Internal Revenue Service
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 Rev. Rul. 77-56

1977-1 C.B. 135

Section 453

IRS Headnote

Installment sale; indemnification agreement. An agreement to indemnify the purchaser for breach of certain warranties and representations by set-off against the purchase price does not make the original contract price indeterminable to preclude the seller from using the installment method of reporting gain.

Full Text

Rev. Rul. 77-56

Advice has been requested whether, under the circumstances described below, the taxpayer may elect to report the income from the sale of stock on the installment method of accounting under section 453 of the Internal Revenue Code of 1954.

The taxpayer, an individual, owned all of the stock of X corporation. On January 1, 1976, the taxpayer sold all of the stock of X to Z company for $70 per share. The selling price exceeded $1,000 and the taxpayer wants to report the gain on the installment method under section 453 of the Code. After the sale the taxpayer had no interest in or control of X or Z. The taxpayer received for each share of X stock $10 cash in the year of sale. The balance is payable in twenty consecutive semi-annual installments, the first of which is payable March 31, 1977.

In connection with the sale of X stock to Z, the taxpayer was required to make certain representations and warranties pertaining to the assets, liabilities and business of X and, in addition, to guarantee that Z would acquire valid and marketable title to X's stock.

The taxpayer agreed to indemnify Z for any loss sustained or expense incurred as a result of a breach of any representation or warranty. The right of indemnification extends for a period of 1 year from the date of sale for inventory losses and 4 years for specific losses other than inventory. Any amount that becomes due Z under the indemnity agreement may be recovered only by means of an offset against the unpaid balance of the purchase price.

Section 453(b) of the Code provides, in part, that income from the casual sale of personal property for a price exceeding $1,000 may be reported on the installment method of accounting in the manner prescribed in section 453(a), if, in the year of sale, there are no payments, or the payments (exclusive of evidence of indebtedness of the purchaser) do not exceed 30 percent of the selling price. Section 453(a)(1) provides for the reporting of income on the installment method of accounting as the installment payments are actually received.

The question is whether the existence of the agreement providing for indemnification for breaches of warranties and representations, by a set-off against the purchase price, makes the total contract price indeterminable and, thereby, precludes the use of the installment method of accounting for the sale.

In J.P. Jerpe v. Commissioner, 45 B.T.A. 199 (1941), acq., 1942-1 C.B. 9, when a taxpayer elected the installment method of reporting the gain on the sale of stock, the cancellation of two payments in a later year did not affect the taxpayer's election to use the installment method. The taxpayer in that case was required to recompute the percentage of gain to be reported upon the basis of subsequent installment payments. See also Rev. Rul. 72-570, 1972-2 C.B. 241.

Where, as here, the seller has a potential liability that is contingent upon the breach of one or more warranties or representations, the existence of that contingency does not make the original contract price indeterminable. The purchaser's obligation to pay the total contract price is fixed regardless of whether it is satisfied by payment or by an offset against the purchase price.

Accordingly, for the calendar year 1976, the taxpayer may elect the installment method of reporting gain on the sale of X stock to Z. Further, if such an election is made, the taxpayer must continue to use the installment method with respect to that transaction even though in a later year the percentage of gain to be reported must be recomputed because the purchaser exercised the right of offset due to a breach of warranty or representation.