Using an Installment Sale to Reduce Taxes When Selling Your Business

Picture this: you've just received a $10 million offer for your business. Exciting, right? Then you see the tax bill. You'll owe nearly $2.4 million in taxes if you take the money all at once. Suddenly, you’re not sure the numbers add up.

Most people’s next step is to scramble to find any and all tax strategies that can lower that number. In their haste, they forget the basics. Some strategies may have fantastic tax benefits, but they can prevent you from buying that vacation home that you dreamed of spending time with your family at post-exit

The first step to preventing that and designing your ideal exit is knowledge. Today we’re going to review the first and most basic (not necessarily a bad thing!) tax strategy out there for business sales – the Installment Sale.

What is an Installment Sale?

Installment Sales are governed by IRC §453 and refer to a business sale where the buyer spreads their payments to purchase a business over multiple years instead of providing the entire purchase price upfront. As a result of the payments being spread over multiple years, the seller doesn’t have to pay taxes on the entire gain in year 1. Instead, they pay taxes as their gain is received over the payment period.

An installment sale is typically requested by the buyer. Who wouldn’t want to buy a business with less money out of pocket? However, it can also benefit the seller by reducing their taxes in the right circumstances and increasing the pool of possible buyers.

To execute an installment sale, both parties must agree to the terms of the installment. Nothing happens unless both parties agree to structure payments this way. Once the structure is agreed, a promissory note, or loan document, is drawn up that records the buyer’s obligation to pay the seller. One benefit to the seller is that you will also receive interest as part of an installment agreement because you are, in effect, loaning money to the buyer to purchase your business.  

Once the agreement is finalized, the seller will file IRS Form 6252 with their tax return to elect that their sale be treated as an installment. If not, you may still owe all of the taxes in year 1, which I think everyone wants to avoid!

How Installment Sales Can Save You Money on Taxes

The main tax benefit that installment sales provide is time, specifically it gives you time to spread your taxes over multiple years. In the US tax code, you pay more taxes as you earn more. If you can spread those taxes over multiple years, more of your money is in the lower tax brackets, which means less taxes.

The Math Behind the Tax Savings: How the Daniels Benefit from an Installment Sale

The Daniels family are a husband and wife duo who are looking to sell their business for $10,000,000 and have $500,000 of basis in their firm.

Here’s an example of how the timing of an installment sale works for the Daniels.

They have $9,500,000 in taxable gains.

If they pay that all in year 1, $96,700.00 is in the 0% bracket, $503,349.00 is in the 15% bracket and $8,899,951.00 is in the 20% bracket.

If they use an installment sale to spread that amount equally over 10 years, $967,000 winds up in 0% bracket, $5,033,490 winds up in the 15% bracket and $3,499,510 winds up in the 20% bracket[1].

That’s a huge deal!

So now that we know installment sales work, how would the results look for the Daniels?

If you look at the installment sale example with 0% interest, the tax savings are $523,035. Because there is no interest, this isolates the savings attributable purely to spreading the taxes out over time. Nothing to sniff at.

Now if you look at the interest-bearing example, the Daniels actually wind up paying more in taxes. However, that’s because they made more than they otherwise would have due to the interest payments!

As you can see, the economics of installment sales really aren’t bad. The real question is are the benefits worth the risks associated with them.

Key Requirements of an Installment Sale

As with any strategy, there are a few things that must be done to make this happen.

• An installment sale must be written into the purchase agreement
• A promissory note must be created – think about what needs to collateralize your loan to provide the most protection possible. Oftentimes, a full personal guarantee is required in these sales.
• IRS publishes tables of the minimum interest rates, Applicable Federal Rates, that can be charged. If you go below, the foregone interest will be considered a gift to the buyer and can complicate things, especially in transactions with related parties. When in doubt, keep the interest rate set at market rates.
• Form 6252 must be filed to elect installment sales treatment.

Do I need to setup my installment sale before I sell my business?

Unlike many other tax savings strategies, you do not need to have an installment sale planned before your sale goes through. You only need to structure the sales agreement to reflect your wishes.

Having said that, it definitely makes sense to review a model of your sale to make sure you won’t get surprised by any unforeseen taxes and to see how receiving the cash over time changes your financial plan.

What can go wrong with an Installment Sale?

There are also several risks & limitations that you need to be aware of when contemplating an installment sale.

