An installment sale is defined by the Internal Revenue Service in Publication 537 as the sale of a business or property in which at least one payment is received after the tax year of the sale.
An installment sale is a form of seller financing where the seller bears the risk of buyer default while the buyer preserves their most precious asset (cash) and pays for the business over time.
There is rarely any argument that an installment sale heavily favors a business buyer. However, there are a few small benefits to the seller that should be noted. For all intents and purposes, the seller serves as the bank in an installment sale transaction. As with any bank or third party lending institution, the seller will require interest payments from the buyer in return for allowing access to their cash. The interest revenue received in excess of the principle increases the total compensation to the seller. However, the interest received is taxed at ordinary income rates while the taxable gain on the principle receives preferential capital gains treatment (at the personal level).
Another slight benefit to the business seller is the tax benefit of receiving the purchase price over time rather than in one lump sum. Since the US tax system is progressive (the higher your income in an individual year, the higher the tax rate or “bracket”) and the purchase price is taxed in the year received, receiving the proceeds over several tax years typically lowers the seller’s total effective tax rate. The downside however is the offsetting opportunity cost arising from not receiving full payment at the time of sale, incurring the higher tax, and investing the net proceeds. The seller must consider the risk profile and rates of return on other investments as an alternative to their investment in the buyer of the business. The seller must consider their entire portfolio and/or their potential portfolio before making this investment in the buyer. As always, the best portfolio will be the one that minimizes total investment risk while maximizing total investment returns.
Typically it is not the potential rate of return on an installment sale that makes it unpalatable but rather the high risk of buyer default. If only there were ways to shift some of the default risk back to the buyer……
We’ll discuss these strategies in our next post.