MEMORANDUM
PRIVILEGED AND CONFIDENTIAL ATTORNEY-CLIENT PRIVILEGED ATTORNEY WORK PRODUCT
TO:
Marcus Pellegrino, Partner, Healthcare Ardent Capital Partners III LP 600 Lexington Avenue, 38th Floor New York, NY 10022
Claire Ashworth, Co-Founder & Managing Partner Ardent Capital Partners III LP 600 Lexington Avenue, 38th Floor New York, NY 10022
FROM:
Leonard Cross, Responsible Partner, Tax — Calderwood & Harkness LLP Robert Jansen, Lead Associate, Tax — Calderwood & Harkness LLP Garrett Simmons, Working Associate, Tax — Calderwood & Harkness LLP
DATE: March 5, 2024
RE: Earnout Reporting Alternatives — Open Transaction vs. Closed Transaction / Installment Method Analysis — Acquisition of Pinnacle Health Services Group LLC
Engagement No.: 1001-00006
Matter No.: 1001-00006
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I. Executive Summary
You have asked us to analyze the federal income tax reporting alternatives available to the sellers of membership interests in Pinnacle Health Services Group LLC ("Pinnacle" or the "Company") in connection with the contingent earnout consideration payable under the Agreement and Plan of Merger (the "Merger Agreement") by and among Ardent Healthcare Merger Sub LLC, Ardent Healthcare Intermediate Inc., Ardent Healthcare Holdings LLC, Pinnacle Health Services Group LLC, and the equityholders of Pinnacle (anticipated signing date: March 15, 2024). This memorandum is intended to serve as a comprehensive tax planning resource for the deal team and for communication with sellers' counsel regarding the appropriate reporting methodology for the earnout.
Transaction Overview. Ardent Capital Partners III LP ("Ardent" or the "Fund") is acquiring 100% of the outstanding membership interests in Pinnacle via a reverse merger of Ardent Healthcare Merger Sub LLC ("Merger Sub") with and into Pinnacle, with Pinnacle surviving as a wholly owned subsidiary of Ardent Healthcare Intermediate Inc. ("Intermediate Inc."). The transaction has an enterprise value of $412,000,000 and an equity value of $339,400,000 (reflecting the enterprise value less $72,600,000 of net debt to be assumed or refinanced at closing). The anticipated closing date is May 31, 2024.
Earnout Structure. In addition to the closing cash consideration and rollover equity, the sellers are entitled to contingent earnout payments structured across two measurement periods. Period 1 (June 1, 2024 through May 31, 2025) provides for a payment of $15.0 million if Pinnacle achieves adjusted EBITDA of $58.0 million during that period. Period 2 (June 1, 2025 through May 31, 2026) provides for a payment of $20.0 million if Pinnacle achieves adjusted EBITDA of $65.0 million during that period. The maximum aggregate earnout consideration is $35.0 million. The earnout payments are allocated pro rata among all pre-closing Pinnacle members, including rollover participants on their cashed-out portions.
Reporting Methods Analyzed. This memorandum evaluates three reporting methods for the earnout:
1. Closed Transaction / Fair Market Value Method under Section 1001 of the Internal Revenue Code of 1986, as amended (the "Code"), which would require sellers to include the fair market value of the earnout right in the amount realized in the year of closing;
2. Open Transaction Method under Burnet v. Logan, 283 U.S. 404 (1931), which would permit sellers to defer gain recognition on the earnout until payments are received and basis is fully recovered; and
3. Installment Method under Section 453 of the Code, which would permit sellers to recognize gain ratably as earnout payments are received, based on a gross profit ratio derived from the maximum selling price.
Recommendation. For the reasons discussed at length below, we recommend that individual sellers report the earnout under the installment method provided by Section 453 of the Code. The installment method is the default reporting method for qualifying sales where at least one payment is received after the close of the taxable year in which the disposition occurs. The Pinnacle earnout qualifies as a contingent payment sale with a stated maximum selling price under Treasury Regulation § 15a.453-1(c)(2), and the installment method provides the most favorable timing of gain recognition for the sellers while avoiding the practical and legal difficulties inherent in both the closed transaction method (which requires an FMV determination of a binary, non-transferable earnout right) and the open transaction method (which is reserved for "rare and extraordinary" cases and is not available here given the stated maximum selling price and fixed payment period). We discuss the implications for each category of seller below.
Cross-References. This memorandum should be read in conjunction with the following companion analyses previously delivered or in preparation:
• Earnout Tax Characterization Memorandum dated March 1, 2024 (addressing capital gain vs. ordinary income / compensation characterization of the earnout payments);
• Rollover Equity Tax Memorandum dated February 22, 2024 (addressing the tax-deferred treatment of rollover equity contributions under Section 721); and
• State & Local Tax Memorandum dated February 20, 2024 (addressing state income tax conformity and nonresident withholding obligations).
This memorandum assumes throughout that the earnout payments constitute additional purchase price for the sale of Pinnacle membership interests and will be treated as capital gain to the sellers, not as compensation for services. The basis for that characterization is set forth in the separate Earnout Tax Characterization Memorandum dated March 1, 2024.
II. Background and Transaction Facts
A. The Sellers and Their Interests
Pinnacle Health Services Group LLC is a Delaware limited liability company (EIN 82-1947632) classified as a partnership for federal income tax purposes. The Company is headquartered at 2200 Renaissance Boulevard, Suite 400, King of Prussia, Pennsylvania 19406. Pinnacle was founded in 2016 by Dr. Raymond Carvallo and Dr. Nadia Ostrowski and has grown to operate a network of 34 urgent care clinics and 8 ambulatory surgery centers, totaling 42 facilities across five states: Pennsylvania, Virginia, Maryland, North Carolina, and Georgia. For the fiscal year ending December 31, 2023, Pinnacle reported revenue of $287.4 million and adjusted EBITDA of $51.8 million. The Company employs approximately 1,620 individuals, including 142 employed physicians.
