Installment Sale of Business

Why Defer Receipt of Purchase Price?

Generally speaking, the seller of a closely held business would prefer to be paid in cash at closing. There are situations, however, in which the seller may prefer to dispose of the business in exchange for some combination of cash and an installment note, especially where the buyer is creditworthy and the note is secured. It that case, the seller will be entitled to periodic payments of interest in respect of the unpaid principal. In addition, the seller will be able to defer recognition, and taxation, of the gain realized on the sale of the business.

Specifically, and unless the seller elects otherwise, under the installment method of reporting the seller will report – and be taxed on – a proportionate part of the total gain realized on the sale only as the seller receives principal payments. Thus, the taxation of the sale gain may be spread out over several years.

Conversely, the buyer may prefer to acquire the business in exchange for its promissory note where the buyer must immediately satisfy certain liabilities of the seller, or where the buyer must invest capital in the newly-acquired business. In addition, the buyer may prefer to issue a note in order to secure itself against any breaches of the seller’s representations and warranties in respect of the business; in the event of any such breach, the buyer may simply reduce the outstanding principal amount of the note.

Rationale

Although the installment method of reporting is generally viewed as a beneficial tax deferral mechanism for the seller, in reality it is simply a recognition of the inverse economic relationship that exists between, and that theoretically justifies the different tax treatment of, one who receives immediate value in a sale transaction, versus one who receives only a promise of payment in the future and the credit risk that it entails.

Limitations on Installment Reporting

Assuming that a seller is comfortable with the credit risk (whether because the buyer’s note has been guaranteed by another person, bears sufficient interest, and/or has been secured by a stand-by letter of credit), and that the gain from the assets to be sold qualifies for installment reporting, there are still a number of limitations on the seller’s continued use of the installment method of which the seller’s tax advisers must be aware. For example, if the holder of an installment note (the seller of the business) pledges the note to secure a debt incurred by the note holder, the holder will have to recognize the gain inherent in the note to extent the note has, thus, been monetized. 

Dispositions

Similarly, if the holder of an installment note disposes of the note, the holder will generally have to recognize the deferred gain from the sale that is inherent in the note. Thus, gain is recognized upon the satisfaction of an installment obligation at other than its face value, or upon the distribution, transmission, sale, or other disposition of the installment obligation. 

There are several exceptions to this “acceleration-of-gain-on-disposition” rule. The IRS recently proposed regulations relating to one such exception. 

IRS Proposal: Capital Contributions and Debt Satisfaction

In general, under the proposed regulations, a seller will not recognize gain on certain dispositions of an installment note if gain would not be recognized on the disposition of the note under another provision of the Code. The exceptions identified in the regulations include certain capital contributions to corporations and to partnerships.

The IRS had previously ruled that these exceptions to recognition of gain under the installment sale rules do not apply to the transfer of an installment obligation that results in a satisfaction of the obligation — after all, the obligation ceases to exist. Thus, the IRS ruled that the transfer of a corporation’s installment obligation to the issuing corporation in exchange for stock of the issuing corporation resulted in a satisfaction of the obligation. In that case, the transferor must recognize gain on the satisfaction of the obligation to the extent of the difference between the transferor’s basis in the obligation and the fair market value of the stock received, even though gain or loss generally is not recognized on such capital contribution transfers, and even though the equity interest represents an illiquid asset.

The proposed regulations provide that this general “non-acceleration-of-recognition” rule does not apply to the satisfaction of an installment obligation. They incorporate the IRS’s earlier holding to provide that a seller recognizes installment gain when the seller disposes of an installment note in a transaction that results in the satisfaction of the note, including, for example, when an installment obligation of a corporation is contributed to the corporation in exchange for an equity interest in the corporation.

They also expand the exception to the non-recognition rule to cover the satisfaction of an installment obligation of a partnership when it is contributed to the partnership in exchange for an equity interest in the partnership.

What’s a Note Holder To Do?

Notwithstanding the fact that these regulations are proposed to apply to satisfactions, distributions, transmissions, sales, or other dispositions of installment obligations after the date the regulations are published as final regulations, taxpayers would be well-advised to start abiding by these rules now.

Moreover, sellers who receive installment notes in exchange for the sale of a business should be aware that the “acceleration-of-gain-on-disposition” rule may apply to a number of common situations, including the transfer of the note by gift. And while distributions by a partnership to its partners are generally excluded from the recognition rule (subject to certain exceptions), distributions by a corporation-seller will result in acceleration of gain recognition.

The bottom-line: before a note holder does anything other than collect the scheduled interest and principal payments with respect to an installment note that has been received in exchange for the sale of the holder’s business, the note holder should consult with its tax advisers. Only in this way can it avoid a situation where it will have to recognize the gain inherent in the note before the note has been paid and satisfied, or otherwise monetized.