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Background. I owned series A and series B preferred stock in a private company that merged with a public company in 2015 giving rise to large gains.The merger closing date occurred in September 2015 at which time cash proceeds were paid out shortly thereafter but 10% of the sales consideration was placed in escrow for one year and "available to the buyer in certain situations to cover indemnification claims". The escrow was paid in full to the selling shareholders one year later. I later learned that this merger agreement ("MA") stated that the escrow payouts "distributions of cash out of the Escrow Fund should be eligible for installment sale reporting". The MA describes the mechanics of the installment method.

2015 Reporting. I received a 1099-B from the escrow agent itemizing the series A and B proceeds paid out in 2015 (cost basis was not shown on the 1099). The 1099 did not include the escrow amounts held back payable in 2016. At the time of filing my 2015 return, I was not aware of the installment sales method. I filed the return based on the sales proceeds reported on the 1099, and I used the full cost basis of each investment to report the gain (did not use installment method).

2016 Reporting. At the time I filed the 2015 return, I did not know what portion of the escrow proceeds might ultimately be paid out, if any. My plan at the time was to report all escrow proceeds received as gain (since I used all cost basis when calculating the gain reported on my 2015 return). Hence, proceeds received in 2016 = gain amounts.

Issues. Now that I have recently become aware of the installment method and the fact that the gains were presumably eligible for installment sales treatment, I'm not sure what to do. I've read that you can only elect out of the installment sales method by filing the full gain (including any escrow paid in future years) in the tax year of the transaction. Because I never reported the full gain (including escrowed amounts) in 2015, I never correctly elected out of the installment sale method. So I under-reported the taxable gain in 2015, even though I would have reported the correct gain amount for the entire transaction once my 2016 were filed (i.e. over-reporting in 2016). I am in the same marginal tax bracket and subject to 20% capital gains tax rate in both 2015 and 2016 regardless of whether I had reported the full gain (with escrow) in 2015 or, alternatively, had correctly reported using the installment sales method.

What should I do? So I don't know how to correctly amend the 2015 return, or even if an amendment is necessary? Do I recompute the reportable gain for 2015: (a) using the installment sales method or (b) based on the entire merger consideration including the escrow proceeds, or do I (c) not amend the 2015 return and simply report the proceeds received in 2016 as gain on the 2016 return (unbeknownst to me, I think the way I filed 2015 is called an "open transaction"?

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After much research, the answer is "a": recompute the tax return using the installment sales method because (1) the escrow payment was subject to "substantial restrictions" by virtue of the escrow being structured to pay buyer's indemnification claims and (2) the taxpayer did not correctly elect out of the installment method by reporting the entire gain including the escrow payments on the return in the year of the transaction.

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    This has the potential to be a good answer, but particularly for tax questions, I think it is critical to include references that the asker can use to confirm the answer himself/herself. Personally, I would not want my stated words to be given as fact in a tax context in an open site like this, I would prefer to state a limited interpretation of a direct link to the IRS website. Adding sources would greatly increase the value of this answer. – Grade 'Eh' Bacon May 26 '17 at 18:38

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