The ownership structure of Pinnacle and the disposition of each member's interests in the transaction are summarized below:
Total rollover equity is $59.54 million ($32.41 million from Dr. Carvallo, $24.18 million from Dr. Ostrowski, and $2.95 million from Mr. Farnsworth). Rollover participants will receive Class B Units of Ardent Healthcare Holdings LLC in exchange for their contributed interests. The rollover contribution is intended to qualify as a tax-deferred contribution under Section 721 of the Code, as analyzed in the separate Rollover Equity Tax Memorandum dated February 22, 2024. The 14 minority physician-investors are fully cashing out and do not participate in the rollover.
Each seller's adjusted outside basis in their Pinnacle membership interests has not yet been confirmed. We are coordinating with Brewer Stanfield & Associates LLP, Pinnacle's tax return preparer and accounting firm, to obtain the sellers' capital account and basis information as reflected on the most recent Schedule K-1s (for the taxable year ending December 31, 2023) and to determine the impact of any income, loss, and distribution allocations through the closing date. The illustrative computations set forth in this memorandum and in Appendix A use assumed basis figures pending final confirmation.
B. The Earnout Consideration
In addition to the closing cash consideration and rollover equity described above, the sellers are entitled to contingent earnout payments under the Merger Agreement. The material terms of the earnout are as follows:
Period 1 Earnout. A payment of $15.0 million is payable to the sellers if Pinnacle achieves adjusted EBITDA of at least $58.0 million for the twelve-month measurement period beginning June 1, 2024 and ending May 31, 2025. Payment, if earned, is due within sixty (60) days following the conclusion of the measurement period and completion of the earnout calculation and dispute resolution procedures set forth in the Merger Agreement.
Period 2 Earnout. A payment of $20.0 million is payable to the sellers if Pinnacle achieves adjusted EBITDA of at least $65.0 million for the twelve-month measurement period beginning June 1, 2025 and ending May 31, 2026. Payment, if earned, is due within sixty (60) days following the conclusion of the measurement period and completion of the earnout calculation and dispute resolution procedures.
Maximum Aggregate Earnout. The maximum aggregate amount payable under the earnout provisions is $35.0 million ($15.0 million for Period 1 plus $20.0 million for Period 2).
Earnout Acceleration. One hundred percent (100%) of any remaining unpaid earnout amounts become immediately payable upon a change of control of Ardent Healthcare Holdings LLC during the earnout period, without regard to whether the applicable EBITDA targets have been achieved.
Allocation Among Sellers. The earnout is allocated pro rata among all pre-closing Pinnacle members based on their respective percentage interests. For rollover participants (Carvallo, Ostrowski, and Farnsworth), only the cashed-out portion of their interests participates in the earnout; the rollover portion is not entitled to earnout payments. The illustrative allocation of the maximum aggregate $35.0 million earnout is as follows:
Characterization. As noted above, the earnout payments are treated as additional purchase price for the sale of Pinnacle membership interests and will constitute capital gain to the sellers (not compensation). This characterization is analyzed separately in the Earnout Tax Characterization Memorandum dated March 1, 2024.
Section 483 Imputed Interest. The earnout payments under the Merger Agreement do not provide for stated interest. Because certain earnout payments may be received more than one year after the closing date, Section 483 of the Code applies to re-characterize a portion of each such deferred payment as imputed interest taxable as ordinary income. The applicable federal rates ("AFRs") at the anticipated signing date (March 15, 2024) are 5.12% for the short-term AFR (obligations with a term not exceeding three years) and 4.67% for the mid-term AFR (obligations with a term exceeding three years but not exceeding nine years). The interaction between Section 483 and the installment method is discussed in detail in Section VI below.
C. Acquisition Structure
Calderwood & Harkness LLP structured a three-tier acquisition vehicle for the Fund's acquisition of Pinnacle:
Ardent Healthcare Holdings LLC — A Delaware limited liability company (EIN 93-2187445) classified as a partnership for federal income tax purposes. Holdings LLC serves as the top-level holding company in the acquisition structure and is the entity in which the Fund's committed equity, the rollover Class B Units, and the mezzanine lender's equity warrants are held.
Ardent Healthcare Intermediate Inc. — A Delaware corporation (EIN 93-2187512) classified as a C-corporation for federal income tax purposes. Intermediate Inc. serves as a "Blocker" entity interposed between Holdings LLC and Pinnacle to facilitate the Fund's tax structuring objectives and to serve as the direct parent of the surviving entity following the merger.
Ardent Healthcare Merger Sub LLC — A Delaware limited liability company formed solely for the purpose of effecting the merger. On the closing date, Merger Sub will merge with and into Pinnacle, with Pinnacle surviving as a wholly owned subsidiary of Intermediate Inc.
The acquisition is financed as follows:
The mezzanine notes issued to Cascadia Mezzanine Fund IV LP carry fully diluted equity warrants representing 2.5% of Holdings LLC on a fully diluted basis.
Following the closing, Pinnacle will make an election under Section 754 of the Code. The Section 743(b) adjustment attributable to the acquisition will provide a basis step-up of approximately $224.4 million, calculated as the difference between the $412.0 million enterprise value and the approximately $187.6 million of aggregate inside basis in Pinnacle's assets.
III. Legal Framework — Overview of Reporting Methods for Contingent Consideration
When a sale of property involves contingent consideration — such as an earnout — the seller must determine the appropriate method for reporting gain or loss. The Internal Revenue Code and Treasury Regulations provide three potential frameworks, each of which carries distinct consequences for the timing and character of gain recognition. This section describes each method in the abstract before applying them to the Pinnacle transaction in Section IV.
