Business Exit Strategies Series - Installment Sale
Are you a business owner looking to exit your business? Do you need income from the business sale? Would you like to spread that income out over multiple years to reduce tax burden? An installment sale might be the best fit.
Let’s look at Jill, a business owner. Jill wants to sell her business and she thinks that she needs to receive all the proceeds at once. Jill plans to pay taxes on the gain (sale price – basis). Let’s say Jill invested $100,000 into a business and, 20 years later, it sells for $500,000. Jill would have a $400,000 gain on which she pays capital gains taxes (0%, 15%, or 20% depending on income). If Jill has a $400,000 of gain, she’ll pay 15% or 20% of it to capital gains tax (depends on other tax factors). Let’s say Jill has no other sources of income, then she would pay 15% capital gains tax. That’s $60,000. Thus, she walks away with $440,000.
But let’s suppose Jill entered into an installment sale and spread out the sale with 10 years of payments. Instead of getting $500,000 all at once, she would get $50,000 / year for 10 years. Installment sales also spread out the capital gain. So she would recognize $40,000 in capital gain each year for 10 years. If Jill had no other income, this would push her down into the 0% capital gains tax bracket. If Jill was married and their total taxable income each year was less than $89,250 (2022), then she would pay 0% capital gains taxes. By strategically selling her business with an installment sale, Jill could conceivably pay 0% capital gains tax on the sale of her business. Business owners with higher sale prices (think millions) can use installment sales to move from the 20% capital gain tax bracket to the 15% capital gain tax bracket, depending on their unique tax situation. Installment sales can generate income streams from business sales as well as potentially reduce taxes, but there are a few rules of which business owners should be aware.
Many times, an installment sale is sold to a “related party” (siblings, spouses, children, grandchildren, lineal descendants). This has advantages and disadvantages. On the positive side, this keeps the business in the family, the business seller receives an income stream after the business sale (presumably in retirement), the sale doesn’t burden family members with a large purchase payment in one year (they can use the business profits to buy out the previous owner over time), and the business seller has the legal right to reclaim the business if payments aren’t received. However, there’s one rule that needs to be observed. We call it the “two-year rule”. If the property is sold by a related party buyer within two years of the date of the installment sale, “the original seller is deemed to have been paid in full for income tax purposes”. Translation: All the taxable gain gets frontloaded on the original seller. From the IRS’s perspective, this keeps parents from using their children’s presumably lower tax bracket to sell the business quickly. However, from the business seller’s perspective, they must make sure their “related party” (usually a child) doesn’t turn around and sell the business within two years or the original seller will get hit with a huge tax burden.
Installment sales can also have an impact on estate planning. First, if the seller dies before all the payments have been made, their estate must include the present value of all remaining payments. Second, if an installment note is forgiven in the seller’s will, the debt is considered paid to the estate, and the estate must report all the remaining gain.
In summary, an installment sale of a business can be excellent way to sell your business. It defers the capital gain (potentially reducing capital gain taxes) and generates an income stream. There are tax and estate planning considerations, especially if your installment sale is to a related party. If you have questions about installment sales or want to learn how installment sales could fit into your financial plan, give us a call at 571-969-1459 or email us at ryan@ifpinvest.com.
