Under the cash method, the taxpayer would recognize the income when it is received, including the entire sum paid in the form of a negotiable note.
[7] Nothing in the language of the governing statute (section 453 of the Internal Revenue Code) requires the use of the installment method where the disposition results in a loss.
One of the primary reasons that sellers elect out of the installment method is the harsh treatment of contingencies in the regulations accompanying IRC 453.
In this case, the regulations require the seller to calculate the profit ratio by assuming that the maximum will actually be reached.
As compared to a situation where the maximum in fact is not reached, this requirement has the effect of increasing the profit ratio and thus the gain reportable for each year, deferring recovery of basis.
Any deficiency between the actual amounts received and the stated maximum selling price will result in unrecovered basis, for which no loss may be reported until there is no more right to future payments.
Second, if there is no maximum selling price, the contingent payments may be subject to a finite duration, e.g., "5% of future profits for ten years."
Especially if the item sold declines in profitability over the stated finite duration, it is possible that there will be unrecovered basis at the end of the period, for which no loss may be reported until that final year.
In this case, the first step is to consider whether there is a sale at all; the transaction may in fact be for rent or royalties, since beneficial ownership arguably remains with the seller.
If, for example, the seller is an individual who is retiring off of the proceeds of the sale, the capital loss on the back end would be almost worthless (except to the nominal extent usable against ordinary income).
Where the profit ratio would have been high anyway and the fair market value of the contingent payments are low, the taxpayer may experience favorable consequences by effectively paying a little more tax up front and in return getting the first crop of contingent payments tax-free, while eliminating the risk of an unusable future capital loss.
Whether or not the seller elects out, the total net gain or loss reported will be the same, but timing and characterization can vary widely.
Whether, in a merger or acquisition, escrows established to secure the continued employment of selling shareholders who are also management employees (so-called "golden handcuffs") are reportable on the installment method is currently an unresolved question, even if it is assumed that such amounts are properly treated as merger consideration and not compensation for employment.
The seller may often retain a lien against the property to secure payment of the installment obligation, which itself may or may not be evidenced by a promissory note.