Category: Sales and Exchanges
Subject: Original Issue Discount
Title: OID on Contingent-Payment Only Sales
IRC Sections: 1275
Filename: 1025.html
Date Produced: 1/98

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Ownership interests in several entities are being sold over an extended period based on a payment plan wholly contingent on the profits of the underlying entity. Various payments are specified under the purchase/sale contract, but the buyer's obligation to make each of those payments is contingent upon the earnings of the entity. No payments are unconditionally due to the seller under the purchase/sale contract.

No interest is specified in the contract.

The tax treatment of issuing a contingent debt instrument in exchange for non- publicly traded property is set forth at Regulation Section 1.1275-4(c). Under those rules, the contingent debt instrument is split into two pieces, a non-contingent portion and a contingent portion with each piece treated as a separate debt instrument for purposes of the OID rules.

In this case, we have only contingent payments due under the contract. Any payments made under the contract are divided between principal and interest by computing the present value of any such payment using the test rate--generally the AFR--in effect when the debt instrument was entered into. The present value represents the principal portion and the remainder of the payment is treated as interest. Both buyer and seller account for the interest portion based on their normal methods of accounting, and the buyer increases his basis in the purchased property by the principal portion of any payment at the time such payment is made.

Although one might infer from the previous paragraph that the OID rules in question are clear-cut and fairly simple, that is far from the case. I suggest avoiding these rules altogether by simply providing for interest as part of the contractual terms. I have computed the present value of each payment due under all the contracts using a rate slightly higher than the minimum long-term AFR for January, 1998. By providing for stated interest in the contract at a rate that is clearly no less than the AFR, we avoid confusion and the need to review these rather onerous regulations.

I suggest incorporating the computation into the contract as an exhibit and adding language such as the following. This language must be reviewed and approved by a qualified attorney.

The purchase price amounts set forth in Article xx represent payments of principal and interest. The allocation between principal and interest for each payment is set forth at Exhibit zz. Should the amount of any payment required under Article xx be reduced by the provisions of Article yy (Reduction in Maximum Purchase Price), the allocation between principal and interest for the reduced payment shall be such that the interest portion of the reduced payment bears the same ratio to the total amount of the reduced payment as the interest portion of the corresponding payment at Exhibit xx bears to the amount of the corresponding total payment.

In the event it becomes necessary to manually compute an allocation between the principal and interest portions of any payment, the principal portion is computed as the present value of the payment discounted from the date of such payment back to the date of closing using a discount rate of 6.25% compounded semi-annually. [6.25% compounded annually for the JB payments in the amount of $84,000.] The interest portion is the total amount of such payment reduced by the principal amount computed as per the previous sentence.