Installment Sale of Business
By Sara Craven, CFP®
February 3, 2022
If you’re considering selling your business and want to use a strategy that provides ongoing and periodic liquidity, and smooths out the taxation of a sale, an installment sale may be the solution. There are several reasons this type of sale is implemented, but first, let’s explain what it entails.
An installment sale works just like the name implies. The buyer pays you, the seller, at the time of the deal with a promissory note, ensuring complete ownership, and then pays for the business in installments over a determined period of time. The definition is based on at least one payment received within a different tax year. A key component is that the buyer uses cash flow directly from the business profits to pay both the taxes and the promissory note. As the seller, capital gains and interest income still go to you. For this reason, you should only use this strategy if the business provides steady income and the buyer is expected to do well. Yearly fluctuations can impact the buyer’s ability to pay the promissory note or taxes.
Are there any advantages for the seller in doing this?
Yes, the main advantage when selling to a family member, co-owner,
or employee is the avoidance of gift taxes. If you sell your business for less than fair market value, it’s considered a gift. The same goes for leaving it as part of your estate to your heirs. By selling your business at fair market value, gift tax implications do not apply. Keep in mind that you must also use interest rates comparable to the current market. Mainly, this is an excellent solution for ensuring your business goes to the family member or person of your choice that you think has the best chance of growing your business in the future.
If selling to a non-family buyer, this strategy may be a path to obtain a better price for the business in the long run while ensuring your heirs continue to receive payment for the business. Additionally, many factors go into closing a deal, and an installment sale can allow a buyer to place a contingency on the sale if they are wary about the business’s success once the seller steps down.
Another possible perk is tax deferment. Because the payments are received over time, the tax liability is spread out over the length of the installments. If carefully orchestrated, you might even be able to stay below the net investment income tax and long-term capital gains threshold. However, a future increase in capital gains rates can void this strategic tax maneuver. It must also be noted that a depreciation recapture must be reported the year of the sale. This is considered a gain, and if the first installment doesn’t cover the tax liability, you’ll need another source of income to pay this obligation.
There are a few considerations to be taken into account when making an installment sale to alleviate possible issues in the future. For one, a seller can request a life insurance policy on the buyer to ensure full payment in the event of unexpected death. A seller can also place parameters on the buyer’s ability to borrow future monies at the risk of the business. Lastly, a seller can outline higher payments in the future if the business outperforms expectations. These are called “earn-outs.”
Now that the basics have been outlined, let’s discuss the conditions. It’s essential to meet with an attorney and CPA to ensure all of the legal parameters have been met for the deal to qualify according to IRS regulations, or else the gains won’t be deferred, or gift tax liabilities will incur. As previously mentioned, the price must meet the fair market value, so an evaluation of the business by a qualified accountant is imperative. Similarly, an attorney will be able to advise which contingencies to place upon the sale or purchase to guard against future concerns.
One other vital step to take is speaking with your Wealth Manager. They can help you set up a retirement plan based on the promissory note and determine a plan for the money you make on the deal, while reserving for taxes. They can also help you navigate your estate plan and legacy documents to ensure this sale benefits the next generation.
References:
https://www.irs.gov/taxtopics/tc705
https://www.blueandco.com/should-i-sell-my-business-by-installment-sale/
https://exitadviser.com/selling.aspx?id=sell-business-installment-sales
https://www.thebalance.com/installment-sales-3192872
https://www.moranwm.com/wp-content/uploads/2019/09/selling-a-business-through-an-installment-sale-to-individual-buyers.pdf
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