How to Defer Taxes with an Installment Sale of Your Business

October 18, 2023

If you own a small business or investment property, then someday you may want to sell your business or real estate. An installment sale of your business is an advantageous way to avoid a huge tax bill and defer taxes to future years. Read on to learn everything you need to know about an installment sale of your business.

What is an installment sale?

An installment sale is a sale in which the buyer of your eligible business or property pays you at the time of sale with a promissory note including a legal transfer of ownership, then continues to pay you in installments over a pre-determined period of time.

The IRS defines an installment sale as the seller receiving at least one payment after the close of the tax year in which the transaction was conducted. People sell their businesses or investment properties in installments as a way to offset the tax burden of the transaction. Let’s take a look at the tax advantages an installment sale provides.

Advantages of an installment sale

Here are some advantages to consider with an installment sale:

  • Avoid gift taxes - When you sell to a family member, co-owner, or employee, you can avoid gift taxes that would be applied if you sold the property below fair market value or included it with your estate for your heirs.
  • Defer taxes – With payments spread out over time, the tax liability can be deferred years into the future when you may be in a lower tax bracket.
  • Negotiate a better price – You may be able to negotiate a better price in the long-run if the buyer doesn’t owe the full sale price at the time of sale.
  • No third party involvement – You and the buyer can conduct the sale according to your needs without third-party approval or financing.
  • Custom payment schedule – You can create a payment schedule that corresponds with the business’s cash flow, your financial needs, and those of the buyer.

An installment sale also has a few disadvantages, which we’ll discuss next.

Disadvantages of an installment sale

Here are a few disadvantages to installment sales:

  • ⛔️ Added risk – If business cash flow is inconsistent or the buyer is unable to pay the promissory note or taxes, you are still responsible for the capital gains and interest.
  • ⛔️ Capital gains tax – If you choose to sell your business or property rather than gift it, you will owe tax on any capital gains realized from the sale. You can compensate by spreading the tax liability over the life of the installment agreement.
  • ⛔️ Follow IRS guidelines on interest – You will need to charge interest on the installments according to the IRS minimum interest rate guidelines and pay income tax on those interest payments.

Even with the disadvantages outlined above, you can follow a few best practices to ensure a successful installment sale of your business.

Best practices for the installment sale of your business

Follow these best practices if you choose to sell your business or investment property in installments:

  • 🌟 Work with financial and legal experts to draw up an agreement that meets your best interests and protects you as the buyer.
  • 🌟 Consider requesting a life insurance policy on the buyer to ensure full payment in the event of an unexpected death.
  • 🌟 Consider placing limits on the buyer’s ability to borrow funding in the future at the risk of the business.
  • 🌟 Consider requiring higher payments in the future if the business outperforms expectations (known as “earn-outs”).

Installment sale cannot be used in several situations

There are a few circumstances in which you cannot use an installment sale. They are:

  • ❌ The sale of inventory consisting of personal property with the exception of property used or produced in farming
  • ❌ The sale of inventory sold in the ordinary course of a trade or business
  • ❌ The sale of stock or securities traded on an established securities market
  • ❌ The sale of depreciable property to a related buyer, unless proof is offered to the satisfaction of the IRS that the sale was not conducted for tax avoidance

If you are considering an installment sale for your childcare business or other investment property, contact the experts at Honest Buck. We can help you evaluate whether this type of transaction may be beneficial in your situation. Reach out to our team of accounting professionals today.

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