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Professional Judgment
 
Unrealized Income

In some situations a family might have unrealized income which might or might not be reported as untaxed income. This can occur in the following situations:

  • Earn-outs. An earn-out is when a business is sold on an installment contract. This involves an up-front payment upon signing the sales agreement, and an annual royalty for a specified number of years afterward. The annual fee might be a flat amount or a percentage of revenues. Earn-outs are common when certain types of professional businesses are sold, such as accounting and veterinary practices.

  • Seller financing. This occurs when the seller provides the buyer with financing to help facilitate the sale. The seller receives a down payment and a future stream of payments in exchange for the property.

  • Forward sale. A forward sale occurs when a stockholder agrees to sell shares in a corporation at a future date in exchange for payment now. The number of shares that will be sold will depend on the stock price at that time, within a specified range. This is effectively a form of hedging, akin to bracketing the transaction with puts and calls to limit risk. In the meantime the stockholder retains the voting rights, gets cash now to diversify their portfolio, and doesn't have to report the transaction as a sale (possibly affecting the stock price).

  • Deferred compensation. An employee can sometimes forgo their wages in exchange for unspecified compensation at a future date. The employee presumably lives off of savings in the interim. This might or might not be a hands-length transaction (i.e., the employee might have a controlling interest in the employer). This can also occur with artists, who may have a feast/famine cycle where they live off of savings while working on their next great work of art.

In each of these circumstances the income is not realized simultaneously with the completion of the transaction. (A transaction is completed when it can no longer be revoked. For example, in an earn-out a failure to make a payment might constitute breach of contract and cause the business to revert to the original owners.) In some cases it is realized before, in some cases it is realized after, and in some cases it is realized over a period of time. The income might be recognized as taxable income when it is received, or it might be recognized as taxable income only when the transaction is completed.

Clearly, this can significantly complicate the process of assigning value to an asset and identifying the income associated with the transaction. The financial aid administrator may need to use professional judgment to simplify the treatment of the income and assets.

For an earn-out, one approach is to distinguish the present interest in the proceeds from the sale of the business from the future interest in the annual payments. The money already received is treated as a liquid asset. The net present value of the future income is treated as a business asset. If there is income in the base year from the transaction, professional judgment is used to exclude it as income (but it remains as an asset), just like other one-time events. This avoids the complexities of trying to distribute the capital gain among the payments.

Another approach is to amortize the proceeds from the sale over the duration of the sale, which runs from the date the contract is closed to the date the transaction is completed.

Seller financing should generally be treated as two separate transactions, a sale of the asset and a loan to the buyer. This assumes that the sale of the asset represents a completed transaction. In the first transaction, the seller has sold the property in exchange for the full proceeds from the sale, including the balance owed. In the second transaction, the seller has provided a loan to the buyer (probably guaranteed by a security interest in the property) and will be receiving amortized payments on the debt. Thus there are capital gains on the sale of the asset (assuming the transaction was during the prior tax year), an investment asset (the buyer's debt), and investment income (the payments by the buyer on the debt). Sometimes, however, the debt is structured in a manner that is similar to that of an earnout, making it more difficult to assign a value to the debt as an investment asset.

For a forward sale, the simplest approach is to treat it as though it were a completed transaction, representing the net present value of the future tax bill as a liability and the cash received as an asset. Professional judgment is used to exclude the transaction as income.

For deferred compensation, the employee clearly has a future interest in the unspecified income, and that future interest has value, even if it is presently indeterminate. This may represent a very clever attempt to circumvent the need analysis process. However, professional judgment allows the financial aid administrator to make adjustments to reflect the family's true ability to pay during the award year. Perhaps the best approach to use in this case is to replace prior tax year income with an average of several years worth of income.

There is a fourth method families might use to artificially reduce their income for financial aid purposes. In this method, known as "retained income", the employee's salary is paid by a C corporation in which he owns a controlling interest. While his children are in school, the employee has the corporation reduce his income, allowing the corporation to retain the income until after the children graduate from college. The income is no longer reported on the FAFSA as income, as the corporation is a separate legal entity. (This trick does not work with S corporations or partnerships, since the earnings retained by such entities pass through to the income tax returns of the shareholders.) Instead, the income is reported on the FAFSA as an asset, since the corporation is treated as an investment or business asset. This benefits the family, since assets are assessed at a lower rate than income by the need analysis formula. If the family qualifies for the Simplified Needs Test, the value of the asset is disregarded entirely. C Corporations do have a higher income tax rate, so the family will likely pay more in taxes. This trick is most likely to be used by doctors, lawyers and accountants, who often set up a corporation to run their business for liability reasons.

Unfortunately, there isn't much the financial aid administrator can do about the retained income trick, as the corporation is a separate legal entity. Some financial aid administrators will make an adjustment for closely held C corporations that retain income, but it is difficult to determine the appropriate adjustment. A better approach is to use a multi-year average of the employee's income. Unfortunately, if the employee has managed the corporation carefully, the only mention of the corporation will be as a business or investment asset on the FAFSA. There will be no mention of the corporation on the employee's IRS Form 1040, as the corporation files its own income tax return (IRS Form 1120).

 

 
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