A. Section 1001 — Closed Transaction Method
Under the general rule of Section 1001 of the Code and Treasury Regulation § 1.1001-1(a), the amount realized on a sale or other disposition of property includes the sum of any money received plus the fair market value of any other property (including contractual rights) received by the seller. Gain or loss is then determined by comparing the amount realized to the seller's adjusted basis in the property sold.
If the contingent earnout right received by the seller has an ascertainable fair market value at the time of closing, the transaction is treated as a "closed transaction" for tax purposes. The seller must include the full fair market value of the earnout right in the amount realized in the year of sale, together with all cash and other consideration received at closing. The seller's entire adjusted basis in the sold property is allocated against the total amount realized, and the resulting gain or loss is recognized in the year of the disposition.
In subsequent years, when earnout payments are actually received, the seller compares the amount received to the fair market value previously reported. If the actual payment exceeds the previously reported fair market value, the excess is treated as additional capital gain in the year of receipt. Conversely, if the actual payment is less than the previously reported fair market value — or if no payment is received because the earnout targets are not achieved — the seller recognizes a capital loss in the year the contingency is resolved.
The closed transaction method derives from the general recognition principles of Section 1001 and from Commissioner v. Philadelphia Park Amusement Co., 126 F. Supp. 184 (Ct. Cl. 1954). It presupposes that the contingent right received by the seller can be valued with sufficient reliability to support immediate gain recognition.
B. Burnet v. Logan — Open Transaction Method
In Burnet v. Logan, 283 U.S. 404 (1931), the Supreme Court held that where contingent consideration received in exchange for property cannot be valued with reasonable certainty — that is, where the consideration has no ascertainable fair market value — the seller may report the transaction as "open." Under open transaction treatment, the seller first applies all payments received (including closing cash) against the seller's adjusted basis. Gain is not recognized until the seller's entire basis has been recovered. Thereafter, all additional payments — including contingent earnout receipts — are taxable in full as gain.
The practical significance of the open transaction method lies in its deferral advantage: if the closing cash proceeds do not exceed the seller's basis, the seller pays no tax in the year of sale and continues to defer gain recognition until aggregate payments exceed basis. However, the open transaction method is severely limited in its availability. Treasury Regulation § 15a.453-1(d)(2)(iii) provides that open transaction treatment is reserved for "rare and extraordinary" cases in which the fair market value of the contingent consideration cannot reasonably be ascertained. The regulation expresses a strong presumption that contingent payments are amenable to valuation and that either the installment method or the closed transaction method will apply in the ordinary course.
Courts have similarly been reluctant to extend Burnet v. Logan beyond its narrow original context. See, e.g., Campagna v. Commissioner, T.C. Memo. 1990-576 (declining to apply open transaction treatment where contingent payments had an ascertainable value); Estate of Wiggins v. Commissioner, T.C. Memo. 1987-360 (same). Revenue Ruling 58-402, 1958-2 C.B. 15, further confirms the IRS's position that the open transaction doctrine should be narrowly applied and that the installment method is the preferred reporting mechanism for sales involving contingent consideration.
C. Section 453 — Installment Method
Section 453 of the Code provides that, as a general rule, income from an installment sale shall be reported under the "installment method." An installment sale is defined as a disposition of property where at least one payment is to be received after the close of the taxable year in which the disposition occurs. Section 453(a). The installment method is the default reporting method for qualifying sales — it applies automatically unless the taxpayer affirmatively elects out under Section 453(d).
Under the installment method, each payment received by the seller is treated as consisting of three components: (1) a return of the seller's adjusted basis in the property sold; (2) gain on the sale; and (3) if applicable, imputed interest under Section 483 or Section 1274. The proportion of each payment that constitutes gain is determined by the "gross profit ratio," which equals the total expected gain (contract price minus adjusted basis) divided by the total contract price.
For contingent payment sales — including sales involving earnout consideration — special rules are provided by Treasury Regulation § 15a.453-1(c). The applicable sub-rule depends on the terms of the contingent payment arrangement:
(i) Stated Maximum Selling Price. If the contingent payment sale involves a stated maximum selling price (i.e., there is a cap on the total consideration the seller can receive), Treasury Regulation § 15a.453-1(c)(2)(i) provides that the seller's basis is allocated across all anticipated payments assuming the maximum selling price will be received. The gross profit ratio is computed using the maximum selling price as the denominator. If the maximum is not ultimately received — because, for example, earnout targets are not met — the seller's unrecovered basis is recognized as a capital loss in the year the contingency is resolved. See Treas. Reg. § 15a.453-1(c)(2)(ii).
(ii) Fixed Payment Period Without Maximum. If the contingent payment sale has no stated maximum selling price but the payments are to be made over a fixed period of time, Treasury Regulation § 15a.453-1(c)(3) provides that the seller's basis is recovered ratably over the fixed payment period.
(iii) Neither Maximum Nor Fixed Period. If the contingent payment sale has neither a stated maximum selling price nor a fixed payment period, Treasury Regulation § 15a.453-1(c)(4) provides that the seller's basis is recovered ratably over a period of fifteen (15) years commencing with the date of the sale.
The installment method is not available for certain categories of transactions. It does not apply to sales of personal property by dealers, sales of inventory, or dispositions at a loss. Section 453(b)(2), (k). It also does not apply to sales of property that is traded on an established securities market. Section 453(k)(2). Additionally, Section 453(i) requires that any gain attributable to "recapture income" — including ordinary income recognized under Section 1245, Section 1250, or Section 751(a) — must be recognized in full in the year of the disposition, notwithstanding the installment method. This exception for recapture income is particularly relevant in the context of partnership interest sales, as discussed in Section VII below.
