Installment Sales

If you are willing to finance the sale of your business by taking back a mortgage or note for part of the purchase price, you might be able to report some of your capital gains on the installment method. This is good news, because the method allows you to defer some of the tax due on the sale until you get paid over the course of future years.

The installment method is used when you receive at least one payment for your business after the year of the sale. However, it can't be used if the sale results in a loss. Furthermore, payments for many (or even most) of the assets of your business are not eligible for installment sale treatment.

Assets eligible for installment treatment. Generally, anything on which gains must be treated as ordinary income will not be eligible for installment sale treatment. That includes payments for your inventory, for accounts receivable, and for property that's been used for one year or less. It also includes payment for any personal property to the extent of any depreciation that must be recaptured, based on deductions you've claimed over the years. And, it includes any depreciation that must be recaptured on real estate. For all these items, you must pay tax on any gains in the year of the sale, even if you haven't yet received payments for the items.

Looking at it another way, in most cases only gain on assets that have appreciated in value beyond their original purchase price will be eligible for installment sale treatment. For older businesses, gain on intangible assets such as goodwill will also be eligible for installment sale treatment, because under the law prior to 1993 goodwill could not be depreciated or amortized (hence, there's no depreciation to be recaptured).

Using the installment method. To use the installment method, you must allocate the total purchase price for the business among all the assets you've sold with the business.

Then, for each asset to which the installment method applies, you must compute your "gross profit percentage." First, you determine your gross profit. This is your selling price (which is the total cost to the buyer not including interest) minus (1)the adjusted basis of the property, (2) your selling expenses, and (3)any depreciation recapture. This amount is then divided by the selling price of the asset. Then, each time you receive a payment, the principal portion of the payment (i.e., everything but the interest) is multiplied by the gross profit percentage to determine the amount that must be reported as taxable gain for the year.

If the buyer assumes any of your debt as part of the deal, the assumption is treated as a payment to you for purposes of the installment sale rules. If the buyer places some of the purchase price in an escrow account, it's not considered a payment until the funds are released to you, as long as there are some substantial restrictions on your ability to get the money.

If your deal includes an earnout provision under which you may be entitled to additional payments based on future performance, special rules apply. Please see your tax advisor for details.

Related Resources

Tax on Stock or Asset Sales

Capital Gains/Ordinary Income

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