An installment sale is a transaction in which you sell your business to another party and the purchase price is spread over two or more years.
To qualify for installment sales treatment, you (as the seller of the business) must receive at least one payment in a year after the year of the sale.
You have a great deal of flexibility in structuring installment sale payments. The payments can begin and end whenever you like. They can also last for as long a period as you like.
Installment sale treatment may not be available for certain types of assets including inventory and publicly traded securities. Consult your tax attorney or accountant to determine whether all of your business assets qualify for installment sale treatment.
You can think of it as a kind of private annuity, except that instead of the payments lasting for your lifetime, you can structure the payments to begin and end whenever you like.
So why use an installment sale?
Spread Taxable Gain Over Several Years
Selling your business through an installment sale may allow you to spread the taxable gain over several years. More specifically, your gain can be spread over the installment payment period.
Each installment payment must be broken down into a tax-free return of capital, a taxable profit or gain element, and taxable interest income.
The part of the installment payment that is considered interest income is taxed as ordinary income; the gain or profit element can be taxed either as ordinary income or as a capital gain.
Shift Income From High-Tax Years to Low-Tax Years
One big potential advantage to using an installment sale to sell your business is that you can postpone the taxable income from the sale to years when you may be in a lower tax bracket.
With an installment sale, you can structure the payments to begin and end whenever you like. Thus, if you will be in a high tax bracket in the year of the sale, you can postpone receiving payments until years when you may be in a lower tax bracket.
Help Reduce Estate Taxes
Selling your business through an installment sale is also a very effective estate-freezing technique. This is especially true when the sales transaction is between family members and involves an appreciating asset like a successful business.
When the company is sold for the full fair market value, only the present value of any unpaid installment payments is included in your estate when you pass away.
Any appreciation in the business after the time of the sale will not be included in your taxable estate. As a result, you keep the value of the company at the time of the sale.
Keep Security Interest in the Business
With an installment sale of your business, you may retain a security interest in the business after the sale to secure the installment payments. Retaining a security interest will not jeopardize the installment sale treatment (for income tax purposes) of the payments.
By contrast, with a private annuity, if you retain a security interest, the entire gain will be taxable in the year of the sale.
Help Buyer Purchase Company
By spreading the payments over several years, an installment sale may make it easier for the buyer to purchase
your company.
An installment sale may be especially attractive if the buyer is one of your children or another family member. They may not have enough cash to purchase the company outright, but by spreading the payments out over some time, they may be able to use the cash flow from the company to make the installment payments.
Conclusion
An installment sale can be a standout method for transferring your business. It depends on your unique circumstances and an understanding of all the tools available to achieve what you want.
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