The buyer wants to structure part of our purchase price as a multi-year contingent earnout alongside a fixed promissory note. How does the IRS installment method under Section 453 treat basis recovery on contingent payments, and how do we avoid paying taxes on money we might never collect?

Question

Tyler Smith · Accepted Answer

When an acquisition includes contingent payments like an earnout alongside fixed deferred consideration under Section 453, the IRS applies specific contingent payment installment sale regulations that can create severe tax timing mismatches.

If your deal has a stated maximum selling price, Treasury regulations require you to allocate your tax basis across all payments assuming the full maximum amount will be received. If you do not hit the earnout targets in later years, you end up front-loading capital gains taxes in the early years and claiming an artificial capital loss in the final year. That loss cannot easily be carried back to recover the taxes you already paid.

If there is no stated maximum price but a fixed term of years, the IRS forces you to recover your basis ratably in equal annual increments over that term. If early payments are small, you pay disproportionate tax on phantom gains.

To protect your cash position:
- Negotiate a realistic maximum selling price in the purchase agreement rather than an inflated ceiling that distorts basis recovery.
- Structure the earnout as a separate contractual right or evaluate whether electing out of Section 453 installment treatment makes sense if you have large offsetting capital losses in the closing year.
- Require the buyer to pay enough cash at closing to cover the worst-case initial tax liability under the maximum selling price scenario.

Align your leadership team on realistic financial targets during your quarterly planning sessions before agreeing to earnout structures that gamble with your tax basis.