This page describes a composite hypothetical. It is not a real client or a real result. All amounts and rates are assumptions for illustration.
The Scenario in Brief
The owner of a small distribution business has an offer to sell the business for 2,000,000 dollars. The buyer proposes to pay 500,000 dollars at closing and the balance in equal annual installments over five years, with interest. The owner asks an advisor how the installment method works and whether it makes sense.
Assumptions Used
- Sale price: 2,000,000 dollars, structured as an asset sale.
- Allocation: 300,000 dollars to equipment with an adjusted basis of 50,000 dollars, and 1,700,000 dollars to goodwill with no basis.
- Payments: 500,000 dollars at closing, then five annual payments of 300,000 dollars, plus interest at an adequate stated rate.
- Assumed flat rates: 37 percent ordinary and 20 percent long-term capital gain. State tax and net investment income tax are ignored.
How the Installment Method Applies
Under the installment method, gain is generally reported as payments are received, in proportion to the gross profit percentage. However, depreciation recapture must be recognized in the year of sale, regardless of when payments are received. In this scenario, recapture on the equipment is 250,000 dollars, the excess of the allocated price over the adjusted basis. That amount is ordinary income in year one.
Worked Arithmetic
| Item | Amount |
|---|---|
| Total gain | 250,000 dollars (equipment) plus 1,700,000 dollars (goodwill) = 1,950,000 dollars |
| Recapture recognized in year one | 250,000 dollars |
| Basis for installment purposes after adding recapture | 300,000 dollars (50,000 plus 250,000) |
| Gross profit | 1,700,000 dollars (2,000,000 price minus 300,000) |
| Gross profit percentage | 85 percent (1,700,000 divided by 2,000,000) |
| Year-one payment | 500,000 dollars |
| Capital gain reported in year one | 425,000 dollars (500,000 times 85 percent) |
| Each later annual payment of 300,000 dollars | 255,000 dollars of gain (300,000 times 85 percent) |
The computations are simplified to show the concept, and a real computation would include selling costs and other adjustments. Year one would therefore include 250,000 dollars of ordinary recapture income plus 425,000 dollars of capital gain, with each of the five later years including 255,000 dollars of capital gain. The total, 250,000 plus 425,000 plus 1,275,000, equals the full 1,950,000 dollars of gain. Interest on the note would be additional ordinary income each year.
Advantages the Advisor Would Explain
Spreading capital gain over several years can help manage income tax brackets and thresholds for surtaxes. It may also make it easier for a buyer to finance the purchase, and it aligns cash received with tax due on the deferred gain.
Risks the Advisor Would Emphasize
The seller bears the buyer's credit risk. If the buyer defaults, the seller may have to recover the business or the assets, and the tax result of that recovery is complex. The security for the note, personal guarantees, and the buyer's financial strength matter. The seller should also consider whether the note is transferable and whether a lump sum from a different structure might be better. Large installment obligations can trigger an interest charge on the deferred tax. Legislation could change rates before later payments arrive, in either direction.
Scenario Variations Worth Considering
If the buyer offered a higher price for installment terms, the owner would compare the extra amount with the credit risk. If the business had real estate with unrecaptured depreciation, that portion would also be recognized in the year of sale. If the owner is elected out of installment reporting, all gain would be recognized in year one. If the parties structured part of the price as an earnout, the amount and timing of gain would depend on future results.
Risks and Limits
- Recapture is recognized in the year of sale.
- The buyer's credit risk is real.
- The computation is more complex than the simplified table.
- Future tax rates are uncertain.
What This Scenario Teaches
Installment reporting can spread tax, but it does not spread all tax, and it exposes the seller to risk. The decision should weigh both the tax result and the commercial risk.
Questions to Bring to Your Advisor
- How much income will be recognized in year one?
- What security supports the note?
- What interest rate is required?
- How does this compare with a lump-sum sale?
Questions About the Note Itself
An advisor would also go through the terms of the note. Is it secured by the assets or by a personal guarantee? What happens if a payment is late? Is there a prepayment right, and how would that affect the timing of gain? Are there covenants that restrict the buyer from borrowing or selling assets before the note is repaid? Who would negotiate remedies in a default? These are largely legal and commercial points, but they determine whether the deferral in the tax calculation is worth the risk in the deal. A seller who focuses only on the tax deferral may accept terms that a purely commercial analysis would reject.
Frequently Asked Questions
Can I defer all the tax by taking an installment note?
No. Depreciation recapture is generally recognized in the year of sale, and deferred gain is recognized as payments are received.
Is the interest on the note taxable?
Yes, generally as ordinary income when received or accrued.
Want to Talk Through Your Own Situation?
These scenarios are illustrations only. Book a discovery call with AE Tax Advisors to discuss the facts of your own business or portfolio.
Book a Discovery CallEducational purposes only. This page is an illustrative educational scenario, not tax, legal, or accounting advice, and it does not describe a real client or a real result. Tax laws change and outcomes depend on individual facts, so consult a qualified professional before acting. No result is guaranteed.