Installment Sales

April 13, 2006

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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. It can't be used if the sale results in a loss.

The bad news is that payments for many (or even most) of the assets of your business are not eligible for installment sale treatment. Moreover, in December of 1999, the problem was made worse when the installment sales method of accounting for accrual method taxpayers was repealed. As a result, when a small business was sold to a buyer making payments over a period of time, the seller had to report and pay capital gains tax on the entire purchase price, even though the seller hadn't received all the money from the buyer. Small business groups cited the tax change as decreasing the value of many closely held small businesses, most of which are sold using the installment sales method.

However, the uproar that followed resulted in retroactively eliminating the restriction in December of 2000. This retroactive repeal allows businesses sold in 2000 under an installment sale to file for refunds on estimated tax payments and to ignore the repealed law entirely when filing 2000 tax year returns.

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." This is basically your gross profit (your selling price minus: the tax basis of the property, selling expenses, and any depreciation recapture) 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.

Let's say you sold your business on January 1, 2000. Your business included a commercial building, the allocated price for which was $500,000 (excluding the cost of the land underneath). You originally purchased the building 10 years ago for $300,000, and over the years you've claimed $100,000 in depreciation using the straight-line method. For simplicity, we'll assume you're a cheapskate and made no capital improvements in the building during the time you owned it.

The buyers made a $200,000 down payment and will pay the rest off at 10 percent interest on a 20-year amortization schedule, except that at five years the unpaid principal will be due in a balloon payment.

If your expenses of the sale were $37,500, your basis in the building would be ($300,000 - $100,000) + 37,500 = $237,500.

Your net profit on the sale will be $500,000 - $237,500 = $262,500. Since this amount is greater than the depreciation, all of the depreciation you claimed over the years would be "recaptured" and taxed in the year of the sale at a special 25% rate.

The remainder of your profit, or $162,500 (since $262,500- $100,000 = $162,500) would be divided by the selling price or $500,000 to arrive at your gross profit percentage: $162,500/$500,000 = .325, or 32.5 percent

So, for every payment you receive, including the down payment and the balloon, separate the principal from any interest (all interest is taxed as ordinary income). Of the principal, 32.5 percent of each payment will be taxed as capital gains. The rest represents either the recaptured depreciation, which was taxed in the year of the sale, or the return of your capital which is not taxed.

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.