• Buyer Credit Risk – the largest risk is that the buyer defaults on their payments. This can be mitigated with personal guarantees on the loan, but that amount may not cover the balance of the loan. If you’re worried about this, a Structured Installment Sale could be an option for you.
• Other Income – if you have other significant sources of income, you may not be in a lower tax bracket post-exit, rendering the installment method of spreading gains out ineffective.
• $5,000,000 Limit - IRC §453A charges interest on the deferred tax liability of installment sales over $5,000,000 per person. In this case, the Daniels would be ok because they both own the business. However, if only one owned the business, that would mean that they were deferring $10,000,000 and $5,000,000 of the installment would be subject to §453A interest.
• Property Limitations – some types of property sold in an installment sale are ineligible for deferral. The top three that we encounter are Accounts Receivable, Inventory, and Depreciated Assets subject to Section 1245 and 1250 recapture. Inventory, accounts receivable, and Section 1245 are all subject to ordinary income. Section 1250 property is subject to a mixture of ordinary income (if you use bonus depreciation), ordinary income capped at 25% and capital gains. If you sell your business in an installment sale, you will still owe these taxes in year 1 which may severely impair your cash flow.
• Related Party Rules – you cannot sell depreciable property to related parties using the installment method. If your business sale is taking the form of an asset sale, an installment sale may not work.
• Flexibility – the final limitation on installment sales is flexibility. Once you’ve setup an installment sale, you’re stuck with the terms. You’ll be stuck with the terms of your promissory note and will receive the payments over the designated period unless the buyer prepays the note.
• Tax Rate Risk – if tax rates increase while you’re deferring, you may wind up paying more!
• Refinance Risk – If you’re planning to slowly recognize the gains, another risk is that the buyer refinances your loan with a traditional loan and prepays your installment note. When they refinance, you’ll receive the balance of your loan. However, you’ll owe what’s left of your taxes that year!

Is an Installment Sale Right for Your Business?

In our opinion, an installment sale is best for a few types of business owners who are considering an exit:

• You are dealing with known buyers whose ability to run the business you trust, but who don’t have the funds necessary to buy you out day 1.  Oftentimes, this may be your current executive team or family members.
• You’ll be in a lower tax bracket post-exit. If you have significant outside assets, that may not be the case and then all the tax savings we discussed earlier may not exist!
• You don’t need the balance of your funds day 1, and can afford to live off of a payment stream for a period of time.

If any of this sounds like you, an installment sale may work. If none of them do, don’t go chasing a tax strategy just for the taxes – an installment sale may not be worth the potential problems they could cause.

How Ironclad Wealth Management Helps with Installment Sales

When you partner with Ironclad Wealth Management on your exit plan, our first job is to find the right strategy that works for you.  Installment sales are effective tools, but there very well may be another strategy that works best for you.

Once we cutdown on the various options available to you, we get to work modeling and projecting the best strategies (or combinations of them) for you to estimate your tax savings and see if your sale will close your Wealth Gap and lead to a stress-free exit. We work closely with your CPAs, Lawyers, and other advisors to make sure that everyone is onboard and no risks are missed.

If you want a team who will have a deep understanding of what you’re trying to accomplish, will run the numbers to validate their opinions, and will work closely with your team, Ironclad Wealth Management is here to help.

Before signing your LOI, speak with Ironclad Wealth Management about tax-efficient deal structuring.

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

[1] This uses current tax brackets and does not adjust for inflation.

One Seven LLC ("OneSeven") is a registered investment adviser with the U.S. Securities and Exchange Commission (SEC). Registration with the SEC does not imply a certain level of skill or training. All titles listed for individuals associated with Ironclad Wealth Management represent the individual's role with Ironclad Wealth Management, and not their role with OneSeven. Services are provided under the name Ironclad Wealth Management, a DBA of OneSeven. Investment products are not FDIC insured, offer no bank guarantee, and may lose value. Please visit our website www.WeAreOneSeven.com for important disclosures.

Please note, the information provided in this presentation is for informational purposes only and investors should determine for themselves whether a particular service or product is suitable for their investment needs. Please refer to the disclosure and offering documents for further information concerning specific products or services.

Nothing provided in this presentation constitutes tax advice. Individuals should seek the advice of their own tax advisor for specific information regarding tax consequences of investments. Investments in securities entail risk and are not suitable for all investors. This site is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.

‍