Selling, or monetizing, your business is a significant milestone. One of the key considerations when structuring the sale is how you will be paid. While there are several options to consider, one popular option is an installment sale, where the buyer pays the seller over time rather than in a lump sum.
While providing flexibility for both parties, an installment sale also has tax implications that need to be carefully considered. Let’s explore how an installment sale works, what the tax implications are, and how you can effectively manage the payments.
An installment sale allows the seller to defer some of the tax liability by spreading it out over several years. Instead of receiving the entire sales price upfront, the seller receives periodic payments from the buyer.
This structure can be especially beneficial in easing the buyer’s financial burden and helping the seller avoid being pushed into a higher tax bracket in the year of the sale.
When you receive payments from an installment sale, the IRS views the payments as being composed of three key components:
Interest: Since the buyer is paying over time, interest is typically added to compensate the seller for not receiving the full amount upfront. This interest is taxed as ordinary income.
Capital Gain: Profit from the sale of the business. The capital gain portion of each installment payment is taxed at capital gains rates, which are typically lower than ordinary income rates.
Return of Basis: The original investment (or basis) you made in the business is tax-free when returned to you. This portion is not subject to tax, as it merely represents the recovery of what you initially invested in the business.
Let’s look at an example of how the payments are taxed if you sell your business for $1,000,000 using an installment sale.
Step 1: Calculate Capital Gains
First, determine the total gain on the sale. Let’s say your basis in the business is $200,000.
Sale Price – Basis = $1,000,000 – $200,000 = $800,000 gain, subject to capital gains tax.
Step 2: Determine Gross Profit Percentage
Next, calculate the gross profit percentage:
Total Gain / Sale Price = $800,000 / $1,000,000 = 80% of each payment will be treated as capital gain.
Step 3: Tax Treatment of Each Payment
Using a basic Time Value of Money calculation for this scenario, annual payments will amount to $230,975. Here’s how the tax treatment would break down for each payment in the first year:
For larger capital gains, the tax rates will vary based on your overall taxable income:
Capital Gains Tax Brackets:
Net Investment Income Tax (NIIT): Since your gain exceeds $250,000 (for married filing jointly), you’ll also pay the 3.8% NIIT on the portion of your income above that threshold.
Assume that your other taxable income is $150,000, bringing your total income with the first installment payment to $350,000 plus the capital gain portion.
Capital Gains Tax:
Interest Tax:
Net Investment Income Tax (NIIT):
First Year Total Tax Summary:
You will need to recalculate the total tax liability each year as these dollar amounts shift with the principal being paid down.
You may also be subject to depreciation recapture. If you’ve depreciated certain assets in the business, the amount of depreciation previously claimed is “recaptured” and taxed at ordinary income tax rates. With an installment sale, this recaptured depreciation must be reported in full in the year of the sale, even if you are receiving payments over several years.
1. Tax Deferral: By spreading out the gain over several years, you defer taxes and potentially reduce the amount of tax you pay each year. This is particularly helpful if a lump sum would push you into a higher tax bracket.
2. Cash Flow: An installment sale provides ongoing cash flow for the seller, which can be useful for retirement or reinvesting in other opportunities.
3. Lower Tax Bracket: Spreading the payments out can help keep the seller in a lower tax bracket over the installment period, reducing overall tax liability.
Potential Downsides
While an installment sale offers benefits, there are also some risks to consider:
1. Buyer Default: If the buyer defaults on the payments, the seller may not receive the full sale price. Additionally, if the buyer has already taken control of the business, recovering the asset or reselling it could be challenging and costly. This risk can complicate your financial planning and the realization of the sale proceeds.
2. Interest Rate Risk: If market interest rates rise, the interest on the unpaid balance may no longer be as attractive. In this case, you could end up receiving lower returns on the deferred payments compared to what you could have earned by investing a lump sum at current market rates.
3. Loss of control over the business after the sale: Once the buyer takes ownership, they make decisions that could impact the business’s value or financial health. If the buyer mismanages the business, you lose influence over its operations, even though you’re still financially tied to it through the remaining payments.
Selling your business on an installment sale can offer tax benefits and a steady stream of income. By carefully structuring the deal and understanding the tax implications, you can maximize the benefits, reduce risks, and ensure a smoother transition.
Considering an installment sale for your business? By partnering with your tax professional, we can help ensure you structure the sale in the most advantageous way possible.
Life Moves Wealth Management is a registered investment advisor offering advisory services in the States of Arizona and Indiana, and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. Information contained on this site should not be considered a solicitation to buy, an offer to sell, or a recommendation of any security in any jurisdiction where such offer, solicitation, or recommendation would be unlawful or unauthorized.
The information on this site is not intended as tax, accounting or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement of any company, security, fund, or other securities or non-securities offering. This information should not be relied upon as the sole factor in an investment making decision. Past performance is no indication of future results. Investment in securities involves significant risk and has the potential for partial or complete loss of funds invested. It should not be assumed that any recommendations made will be profitable or equal any performance noted on this site.
HYPERLINK DISCLOSURE – The information being provided is strictly as a courtesy/convenience. When you link to any of the web sites provided here, you are leaving this website and assume total responsibility and risk for use of the web sites you are visiting. We make no representation as to the completeness or accuracy of information provided at these websites. Life Moves Wealth Management is not liable for any direct or indirect technical or system issues or any consequences arising out of your access to or your use of third-party technology, web sites, information and programs made available through this website. Life Moves Wealth Management does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to Life Moves Wealth Management’s web site or incorporated herein, and takes no responsibility thereof.
Author: Dale Shafer II, CFP®, CBEC®, APMA®
This website uses cookies to make sure you get the best experience on our website. You can find more information under the Privacy Policy.
