Structured Installment Sales: Deferring Taxes on Business Exits

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Key Takeaways

• Structured installment sales enable business owners to defer capital gains taxes, providing both flexibility and potential for long-term tax advantage during business exits.
• Clear agreements, documentation and legal compliance are key to successful structured installment sales, helping to minimize misunderstandings and legal risks.
• Annuity payments in these sales offer a predictable income stream, helpful for managing financing and cash flow.
• By measuring buyer creditworthiness and keeping everyone involved in the loop, you can minimize the risk of a bumpy deal or delayed payments.
• Evolving tax codes, unpredictable markets, and poor estate planning all pose threats that need to be navigated through expert counsel and ongoing agreement updates.
• By contrasting other tax deferral strategies — like deferred sales trusts and 1031 exchanges — sellers can select the most appropriate approach for their specific circumstances.

Structured installment sales allow business owners to spread out payments from selling their business, deferring taxes on business exits.

This approach provides additional time to pay taxes and may reduce the total tax punch in each year. Many business owners opt for this choice to retain more money up front and better control cash flow.

To determine whether this matches your exit strategy, it’s useful to understand the basic rules and advantages.

The Mechanics

Well-structured installment sales allow business owners to spread out tax payments when exiting, making the process more manageable and less risky. This method breaks up the sale proceeds over a number of years, allowing sellers to pay taxes as they receive each installment, rather than all at once.

Both sides–buyers and sellers–need to know how these sales work, the agreement, the assignment, the annuity, the payment, the people.

1. The Agreement

An installment sale agreement defines how the sale of the business will proceed. Be explicit about when payments will be made, what amounts, at what interest rate, and what happens if a payment is late or missed.

The paper has to adhere to all applicable local laws and the tax authority’s standards, which usually involves particular care around IRS regulations to make sure the seller receives long-term capital gains tax treatment. Legal compliance is key so that the seller cannot be taxed all at once by having ‘constructive receipt’ of the sale proceeds.

You’ll need a formalized sales professional — a tax advisor or lawyer — to write up and check the contract. This expert ensures that the terms are transparent, the seller’s tax deferral is preserved, and the deal accommodates the parties’ requirements.

2. The Assignment

The factoring stage is when the sales receives the right to future payments from a third party, typically a middle man. This process can de-risk the seller’s credit risk as the intermediary guarantees payments, sometimes through a collateralized investment account.

Good paperwork is essential–otherwise, the deal may not be enforceable or might cause unexpected tax consequences. Sometimes, issues arise during this phase, such as delays in configuring the middleman or collateral ambiguity.

These can impact both the purchaser’s risk profile and seller’s tax deferral capabilities.

3. The Annuity

A structured installment sale annuity is the tool that converts the buyer’s payments into an income stream. This setup results in the seller being paid over multiple years, evening out income and diffusing taxes.

The annuity may be customized—monthly, yearly, or custom intervals—based on what works best for the seller’s future plans. Unlike stocks or mutual funds, this annuity isn’t linked to market swings, so payments are consistent.

That makes it handy for sellers who desire economic certainty after departing their enterprise. It even facilitates planning for retirement or retirement elsewhere, like receiving payments after you move to a low-tax country.

4. The Payments

Sellers and buyers are free to select from a variety of payment schemes — fixed amounts, variable payments linked to results, or balloon payments at the conclusion. Each arrangement impacts the timing and amount of tax the seller pays, and the seller’s cash flow.

Establishing a payment schedule in the contract is important. Payment terms can even be updated if markets shift or the buyer’s business outperforms or underperforms.

Short-term deferrals are available as well, like if a seller desires to relocate to a lower-tax jurisdiction before receiving the majority of their proceeds.

5. The Parties

The principals are the seller, buyer and an intermediary (usually a trust company). The seller relinquishes title, the buyer pays incrementally, and the middleman can control disbursements and assure payment.

Be clear about everyone’s responsibilities. The seller has to confirm the buyer’s ongoing ability to pay—credit checks and collateral reduce risk.

As with everything, the rapport between the parties, and their faith in one another, determines if the sale is seamless.

Tax Implications

Structured installment sales allow sellers to receive their proceeds in installments rather than a lump sum, and this can influence the timing and method of taxation when exiting a business. This arrangement can allow individuals to have more control over their tax liability by distributing income among years and potentially decreasing the quantity taxed at higher brackets.

Installment sales are covered under Internal Revenue Code §453, which allows sellers to report capital gains tax in the period in which they receive payments, rather than all at once. This can even be a big help, especially for those who would otherwise face a huge tax bill from a big sale.

The table below illustrates the impact various capital gains tax rates can have on structured installment sales.

For instance, the lowest long-term capital gains tax rate has remained at 0% since 2008. If a seller’s annual payments are low enough, some proceeds might even be taxed at this rate, saving a bundle in taxes. Conversely, high earners—such as in California where the top combined rate reaches 38.10%—must be meticulously planned.