For purposes of the Pinnacle transaction, the sellers are all individuals (not dealers, and not selling publicly traded property), and the sale of Pinnacle membership interests will generate at least one payment (the earliest possible earnout payment under Period 1) that will be received after the close of the 2024 taxable year. Accordingly, the threshold requirements for installment method reporting are satisfied.
IV. Application to the Pinnacle Transaction
A. Does the Earnout Have an Ascertainable Fair Market Value?
The threshold question in determining the appropriate reporting method for the Pinnacle earnout is whether the earnout right has an ascertainable fair market value at the time of closing. If it does, the closed transaction method under Section 1001 would apply, and the sellers would be required to include that fair market value in the amount realized on their 2024 tax returns. If it does not, the analysis proceeds to the installment method under Section 453 (as the default) or, in the narrow circumstance warranting such treatment, the open transaction method under Burnet v. Logan.
The following factors bear on this determination:
Factors Suggesting the Earnout May Have an Ascertainable Fair Market Value:
• The earnout is defined by reference to specific, quantifiable EBITDA targets — $58.0 million for Period 1 and $65.0 million for Period 2 — against which performance can be measured objectively.
• The maximum aggregate earnout is capped at $35.0 million, providing an upper bound on the possible consideration.
• Pinnacle has a meaningful operating history, having achieved adjusted EBITDA of $51.8 million for the fiscal year ending December 31, 2023, which provides a reasonable baseline for evaluating the probability of achieving the targets.
• The measurement period is relatively short — two successive twelve-month periods — limiting the forecasting horizon and, arguably, the degree of uncertainty.
Factors Suggesting Fair Market Value Is Not Readily Ascertainable:
• The earnout has a binary, all-or-nothing payout structure. For each measurement period, the sellers receive either the full stated amount or nothing. There is no sliding scale or pro rata payout based on partial achievement of the EBITDA target. This binary structure makes the earnout more difficult to value than a contingent payment with linear or formulaic payouts, because the value is acutely sensitive to whether a single threshold is crossed.
• Achievement of the EBITDA targets depends on future operational performance under new private equity ownership, which may entail significant changes in management practices, capital expenditure plans, staffing levels, clinical protocols, and payor mix — all of which introduce substantial uncertainty.
• The change of control acceleration provision introduces an additional layer of contingency: the earnout may be accelerated and paid in full upon a change of control of Ardent Healthcare Holdings LLC, without regard to EBITDA performance. The probability and timing of any such change of control event are inherently speculative.
• The earnout right is not freely transferable, tradeable, or marketable. There is no active market for the right to receive contingent payments under the Merger Agreement, and the right cannot be easily monetized or hedged by the sellers.
• The earnout is a contractual right under the Merger Agreement, not a negotiable instrument, promissory note, or security. It is not susceptible to conventional valuation methodologies applicable to traded financial instruments.
Conclusion. Based on the foregoing analysis, we conclude that the Pinnacle earnout does not have an ascertainable fair market value at closing. The binary payout structure, the non-transferability of the right, the operational contingencies inherent in post-acquisition EBITDA performance, and the absence of any market for the earnout right collectively render the earnout incapable of reliable valuation at the time of the disposition. This conclusion is consistent with the weight of authority, including Treasury Regulation § 15a.453-1(d)(2)(i) (providing that contingent payment sales in which the fair market value of the contingent payments is not reasonably ascertainable are reported under the installment method), and with the holdings in Estate of Wiggins v. Commissioner, T.C. Memo. 1987-360, and Campagna v. Commissioner, T.C. Memo. 1990-576 (each finding that binary or highly contingent earnout arrangements lack ascertainable fair market value). Because the earnout lacks an ascertainable fair market value, the closed transaction method under Section 1001 is not the appropriate reporting method.
B. Availability of Open Transaction Reporting
Having determined that the Pinnacle earnout does not have an ascertainable fair market value at closing, the next question is whether the sellers may report the transaction as an "open transaction" under Burnet v. Logan, 283 U.S. 404 (1931), or whether the installment method under Section 453 applies as the default reporting mechanism.
Under Treasury Regulation § 15a.453-1(d)(2)(iii), the open transaction method — under which the seller recovers basis before recognizing gain — is available only in "rare and extraordinary" cases in which the fair market value of the contingent consideration cannot be reasonably ascertained. The regulation's use of the phrase "rare and extraordinary" reflects a deliberate policy choice to limit the open transaction doctrine to exceptional circumstances and to channel the vast majority of contingent payment sales into the installment method framework.
Several features of the Pinnacle earnout weigh decisively against open transaction treatment:
• Stated Maximum Selling Price. The earnout is capped at a maximum aggregate of $35.0 million. The total maximum selling price for each seller's cashed-out interest is determinable: it equals the closing cash-out proceeds plus the seller's pro rata share of the $35.0 million maximum earnout. For example, Dr. Carvallo's maximum total consideration is $97.24 million (cash-out) plus $13.37 million (maximum earnout) = $110.61 million. The existence of a stated maximum selling price triggers the specific regulatory framework of Treasury Regulation § 15a.453-1(c)(2), which governs the allocation of basis in contingent payment installment sales with a stated maximum.
• Fixed Payment Period. The earnout has a defined payment period — two measurement periods ending May 31, 2025 and May 31, 2026, respectively. Payments, if earned, are due within sixty days following completion of the calculation procedures for each period. This is a "fixed period" within the meaning of Treasury Regulation § 15a.453-1(c)(3), further supporting the applicability of the installment method regulations.
• Regulatory Presumption. Treasury Regulation § 15a.453-1(d)(2)(iii) creates a strong presumption that contingent payment sales are reportable under the installment method. Open transaction treatment is available only as an exception to the general rule, and only where circumstances are so unusual as to fall outside the regulatory framework. The Pinnacle earnout — a capped, two-period performance earnout in a negotiated M&A transaction — is precisely the type of contingent payment arrangement contemplated by the installment method regulations.
