Structured Installment Sales: Eliminate Buyer Risk While Deferring Taxes

You've just sold your business for $10 million, but there's a catch. To get the tax benefits of an installment sale, you have to trust that your buyer will actually pay you over the next 10 years. What if they go bankrupt? What if they just disappear?

As we discussed in our blog about installment sales, you can save a significant amount in capital gains taxes purely by spreading those same gains over multiple years. However, to do this properly, you can’t have full possession of your sales proceeds, meaning that you are at risk of the buyer never paying you! Unfortunately, this happens in an installment sale, the seller hands over the keys and then doesn’t get much more than a year or two of payments.

Is there a way to still receive installment sale tax treatment while making sure the buyer ponies up the cash upfront?

There is. Enter the Structured Installment Sale.

What is a Structured Installment Sale?

The Structured Installment Sale is an installment sale with no buyer risk. In this structure, your buyer deposits the entire purchase price with a qualified intermediary, usually an insurance company. The qualified intermediary then pays your installment note and interest out over the agreed upon period. The reason that this works is that you have no control of or access to the balance of your funds during the installment period. If you had access, you would have what’s called constructive receipt, and you would owe taxes on the full balance. Only by using a qualified intermediary with a bona fide contract can you avoid this issue.

How does a Structured Installment Sale Save You Money on Taxes?

The method that a Structured Installment Sale uses to save you taxes is Timing. By simply spreading your taxes out over multiple years, instead of paying all of your taxes in one year, you can save a significant amount in taxes. This is because a higher percentage of your gains wind up in a lower tax bracket.

This is the exact same mechanic as a regular installment sale. The only real difference is that the seller assumes no loan/buyer risk.

Using today’s tax brackets, you can see just how much more of the taxable gain is in the lower brackets if you had a $9,500,000 gain spread over 10 years.

By simply using the tax code to your advantage and spreading your payments over multiple years, you wind up with ~$5.5m less in the top tax bracket.

Case Study: Structured Installment Sale in Action

The Daniels family is married couple living in Georgia who are looking to sell their engineering business. The business is valued at $10,000,000 with $500,000 in basis. They’re considering utilizing an installment sale, and maybe even a structured installment sale, but aren’t sure it’s worth it.

As you can see, there is a substantial benefit to spreading the capital gains over 10 years. Once you add the interest in, the Daniels wind up owing more in taxes, but that’s because they’ve earned more!

Plus, the buyer deposited the full purchase price with their Intermediary, allowing them to sleep well at night knowing they had the full value of the funds.

One thing you may notice is that the interest rates are lower than our regular installment sale example. This is because the intermediaries are investing in safer assets than a loan to a small business buyer and typically pay less in interest as there is less risk present in the transaction.

When do I need to complete a Structured Installment Sale?

The Structured Installment Sale is a capital gains saving strategy that requires minimal pre-planning. Because the funds cannot ever be possessed by the seller, the sales agreement must use specific language related to the structured installment sale, and which institution will serve as intermediary.

Once that is done, a deposit is made, and the sale is complete.

What is required to complete a Structured Installment Sale.

There are several steps to complete a structured installment sale. These include, but are not limited to:

• Must be part of the purchase agreement
• Form 6252 must be filed with the IRS
• Intermediary must be selected (Don’t go with a questionable firm here!)

What could go wrong with a Structured Installment Sale?

There are a few limitations/drawbacks to consider with a Structured Installment Sale:

• IRC §453A charges interest on the deferred tax liability for installment amounts over $5,000,000.
• Not all assets are eligible for tax deferral in an installment sale, including inventory, accounts receivable and Section 1245 and Section 1250 property.
• Once elected, this cannot be changed, and you are locked into your contract.
• You must be comfortable with your intermediary. If they get into financial trouble, your deposit could be lost.
• One thing you’ll note is that buyer risk is gone. That is the largest risk of installment sales and is not present here.

Who is a Structured Installment Sale Best for?

A structured installment sale is best for business owners who will first and foremost be in a lower tax bracket in the years after their sale. In the event you will still be in the highest tax brackets, there are really no savings to be had by deferring your gains.

It is also valuable for business owners who are not comfortable with not receiving their payment upfront and would like to live on an income stream for a set amount of time.

How Ironclad Wealth Management Helps You Structure Your Installment Sale

A Structured Installment Sale is just another strategy to defer your taxes and minimize gains upon your exit. While it’s nice to know about a strategy, incorporating that strategy into a plan is where the magic happens. Whether the right answer for you is the Structured Installment Sale, another strategy, or a combination of both; knowledge is the first step on the path towards a successful business exit.

Want to learn about Structured Installment Sales from a partner who educates you on your various option? Schedule a call with Ironclad Wealth before your LOI is signed.

Want to Keep Reading more about saving capital gains on your business sale? Check out our blogs on Asset vs. Stock Deals, Installment Sales, Qualified Opportunity Zone Funds, Tax Loss Harvesting, Charitable Remainder Trusts, Employee Stock Ownership Plans (ESOPs), and Qualified Small Business Stock Exclusions (QSBS).

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