Massive payments in one year might shove a seller into a higher bracket, costing more in taxes. By distributing installments, sellers can maintain annual income under crucial limits, which reduces their overall tax due.

Every payment in a structured installment sale is partially principal, partially gain, and sometimes partially interest. The IRS makes sellers report these on form 6252 every year they receive a payment. Failing to do these steps, or structuring the deal wrong, can cause headaches.

The IRS has been paying close attention to DSTs since 2008-2010, increasing the potential for audits or challenges. Bartlett v. Commissioner and others have demonstrated that blunders in deal structure can trigger substantial tax bills, along with penalties and interest. It’s important to play by the rules. Just ask if you’re not sure.

Structured installment sales aren’t for every seller or business. Others might find that other tax-saving ideas work better. Knowing your tax bracket, and the impact installment sales have on it, are essential information for savvy planning.

With thoughtful structure and conscientious reporting, they keep risks minimal and reward transparent.

Strategic Advantages

Installment sales are not just academic calculations, but deliver very real, practical advantages for anyone selling a business or large asset. By spreading out payments over years, sellers can better plan for the future, take control of their tax bills, and even make their business more attractive to buyers.

Here are some key points that show the main advantages:

• Reduce immediate tax liabilities by deferring capital gains
• Eliminate the risk of leaping into a higher tax bracket with a large one-time gain.
• Spread payments to suit years with less income or less tax
• Reduce the risk of the 3.8% net investment income tax (NIIT) if well-structured.
• Appeal to more buyers with embedded financing, and flexible payment plans.
• Smooth the handoff to new owners with consistent, scheduled payments.

One key strategic advantage is the ability to defer taxes. When you sell a business in a lump, you could encounter a hefty capital gains tax bill that year, sometimes as high as 38.10%. With an installment sale, you pay tax only when you receive each payment. This could help you keep more of your cash annually, even knocking you down into a lower tax bracket.

Individuals who expect to be in a lower tax bracket in the future can use this to time payments for years when their tax rate is lower. For instance, a near-retiree might elect to receive bigger post-retirement payouts, when their overall income—and tax bracket—will be lower.

Deferring income gives you protection against the NIIT, a tax that afflicts high earners. If installment payments are dispersed and cleverly arranged, you may keep your annual income below the NIIT threshold. That way, you get to keep more of your winnings.

It’s risky. If rates increase in years you rake in, you get stuck with a larger bill than if you had paid all the taxes upfront. That’s food for thought when you’re plotting your own strategy.

Installment sales draw in buyers. Not every purchaser can afford a large, lump-sum payment. With an installment sale, buyers can pay on an installment basis. This opens the door to a broader base of buyers, who may otherwise be priced out.

Not only does it expedite the sale, but it maximizes your chances of getting a square deal. Finally, not all assets or sales are eligible for installment treatment. Sellers have to check the regulations for their specific nation and asset category.

Getting a tax pro’s advice before progressing is wise.

Inherent Risks

If you’re selling your business, a structured installment sale aids in spreading out your tax bills, but not without their own inherent risks. It’s wise to consider these risks prior to your decision. Here’s a checklist to help spot the most common pitfalls:

• Beware of tax law changes! While structured installment sales work under current rules, tax law is never static. Governments can revise or modify tax codes, sometimes with short notice. To give an illustration, if a country limits deferral benefits or cracks down on installment sales, sellers can suddenly be hit with unanticipated taxes. It’s the risk everywhere, not just in one place.

Wherever you sell, however, check with a local tax expert to see if new rules could impact your scheme.

• Market changes alter the deal value. If a business sale is paid out over years, the later money you receive may be worth less due to inflation or investment return declines. If the trust or buyer invests the sale proceeds and the market declines, the payments might be less.

For instance, if the trust invests in equities and the market falls, your subsequent payouts diminish. This risk is difficult to escape and sellers must consider how much risk they’re willing to accept with subsequent payments.

• Estate planning errors that can haunt heirs. If you don’t have your estate plan set up properly, your payments might not land where you desire. This is particularly the case if you die before they’re fully paid. Without explicit direction, your family may encounter probate delays, tax issues, or even legal battles.

In other jurisdictions, inheritance regulations vary, therefore seeking guidance on local laws is crucial.

• Complicated beasts like DSTs layer on additional risks. DSTs require a trust, a trustee, and specific agreements. This, in turn, increases the risk of mistakes or skirmishes over wording. There’s increased scrutiny from tax authorities.

The IRS has fought DSTs, citing cases such as Treas. Reg. § 1.453-4 in 2004, where sellers with excess control forfeited their tax deferral. DSTs can be expensive to establish and operate—trustee and administrative fees nibble at your yields.

If the trust’s investments decline, your income dries up. Some tax pros regard DSTs as risky or even abusive, which could translate to increased audits and fights. For most, DSTs are riskier than more straightforward installment sale structures.

Alternative Strategies

Both paths come with their own code, advantages, and compromises, so it’s useful to compare them. Here’s a handy table to compare your principal choices.

