill amortization in current and future years.

Form 8594 instruction say “if decrease occurs after the tax year of the purchase date, consider it in the tax year in which it occurs”. Does this mean amending is not an option for the Seller?

For the Buyer – what date is the goodwill reduced? First day of new tax year or anniversary date? Or is a separate asset set up on the anniversary date with a negative basis of $25,000?

Buyer is recognizing income. Willy probably knows this one, I'd just be guessing.

The seller will recognize a loss of the same character as the original sale. The buyer will reduce his basis prospectively. If the original sale was reported under the installment method, the reduction in gross profit is recognized prospectively.

The claim of right rule does not apply here because there was not full payment (and gain recognition) received in the prior year and then repayment in current year. There was partial payment under installment method, it sounds like, and future payments to be received were reduced. The installment note profit ratio is adjusted for prospective recognition, (or less recognition).

Riley is correct. This is some expansion on the tax rational of his answer.

The apparent conflict of these principles has resulted in hardships and inequities for taxpayers required to pay taxes on income in one year, only to return it in a subsequent period, with no effective mechanism to recover the taxes originally paid.

Sec. 1341(a) requires:

1. An item was included in the taxpayer's gross income for a prior tax year because it appeared that the taxpayer had an "unrestricted right" to the income;

2. In the absence of Sec. 1341, the taxpayer would be entitled to a deduction for the current tax year because it was established after the close of the prior tax year that the taxpayer did not have an unrestricted right to the item; and

3. The amount of such deduction exceeds $3,000.

The key to a claim is whether it "appeared to the taxpayer that he had an unrestricted right to the income." To satisfy this requirement, a taxpayer must have had "an unrestricted right" to the income in the "year received as distinguished from an unchallengeable right (which is more than an `apparent' right) and from absolutely no right at all (which is less than an `apparent' right)"; see Rev. Rul. 68-153. Under Regs. Sec. 1.1341-1(a)(2), the appearance of an unrestricted right must be based on "all the facts available in the year" the taxpayer included the amount at issue in income. A taxpayer's facts are critical to protecting an overall tax adjustment.

In Rev. Rul. 78-25, a corporation sold its assets to a third party and then liquidated, distributing the sale proceeds to its shareholder. The shareholder paid tax on the capital gain in the distribution year. Under the purchase agreement's terms, the selling corporation placed cash in escrow to indemnify the buyer against liabilities, damages and costs incurred as a result of the failure of the seller or the seller's shareholder to fulfill the agreement's conditions. A judgment was rendered against a former subsidiary of the seller in the year following the liquidation and sale, on a transaction that occurred prior to the sale. As a result, the shareholder paid damages to the buyer. The IRS ruled that Sec. 1341 applied to the shareholder's situation.

A more recent case, Dominion Resources, Inc., 219 F2d 359 (4th Cir. 2000), also shows the application of Sec. 1341. In determining whether it "appears" that a taxpayer had an "unrestricted right" to income in a prior year, the Fourth Circuit focused on the relationship between the income and the subsequent deduction events. In Dominion Resources, the court set forth a "substantive nexus" standard (i.e., as long as there is "substantive nexus" between the right to the income and the circumstances requiring the settlement payment, Sec. 1341(a)'s first requirement will be met). In the case, the substantive nexus between the sales proceeds and the settlement payment is obvious, as both the income reported and the repayment that occurred in a later year arose out of rights and obligations contained in a purchase agreement.

Cases that deny taxpayers the right to use Sec. 1341 are readily distinguished, because of the clear determination of fraudulent activity on the seller's part. In these cases, taxpayers failed outright to have the appearance of an unrestricted right to the income. Several cases that involve Sec. 1341 in the context of a taxpayer's criminal activities (e.g., Culley, 222 F3d 1331 (Fed. Cir. 2000) and Parks, 945 F.Supp. 865 (WD PA 1996)) show that inappropriate actions cause the loss of adjustment or repayment of tax benefits.

The Tax Advisor, October, 2002

How shall we treat buyer?

Sec. 1341 says: //

 Sec. 1341. Computation of tax where taxpayer RESTORES substantial
       amount held under claim of right

   (a) General rule
     If -
       (1) an item was included in gross income for a prior taxable
     year (or years) because it appeared that the taxpayer had an
     unrestricted right to such item;
       (2) a DEDUCTION is allowable for the taxable year because it
     was established after the close of such prior taxable year (or
     years) that the taxpayer did not have an unrestricted right to
     such item or to a portion of such item; and  ///

So there must be a restoring per the title and per the language: a deduction. That could be an accrual deduction if TP is on accrual MOA, But with an installment note, if TP had elected out of installment treatment, and then the note was compromised, you could have a current loss (deduction) and then Section 1341 would apply.

So yes Dennis, it is possible with an installment note, but only if TP has elected out of the installment method. IE, if the income has been deferred, then the compromise is a reduction of future income (unless the settlement says TP must REFUND cash to seller or some such).

Interest on the note is not even figured in when doing computations with regards installment obligations. Interest is separated out.

Riley said Loss on year of restructure, but recalculation of installment profit margin IF sale was on installment method. This is repeating what was just written.

Riley can explain further if needed.

Therefore, I do believe that a repayment could be characterized as a "restoration" eligible for Sec. 1341 treatment if it was determined after the year of sale that the seller did not have an unrestricted right to the sales proceeds. On the other hand, if the sales price was voluntarily adjusted, for example, to accomodate the buyer's deteriorating financial position, then it would appear that Sec. 1341 would not apply.

One would like to think in this case that there would be reciprocal treatment for the buyer: If the sales price is decreased, he would decrease the cost basis of the assets acquired as opposed to having to recognize debt forgiveness income. But that itself raises an additional interesting question: Supposing the assets acquired in an installment sale have already been written off? In that case it would seem revenue recognition would be applicable.

Still . . . very strange the extent to which this problem is not addressed by the IRS given that every time there is a sales price adjustment it impacts both the buyer and the seller .. . .