We’ve talked about different ways to transition a business, but now we want to consider how you can structure the sale of a business. An installment sale is a transaction in which you sell your business to another party and the purchase price is spread over two or more years. To qualify for installment sales treatment, you must receive at least one payment in a year after the year of the sale.
You have a great deal of flexibility in structuring installment sale payments. The payments can begin and end whenever you like. They can also last for as long a period of time as you like. Installment sale treatment may not be available for certain types of assets including inventory and publicly traded securities.
An installment sale is similar to a private annuity in that the payments will be spread out over a period of time. However, private annuity payments must last until your death. With an installment sale, you can structure the payments to begin and end whenever you like.
Reasons for Using an Installment Sale
- May spread taxable gain over a number of years
Selling your business through an installment sale may allow you to spread the taxable gain over a number of years. Each installment payment must be broken down into a tax-free return of capital, a taxable profit or gain element, and taxable interest income. The part of the installment payment that is considered interest income is taxed as ordinary income; the gain can be taxed either as ordinary income or as a capital gain.
- May be able to shift income from high tax year into low tax years
One big potential advantage to using an installment sale to sell your business is that you can postpone the taxable income from the sale to years when you may be in a lower tax bracket. You can structure the payments to begin and end whenever you like. Thus, if you will be in a high tax bracket in the year of the sale, you can postpone receiving payments until years when you may be in a lower tax bracket.
- May help reduce estate taxes
Selling your business through an installment sale can be an effective estate freezing technique. This is especially true when the sales transaction is between family members and involves an appreciating asset like a successful business. When the company is sold for the full fair market value, only the present value of any unpaid installment payments is included in your estate at the time of your death. Any appreciation in the business after the time of the sale will not be included in your taxable estate.
- May retain security interest in business
You may retain a security interest in the business after the sale in order to secure the installment payments. Retaining a security interest will not jeopardize the installment sale (income tax) treatment of the payments. With a private annuity, if you retain a security interest, the entire gain will be taxable in the year of the sale.
- May help the buyer purchase the company
By spreading the payments over a number of years, an installment sale may make it easier for the buyer to purchase your company. An installment sale may be especially attractive if selling to a child or an employee. They may not have enough cash to purchase the company outright. By spreading out payments over a period of time, the buyer may be able to use the company’s cash flow to make installment payments.
Before proceeding with the sale or transition of your business, here is a short video that can help you better understand some of the things you need to think about.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.