Structured installment sales are notable for allowing sellers to spread gains and taxes over several decades, even up to 40 years. This can reduce the total tax rate if payments occur in lower income or lower bracket years.

Installment sales work for all kinds of assets, not just real estate. They don’t have like-kind rules or deadlines as tight as 1031 exchanges. A proprietor can sell shares and receive payment over 15 years, dispersing the tax and providing steady cash.

Deferred sales trusts provide flexibility and asset protection. The seller shifts assets to a trust, then the trust sells to the buyer. This trust can invest the proceeds, with no tax due until the seller makes distributions.

That provides a vehicle for estate planning and protection from lawsuits. Trusts have initial fees, require professional counsel, and pose potential legal liabilities if not established properly. For international readers, trusts might be most effective in jurisdictions with firm legal systems.

The 1031 exchange is common in real estate. It allows sellers to exchange one real estate asset for another and delay paying capital gains taxes. The primary advantage is tax deferral and capacity to build wealth by trading up.

The catch is hard deadlines—45 days to identify a new property and 180 days to close. The properties must be “like-kind,” so it only applies to real estate, not business shares or other assets.

Typical cash sales are the most straightforward. The seller is paid in full, and tax is due that year. This can drive the seller into a higher tax bracket.

For premium exits, this might mean paying the top LTCG, which can be as high as 20%+ depending on your jurisdiction. Since 2008, certain vendors can get a 0% rate, but the majority pay some tax immediately.

Future-Proofing Sales

Future-proofing a structured installment sale is considering in advance those things that might alter the tax result, the flow of payments, and the overall smoothness of the transaction. Sellers seeking to defer taxes on a business exit require a strategy that can weather changing tax laws, income fluctuations, or major market swings.

For a lot of them, this translates to more than just establishing the sale and then stepping aside, but to following up, refreshing conditions and maintaining channels open with the purchaser. One smart move is to consider the tax code and its potential shifts. Brackets and capital gains rates move with new legislation.

Sellers break up payments, instead of taking all the money at once, in order to manage when they have to pay taxes. In other words, by extending payments, sellers can circumvent the “constructive receipt” rule that would require paying tax on all the gain immediately. Others elect to shove payments into years in which their income is lower or tax rates could be reduced.

For instance, if a country’s government indicates an intention to reduce capital gains taxes in two years, a seller could arrange payments to begin after that change. That’s how they hold on to more of their profit. Installment sales can be structured, too, to help sellers dodge risk.

If the buyer blows it, or the market tanks, the seller stands to lose. A lot of organized deals employ third-party companies or insurance products to guarantee that payments won’t decrease. Sellers love this arrangement because it allows them to participate in market upside while avoiding downside.

For example, a seller can lock in fixed payments for ten years, so even if the market dips, they receive the same amount. Deals like this require routine checkups. Tax laws, market rates, and personal goals all change.

Both parties should commit to revisit the sale terms on an annual or ad hoc basis. If a seller’s revenue falls, they may want to accelerate payments. If tax rates go up, they’ll want to put on the brakes. Continuous conversations keep the deal equitable and intelligent for both sides.

Market analysis is the other. Examining market trends, interest rates and even the buyer’s business health can allow sellers to adjust payment schedules or terms. This is particularly useful for larger deals, or when a seller’s livelihood depends on the sale.

Conclusion

Structured installment sales provides a definition of a strategic tool for business owners looking to defer taxes on a major sell. They spread out the payout, separate out tax bills on an annual basis, and assist with cash flow. Every transaction offers its own combination of benefits and hazards. Some owners can experience huge savings, others just have to plan for law changes or market fluctuations. Other ways to sell, such as lump sum payouts or earn-outs, make more sense for others. Each route requires a close examination of figures and objectives. To begin on the right foot, chat with a tax wiz or munificent adviser. Get answers, weigh the facts and find what fits best for your next step.

Frequently Asked Questions

What is a structured installment sale?

A structured installment sale lets you sell your business while taking the proceeds in installments. This can help amortize income and potentially reduce short-term tax burdens.

How do structured installment sales help defer taxes?

You receive payments over multiple years, so you pay taxes as it is received. This tax deferral, in turn, may reduce the effective tax rate.

What are the main risks of a structured installment sale?

Risks are buyer default, tax law changes and inflation. More prudent is to evaluate the buyer’s trustworthiness and obtain expert advice.

Are there alternatives to structured installment sales?

Yes, there’s seller financing and earn-outs and the ability to reinvest in tax-advantaged accounts. Each has varying tradeoffs.

Who should consider a structured installment sale?

Business owners wanting to minimize upfront tax hit and generate income consistently throughout the years might love this strategy. Seek professional advice.

Can structured installment sales be customized?

Yes, timing of payments, interest, duration, etc. Can be customized for both parties’ benefit. Customization helps align with particular financial objectives.

How can I ensure my sale is future-proof?

Collaborate with financial and legal professionals to craft adaptable contracts. Stay on top of tax laws to keep your strategy current.