Conclusion. Open transaction treatment under Burnet v. Logan is not appropriate for the Pinnacle earnout. The stated maximum selling price and the fixed payment period bring the earnout squarely within the installment method framework of Treasury Regulation § 15a.453-1(c)(2). The installment method under Section 453 is the applicable default reporting method.
We note, moreover, that even if open transaction treatment were theoretically available, it would provide limited practical benefit to most Pinnacle sellers. Under Burnet v. Logan, the seller recovers basis from initial closing proceeds before recognizing gain. However, for the principal sellers in this transaction, closing cash proceeds substantially exceed their adjusted basis in their Pinnacle membership interests. For example, Dr. Carvallo's cash-out proceeds of $97.24 million are expected to significantly exceed his adjusted outside basis in the cashed-out portion of his interest (illustratively estimated at $37.0 million, subject to confirmation). In such circumstances, gain would be fully recognized in the year of closing regardless of whether the open or installment method is applied, and the only earnout-related benefit of open transaction treatment would be to eliminate the need to compute a gross profit ratio — a marginal administrative convenience that does not justify departure from the installment method regulations.
C. Application of the Installment Method — Contingent Payment Sale with a Stated Maximum
Because the Pinnacle earnout has a stated maximum selling price ($35.0 million aggregate) and a fixed payment period (two measurement periods ending May 31, 2025 and May 31, 2026, respectively), the contingent payment installment sale rules of Treasury Regulation § 15a.453-1(c)(2) apply.
Under this regulation, the mechanics of the installment method are as follows:
Step 1: Determine the Maximum Selling Price. For each seller, the maximum selling price equals the sum of (a) closing cash-out proceeds received at closing and (b) the seller's pro rata share of the maximum aggregate earnout of $35.0 million. The maximum selling prices for the principal sellers are:
Step 2: Determine Each Seller's Adjusted Basis. Each seller's adjusted outside basis in their Pinnacle membership interests must be determined as of the closing date. For rollover participants (Carvallo, Ostrowski, and Farnsworth), the aggregate adjusted outside basis must be allocated between the cashed-out portion (which is subject to installment sale reporting) and the rollover portion (which is contributed to Holdings LLC on a tax-deferred basis under Section 721). The allocation should be based on the relative fair market values of the cashed-out and rollover portions at closing, consistent with Treasury Regulation § 1.61-6(a) and general basis allocation principles. The actual basis figures are pending confirmation from Brewer Stanfield & Associates LLP. The illustrative computations in this memorandum use assumed figures.
Step 3: Compute the Gross Profit and Gross Profit Ratio. The gross profit equals the maximum selling price minus the seller's adjusted basis allocated to the cashed-out portion. The gross profit ratio equals the gross profit divided by the maximum selling price:
Gross Profit = Maximum Selling Price − Adjusted Basis
Gross Profit Ratio = Gross Profit ÷ Maximum Selling Price
Step 4: Apply the Gross Profit Ratio to Each Payment. Each payment received — including the closing cash-out payment and each earnout payment (net of any imputed interest component under Section 483) — is multiplied by the gross profit ratio to determine the gain recognized in the year of receipt. The remainder of each payment constitutes a return of basis.
Step 5: Adjust for Contingencies Not Achieved. If the maximum earnout is not achieved — for example, if one or both of the EBITDA targets are missed and the corresponding earnout payment is zero — the seller has unrecovered basis that was allocated to the missed payment. Under Treasury Regulation § 15a.453-1(c)(2)(ii), that unrecovered basis is recognized as a capital loss in the year in which the contingency is resolved (i.e., the year in which it becomes certain that the payment will not be made). In the case of the Pinnacle earnout, the contingency for Period 1 would be resolved no later than mid-2025 (when the adjusted EBITDA for the Period 1 measurement period is determined), and the contingency for Period 2 would be resolved no later than mid-2026.
D. Illustrative Computation — Dr. Raymond Carvallo
The following illustrative computation demonstrates the application of the installment method to Dr. Carvallo's cashed-out interest, using assumed basis figures.
Assumptions:
• Carvallo holds 38.2% of Pinnacle membership interests.
• Gross equity proceeds: 38.2% × $339.4M = $129.65M.
• Cash-out portion: 75% × $129.65M = $97.24M (received at closing, May 31, 2024).
• Rollover portion: 25% × $129.65M = $32.41M (tax-deferred under Section 721; excluded from this computation).
• Pro rata share of maximum earnout (on cashed-out portion): 38.2% × $35.0M = $13.37M.
• Period 1: 38.2% × $15.0M = $5.73M
• Period 2: 38.2% × $20.0M = $7.64M
• Maximum total consideration (cash-out plus maximum earnout): $97.24M + $13.37M = $110.61M.
• Assumed adjusted outside basis in cashed-out portion: $37.0M. (Note: This figure is illustrative. Carvallo's proportionate share of aggregate outside basis of approximately $291.1M × 38.2% = approximately $111.20M. Of this, 75% cash-out allocation would yield approximately $83.40M; however, the actual allocation between cash-out and rollover must be determined based on relative fair market values and the specific facts of the rollover. For purposes of this illustration, we assume $37.0M is allocated to the cash-out portion. Actual basis to be confirmed with Brewer Stanfield & Associates LLP.)
• Gross profit: $110.61M − $37.0M = $73.61M.
• Gross profit ratio: $73.61M ÷ $110.61M = 66.55%.
Year 1 (Taxable Year 2024 — Closing Payment):
• Payment received: $97.24M (closing cash-out proceeds).
