Installment sales

In short

A friend of mine sold his small machine shop last spring and asked me one question over coffee. He wanted to know why anyone would take payments over years when a check today looks so much better. If you are about to sell a business, a piece of land, or a stake in a company you built, you may be wondering the same thing. An installment sale is a sale where the buyer pays you over more than one tax year. The tax rules let you report the gain as the cash comes in, not all at once. That can keep a big one time gain from landing in a single tax year. It also means you carry the buyer's risk, so ask hard questions before you sign.

The whole of it

What it is

I once watched a founder close a deal and then stare at his tax estimate like it was a bill from a stranger. He had sold his company for $3,000,000, and nearly all of it was gain. If you are holding a deal like that, you have probably felt the same knot in your stomach.

An installment sale is a sale of property where at least one payment arrives after the tax year of the sale. The seller reports the gain a little at a time, as the payments arrive. The Internal Revenue Code lays this out in section 453, and the IRS explains it in Publication 537, called Installment Sales. The form used to report it is Form 6252.

A fair share of founders sell a company, a building, or a block of stock this way. It suits a buyer who cannot pay everything on day one. It also suits a seller who wants the sale to stretch across several years of income.

Some things do not qualify. The rules shut out sales of inventory, and sales of publicly traded stock. Gain from depreciation recapture is also handled differently, and the seller usually has to report that part in the year of the sale, even if no cash has arrived yet. Publication 537 spells out these limits, and your tax adviser can check them against your facts.

How it works

A neighbor of mine, a good and careful man, once told me the trick is to think of each payment as a slice. Every slice has two parts. One part is a return of what you paid for the property. The other part is profit, and the profit is what gets taxed.

Here is the idea in plain steps. The seller works out the gross profit, which is the selling price minus the adjusted basis and the selling costs. Basis is roughly what the seller put into the property. Then the seller divides gross profit by the contract price to get a gross profit percentage. Each year, that percentage is applied to the principal the seller actually collected. The result is the gain to report that year.

Interest is a separate matter. The buyer pays interest on the unpaid balance, and the seller reports that interest as ordinary income each year. It is not part of the gain on the sale.

The rules also expect the note to carry a fair rate of interest. If the stated rate is too low, the tax law can treat part of each payment as interest anyway. The IRS publishes the minimum rates, called applicable federal rates, every month. Sellers in this position should look at the current table before settling on terms.

One more thing deserves a warning. If the seller pledges the installment note to get a loan, the rules can treat that as if the seller had been paid. Large installment notes can also bring an interest charge on the deferred tax. Both points are covered in Publication 537.

The numbers, and where to find yours

You have probably noticed that tax numbers move around from year to year. So I will not guess at them here. The capital gains rates, the income brackets, and the rate on the net investment income tax all come from law and from IRS tables. They change. The site fills in the current figures with a source and a date. For the long term capital gain rate at the top bracket, the page shows the current figure, which the official source publishes each year. For the extra tax on investment income, it shows the current figure, which the official source publishes each year, and the income level where it starts is the current figure, which the official source publishes each year.

Your own numbers live in your own records. Your basis comes from your purchase papers and your depreciation schedules. Your selling price comes from the sale contract. The monthly interest rate table comes from the IRS under the name applicable federal rates. Form 6252 walks you through each line, and the instructions for it are free on irs.gov.

A worked example

Let me tell you about a woman named Marcy. She started a small packaging company years ago and put about $400,000 into it over time. Her adjusted basis is $400,000. She sells the whole thing to a buyer for $1,000,000, and she pays $50,000 in selling costs.

Her gross profit is the price, minus basis, minus costs. That is $1,000,000 minus $400,000 minus $50,000, which is $550,000.

The buyer pays $200,000 at closing. The rest comes as four yearly payments of $200,000 each, plus interest. So the contract price is $1,000,000, and the total principal is paid across five tax years.

Her gross profit percentage is $550,000 divided by $1,000,000, which is 55 percent.

In year one she collects $200,000 of principal. The gain she reports is 55 percent of $200,000, which is $110,000. The same math repeats in years two, three, four, and five. Each year she reports $110,000 of gain. Five years of $110,000 adds up to $550,000, the full gain.

Compare that with reporting everything at once. In a single year she would show $550,000 of gain. Spread out, she shows $110,000 a year. Whether the rate she pays is lower depends on her other income and on the rates in each year. The spread can keep her out of a higher bracket in some years. It can also be undone by future changes in the law.

Notice what she gave up. Her last $200,000 does not arrive until year five. If the buyer struggles, Marcy is the one waiting. That is the trade.

Where it goes wrong

A fellow I know learned this one the hard way. He sold equipment on an installment note and forgot about depreciation recapture. He had taken years of depreciation, and the IRS rules require the seller to report that recaptured amount as ordinary income in the year of the sale. The cash had not come in yet, but the tax bill had. It stung.

There are other ways to stumble. A seller can pick terms with too low an interest rate and invite the IRS to reset them. A seller can lend to a buyer who cannot pay, and then the note is worth less than its face. A seller can pledge the note for a loan and trigger tax early. A seller can also forget that the deal might be a sale to a related party, and those get extra rules, including a two year watch on any quick resale by the family member.

There is another quiet trap. Choosing the installment method is the default, but a seller can elect out of it and report everything in the sale year. That election has to be made on time, on the return, so it is worth a conversation before you file.

Founders also sometimes forget the state. Some states tax the gain in a way that does not line up with the federal method. Check your own state's revenue department.

Questions to answer before you leave this page

If you are weighing a sale like this, have you asked how much of the price is real gain and how much is a return of what you paid in? Do you know your adjusted basis, and could you find the papers that prove it? Has anyone checked whether depreciation recapture will be due in the year of the sale? What interest rate is the note carrying, and does it meet the minimum set by the IRS applicable federal rates? How well do you know the buyer, and what happens if a payment is missed? Is there collateral behind the note, and who holds it? Have you looked at Publication 537 and the instructions for Form 6252? Have you sat down with a tax professional who has seen your numbers and not just your hopes? And finally, what would a good night's sleep cost you, and does this deal buy it?