• Gain recognized: $97.24M × 66.55% = $64.71M (long-term capital gain, assuming Carvallo has held his Pinnacle membership interest for more than one year prior to the closing date, which is expected to be the case given Pinnacle's founding in 2016).
• Basis recovered: $97.24M × 33.45% = $32.53M.
• Remaining unrecovered basis: $37.0M − $32.53M = $4.47M (allocated to anticipated future earnout payments).
Year 2 (Taxable Year 2025 — Period 1 Earnout, if Achieved):
• Payment received: $5.73M (maximum Period 1 earnout), less any Section 483 imputed interest portion (discussed in Section VI below).
• Gain recognized (on principal portion): $5.73M × 66.55% = $3.81M (before imputed interest adjustment; actual gain on principal portion may be slightly lower due to the reduction of the payment by imputed interest).
• Basis recovered: $5.73M × 33.45% = $1.92M.
Year 3 (Taxable Year 2026 — Period 2 Earnout, if Achieved):
• Payment received: $7.64M (maximum Period 2 earnout), less any Section 483 imputed interest portion.
• Gain recognized (on principal portion): $7.64M × 66.55% = $5.08M (before imputed interest adjustment).
• Basis recovered: $7.64M × 33.45% = $2.56M.
If Either Earnout Period Is Not Achieved:
If the Period 1 EBITDA target of $58.0 million is not met and no Period 1 earnout is payable, the $1.92M of basis allocated to the Period 1 payment would be recognized as a short-term or long-term capital loss (depending on the holding period analysis) in the year the contingency is resolved (2025). Similarly, if the Period 2 EBITDA target of $65.0 million is not met, the $2.56M of basis allocated to the Period 2 payment would be recognized as a capital loss in 2026.
If neither earnout period is achieved, the aggregate unrecovered basis of $4.47M ($1.92M + $2.56M) would be recognized as capital losses in the respective years the contingencies lapse, providing a partial tax offset.
Illustrative computations for Dr. Ostrowski, Mr. Farnsworth, and a representative minority physician-investor are set forth in Appendix A.
E. Seller Categories and Method Applicability
The installment method's availability and application vary depending on the category of seller:
Individual Sellers (Carvallo, Ostrowski, Farnsworth, 14 Minority Physician-Investors). The installment method under Section 453 is available as the default reporting method for all individual sellers. Section 453 applies automatically unless an individual seller affirmatively elects out under Section 453(d) on or before the due date (including extensions) of the seller's federal income tax return for 2024. We recommend that all individual sellers allow the installment method to apply by default, for the reasons discussed in Section V below.
Rollover Equity Participants. For the three rollover participants — Carvallo, Ostrowski, and Farnsworth — the rollover portion of their Pinnacle membership interests is treated as a tax-deferred contribution to Ardent Healthcare Holdings LLC under Section 721 of the Code. The rollover is not a "sale or exchange" and is therefore not subject to installment sale reporting. The installment method analysis applies only to the cashed-out portion of each rollover participant's interest and to the corresponding pro rata share of the earnout allocated to that cashed-out portion. The basis allocation between the cashed-out and rollover portions is discussed in Section IX, Recommendation 6.
Character of Gain. The sale of Pinnacle membership interests generally produces long-term capital gain to the extent the interests have been held by the sellers for more than one year. Given Pinnacle's founding date of 2016 and the continuous membership of the principal sellers since inception or near-inception, long-term holding period treatment is expected for all sellers. However, Section 751(a) of the Code requires that a portion of the gain attributable to Pinnacle's "hot assets" — unrealized receivables and substantially appreciated inventory — be recharacterized as ordinary income, regardless of holding period. The Section 751(a) analysis is addressed in Section VII. To the extent any gain is recharacterized as ordinary income under Section 751(a), such ordinary income cannot be deferred under the installment method and must be recognized in the year of sale (2024) pursuant to Section 453(i). The remaining capital gain portion is reportable under the installment method.
C-Corporation Sellers. There are no C-corporation sellers in this transaction; all Pinnacle members are individuals. However, the deal team should confirm that Ardent Healthcare Intermediate Inc., as the corporate purchaser, does not inadvertently hold any installment obligation (for example, by assuming any seller's rights under the Merger Agreement) that could trigger gain acceleration under Section 453(h) or Section 453B. No such circumstance is anticipated based on the current transaction structure.
V. Election Out of the Installment Method
A. Section 453(d) Election
Section 453(d) of the Code permits any taxpayer to elect out of the installment method with respect to any sale. If a Pinnacle seller elects out, the seller would report the entire gain on the sale — including gain attributable to the contingent earnout — on the seller's federal income tax return for the year of the disposition (taxable year 2024).
The mechanics of the election are straightforward: the seller simply reports the sale on the 2024 return without using the installment method (i.e., without filing Form 6252 for the sale). The election must be made on or before the due date (including extensions) of the seller's federal income tax return for 2024 — generally, October 15, 2025 (assuming a timely extension is filed for an individual calendar-year taxpayer).
If a seller elects out of the installment method, the seller effectively reports the transaction under the closed transaction method described in Section III.A above. This requires the seller to determine the fair market value of the earnout right as of the closing date and to include that value in the total amount realized. The gain or loss recognized in 2024 would then be computed as the amount realized (closing cash-out proceeds plus fair market value of the earnout right) minus the seller's adjusted basis. In subsequent years, the seller would compare actual earnout receipts to the FMV previously reported and recognize additional gain (if actual receipts exceed FMV) or loss (if FMV exceeds actual receipts).
Importantly, once an election out of the installment method has been made, it generally may not be revoked without the consent of the Internal Revenue Service. See Section 453(d)(2). Such consent is rarely granted absent a showing that the taxpayer made the election based on a mistake of fact. Accordingly, the decision to elect out should be made with careful consideration and finality.
B. Circumstances Where Election Out May Be Considered
Although we generally recommend against electing out for the Pinnacle sellers (as discussed below), there are limited circumstances in which an individual seller might consider an election:
• Expiring Capital Losses. If a seller has significant capital losses from other transactions that are expiring (e.g., capital loss carryforwards approaching their five-year expiration for corporate taxpayers, or more commonly, substantial capital losses realized in 2024 from unrelated investments that the seller wishes to offset), accelerating the full gain from the Pinnacle sale into 2024 could provide a useful offset. For individual taxpayers, capital losses in excess of capital gains are deductible only up to $3,000 per year ($1,500 for married filing separately), with the remainder carried forward indefinitely. Thus, the utility of this strategy depends on the magnitude of available capital losses.
• Anticipated Higher Tax Rates in Future Years. If a seller has reason to believe that federal capital gains tax rates will increase in 2025 or 2026 — whether due to legislative action, changes in filing status, or other factors — the seller might prefer to recognize all gain in 2024 at the current rate. As of the date of this memorandum, the maximum federal long-term capital gains rate for individuals is 20%, plus the 3.8% net investment income tax under Section 1411, for a combined rate of 23.8%. Any legislative increase in this rate could affect the relative attractiveness of accelerated recognition.
• Low Perceived FMV of Earnout. If a seller believes the fair market value of the earnout right is low — for example, because the seller has doubts about Pinnacle's ability to achieve the EBITDA targets under PE ownership — electing out and reporting a low FMV for the earnout in 2024 could result in lower taxable gain in the year of sale. If the earnout is subsequently paid and the actual payment exceeds the reported FMV, additional gain would be recognized in the year of receipt. This strategy is speculative and could invite IRS scrutiny of the FMV determination.
Recommendation. We generally advise against electing out of the installment method for the Pinnacle sellers. The installment method provides superior timing of gain recognition, allowing sellers to defer gain on the earnout payments until those payments are actually received. Electing out requires the seller to determine the fair market value of the earnout right — a difficult and potentially contentious exercise given the binary payout structure, non-transferability, and operational contingencies discussed in Section IV.A above. The risk of IRS challenge to the reported FMV (either as too high or too low) is an unnecessary complication. Unless a specific seller has compelling tax circumstances that outweigh these considerations, the installment method should be used.
If any individual seller wishes to explore an election out, we recommend that such seller engage a qualified valuation firm to prepare an independent fair market value appraisal of the earnout right as of the closing date, and that the election be made in consultation with the seller's personal tax advisor.
VI. Interaction with Section 483 Imputed Interest
A. Overview of Section 483
Section 483 of the Code applies to payments made under a contract for the sale or exchange of property where some or all of the payments are due more than one year after the date of the sale or exchange and the contract does not provide for adequate stated interest. When applicable, Section 483 re-characterizes a portion of each deferred payment as "unstated interest," which is treated as interest income to the seller (taxable as ordinary income) and as interest expense to the buyer (potentially deductible, subject to applicable limitations).
The purpose of Section 483 is to prevent sellers and buyers from disguising what is economically interest as part of the purchase price, thereby converting ordinary income to capital gain (for the seller) and a deductible expense to a non-deductible capital expenditure (for the buyer). Section 483 achieves this by imputing interest at the applicable federal rate promulgated monthly by the IRS under Section 1274(d).
The Pinnacle earnout payments under the Merger Agreement do not provide for stated interest. This is customary for earnout arrangements in M&A transactions. Because the earnout payments may be received more than one year after the closing date of May 31, 2024, and because the Merger Agreement does not provide for adequate stated interest on those payments, Section 483 applies to re-characterize a portion of the deferred earnout payments as imputed interest.
B. Applicable Federal Rate and Computation
The applicable federal rates in effect at the anticipated signing date of March 15, 2024, as published by the IRS under Section 1274(d), are as follows:
Because both earnout payment periods fall within a three-year window from the signing date (Period 1 is approximately 14–15 months after signing; Period 2 is approximately 26–27 months after signing), the short-term AFR of 5.12% applies to the imputed interest computation for both periods.
Period 1 Earnout (Payable Approximately June–August 2025). The Period 1 earnout payment, if achieved, is due within sixty days following the end of the Period 1 measurement period (May 31, 2025). The earliest possible payment date would be approximately July 2025, which is approximately 13–14 months after the closing date of May 31, 2024. Section 483 applies to payments made more than one year after the date of the sale. If the Period 1 earnout is paid within one year of the closing date, Section 483 technically would not apply. However, given the sixty-day calculation and dispute resolution period following May 31, 2025, actual payment is likely to occur more than twelve months after closing, placing it within the scope of Section 483. We recommend treating the Period 1 earnout as subject to Section 483 to the extent actual payment occurs more than one year after the closing date, and reserving the position that Section 483 does not apply to the extent payment occurs within one year.
Period 2 Earnout (Payable Approximately June–August 2026). The Period 2 earnout payment, if achieved, is due within sixty days following the end of the Period 2 measurement period (May 31, 2026). Payment would occur approximately 24–26 months after closing, clearly within the scope of Section 483.
Illustrative Computation for Period 2 (Dr. Carvallo's Share):
• Maximum Period 2 payment to Carvallo: $7.64M.
• Assumed payment date: August 1, 2026 (approximately 26 months after closing on May 31, 2024).
• discount period: 26 months (approximately 2.17 years).
• Applicable AFR: 5.12% (short-term, annual compounding).
• Present value at 5.12% for 2.17 years: $7.64M ÷ (1.0512)^2.17 = $7.64M ÷ 1.1131 = $6.86M (approximately).
• Imputed interest: $7.64M − $6.86M = $0.78M (approximately).
• The $0.78M is treated as ordinary interest income to Dr. Carvallo in the year of receipt (2026).
• The remaining $6.86M is treated as principal and is subject to installment method gain recognition (part return of basis, part capital gain).
Note: The illustrative computation in Section IV.D used a slightly different discount period (exactly 2 years) for simplicity. The precise imputed interest amount will depend on the actual payment date and the compounding convention applied. We have used a more refined estimate here for illustrative purposes; the exact computation should be performed at the time each earnout payment is received based on the actual payment date.
Tax Consequences to Buyer. Ardent Healthcare Intermediate Inc., as the purchaser, may be entitled to deduct the imputed interest portion of each earnout payment as interest expense in the taxable year in which the payment is made. However, the deductibility of such interest expense is subject to the limitations of Section 163(j) of the Code, which limits the deduction for business interest expense to 30% of the taxpayer's adjusted taxable income (with certain modifications) for the taxable year. The deal team should confirm the projected Section 163(j) limitation for Intermediate Inc. in the post-closing periods to determine whether the imputed interest deduction will be fully usable or subject to carryforward.
C. Coordination with Installment Method
When Section 483 applies to a contingent payment installment sale, the imputed interest must be separated from the principal component of each payment before the installment method gross profit ratio is applied. Treasury Regulation § 15a.453-1(c)(2)(iv) provides guidance on this coordination.
The mechanical sequence is as follows:
1. Determine the total payment received. For each earnout period in which a payment is made, the total payment amount is the gross earnout payment (e.g., $5.73M for Period 1 or $7.64M for Period 2, in the case of Dr. Carvallo).
2. Separate the imputed interest component. The imputed interest portion is computed by discounting the gross payment to its present value at the applicable AFR as of the closing date. The difference between the gross payment and the present value is the imputed interest, which is taxable as ordinary income to the seller in the year of receipt.
3. Apply the installment method gross profit ratio to the principal component. The principal component (gross payment minus imputed interest) is then multiplied by the gross profit ratio to determine the capital gain recognized in the year of receipt. The remainder of the principal component is a return of basis.
The result is that each earnout payment is bifurcated for tax purposes:
• Imputed interest portion → Ordinary income (taxable at ordinary income rates, up to 37% for 2024–2026, plus the 3.8% net investment income tax under Section 1411).
• Principal portion → Further divided into:
• Capital gain (at long-term capital gains rates, up to 20% plus 3.8% NIIT) — equal to the principal portion multiplied by the gross profit ratio; and
• Return of basis (non-taxable) — equal to the principal portion multiplied by (1 minus the gross profit ratio).
Sellers must report the imputed interest as ordinary income on their returns for the year of receipt and must separately report the installment sale gain on Form 6252 for that year.
VII. Section 751(a) "Hot Assets" Consideration
The sale of a partnership interest is treated for federal income tax purposes as the sale of a single capital asset. See Section 741. However, Section 751(a) of the Code provides an important exception: to the extent the amount realized on the sale of a partnership interest is attributable to the seller's share of the partnership's "unrealized receivables" (as defined in Section 751(c)) and "inventory items" that have "substantially appreciated" (as defined in Section 751(d)), the gain is recharacterized as ordinary income, not capital gain.
Application to Pinnacle. Pinnacle operates 34 urgent care clinics and 8 ambulatory surgery centers. In the ordinary course of its healthcare operations, Pinnacle generates significant accounts receivable from health insurance payors (commercial insurers, Medicare, Medicaid) and from patients for co-payments, deductibles, and self-pay balances. These accounts receivable constitute "unrealized receivables" within the meaning of Section 751(c) to the extent they exceed the partnership's basis in such receivables (which, for a cash-method partnership, would be zero). Even if Pinnacle uses the accrual method, any receivables not yet reflected in income could constitute unrealized receivables. In addition, Section 751(c) includes in the definition of "unrealized receivables" the recapture amounts under Section 1245 and Section 1250, which could apply to depreciable medical equipment and leasehold improvements held by Pinnacle.
Pinnacle may also hold pharmaceutical supplies, medical consumables, and other items that constitute "inventory" for Section 751(d) purposes, though the magnitude of such inventory relative to the overall transaction value is likely modest.
Impact on Installment Method Reporting. Under Section 453(i), any gain attributable to "recapture income" — which includes ordinary income recognized under Section 751(a) in connection with the sale of a partnership interest — must be recognized in full in the year of the disposition, notwithstanding the installment method. This means that the ordinary income component of each seller's gain cannot be deferred; it must be reported on the seller's 2024 return in its entirety.
The practical effect is as follows:
1. Each seller's total gain on the sale of their Pinnacle membership interest is bifurcated into (a) an ordinary income component attributable to the seller's share of Section 751(a) hot assets and (b) a capital gain component attributable to all other assets.
2. The ordinary income component is recognized in full in 2024, regardless of whether the seller uses the installment method.
3. The capital gain component is reported under the installment method, with the gross profit ratio applied only to the capital gain portion.
4. The ordinary income and capital gain components of the earnout payments are determined by allocating the total Section 751(a) ordinary income pro rata across all payments (closing cash and earnout), consistent with the allocation methodology of Treasury Regulation § 15a.453-1(c).
Recommendation. We recommend that the deal team coordinate with Brewer Stanfield & Associates LLP (Pinnacle's accounting firm) and Northmark Advisory Group LLC (the quality of earnings provider engaged by Ardent) to quantify Pinnacle's Section 751(a) hot asset amount as of the anticipated closing date of May 31, 2024. This quantification requires a determination of:
• The fair market value of all unrealized receivables held by Pinnacle, net of any basis therein;
• The fair market value of all inventory items held by Pinnacle that are "substantially appreciated" within the meaning of Section 751(d) (i.e., the aggregate fair market value of all inventory exceeds 120% of the aggregate adjusted basis of such inventory); and