May 22, 2022
The Business Installment Sale Process: What’s In It For Business Sellers
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Through Beacon’s business selling process, you get the versatility to structure your business sale process however you want. It all starts with a free business valuation – after which you could sample over 5 types of business buyers during prequalification, and then maybe try out a business sale escrow, before ultimately settling for either a lump sum or an installment sale.
All these procedures revolve around money. Think about it - while business sellers are driven by a multitude of things, it’s money that takes the crown. Every single one of them ardently looks forward to that payment that culminates the long and tedious business sale process.
Ask any business seller and they’ll tell you about it - that there’s nothing as gratifying as receiving a cheque or an account deposit that reflects the true value of your hard-built business. That windfall is certainly a well-earned settlement to cap off all the effort, time, and resources that went into growing the business from just an idea to a profitable venture.
It’s worth noting, however, that the sale transaction is not always fulfilled via a one-time payout. Advisors at Beacon will advise you that at times, it might be a better idea to sell your business through what we call an installment sale.
To find out why and how we invite you to follow along as we examine the fundamental basics of the installment sale method of selling businesses. You also get to discover its benefits and drawbacks, as well as the tax consequences and tax rates that you should expect if you choose to accept installment payments.
What Is An Installment Sale?
In the business world, installment sale refers to any purchase process in which the buyer settles the payment through multiple periodic remittances.
Instead of clearing the sale price through a one-time payout, they get the benefit of having the amount split up and spread out over an extended period of time. The small payments are then submitted in pre-specified intervals until the original sale price is fully settled.
That’s more or less how installment payments are structured in the business sale scene.
Business buyers manage to purchase company assets by getting into a long-term payment plan, which allows them to settle the sale amount over a fixed time.
The terms for this type of business acquisition are usually laid out in the sale agreement. Then once the deal is closed, the business seller transfers the company ownership to the seller, who subsequently proceeds to make installment payments in intervals until the whole pending amount is cleared in full.
You could say that an installment sale is a form of business seller financing. You essentially choose to delay the gratification of a full payout by dividing and spreading out the buyer’s payment obligations over an extended period - which could be several months or years.
Business ownership is first transferred and then the selling expenses are recovered later in periodic intervals.
The opposite of that is the lump sum method, which entails buying and selling businesses through single combined payouts. Instead of splitting the sale amount into multiple small bits, the payment is settled in full at the time of closing the deal.
This leaves the business buyer free of any post-sales payment obligations. Then the seller gets to laugh all the way to the bank. It’s that simple.
Don’t be quick to make assumptions, though. While the installment sale method might seem to favor business buyers and the opposite would be said for lump-sum payments, it turns out that comparing the two is not that simple.
You’ll notice, for instance, that even when they quote the same principal sale price, lump sum and installment sale methods always end up registering varying purchase prices. Each has its distinctive influence on the total payment amount.
And that’s not all. It just so happens that even the IRS treats installment sale gains differently from lump-sum payouts. That means that business sellers can expect their taxes to be influenced by how they choose to structure their sale payments.
How The Installment Sale Method Works In Business Purchase
If you choose to sell your business through an installment sale, you ought to agree to all the payment terms beforehand.
Sellers are expected to negotiate with their buyers and then draw up a sale agreement that outlines the obligations for both parties - including the business assets to be transferred, their principal pricing, the expected down payment amount, the applicable interest rates, plus the payment schedule for the installments.
According to the IRS, the overall price of the business should be based on a fair market value of all the assets being exchanged.
Once you’ve worked it all out, you can expect the first payment at the time of closing the deal. The buyer of your business should submit a pre-agreed amount as the down payment, which is meant to demonstrate their commitment to the sale process.
Usually, the standard practice is to set the downpayment as a percentage of the principal sale price - 10%, 20%, 25%, 30%, you name it. You’re free to proceed with whatever formula that you deem fit.
Here’s a word of advice: you might want to set a down payment amount that is significantly higher than the accompanying individual installments.
Then, as compensation for financing the sale of the business, you can add a markup to the principal sale price. This is what is typically known as interest, and you can think of it as your profit for being patient enough to accommodate the installment sale. The total earnings themselves depend on the agreed interest rates, as well as the length of the payment period.
Now, in case you’re wondering, the standard interest rates for installment payments across U.S. businesses range between 2.5% and 71% per annum. They tend to be higher in small business deals that involve low-volume payments.
These interest rates are more or less the same ones that you’ll find being charged by traditional lenders. To work within a reasonable limit, you might want to confirm the standard market rates on business purchase financing options such as SBA loans.
Once you finally work out the interest charges, remember to add them directly to the installment amounts. This cumulative approach makes it easy for business buyers to track and honor their payment obligations.
Don’t overstretch your profits, or try to rush the installment schedule. All the payments should be structured based on the expected post-transition business returns.
This gives new business owners the chance to comfortably settle their sale installments from the income that they manage to generate from the company. As such, it’s safe to say that an installment sale makes it possible for businesses to self-finance their purchase. New owners come in and then simply use the returns to make the installment payments.
It’s worth noting that the installment terms are not equally flexible across the types of asset purchases. The IRS has special rules on how payments for certain classes ought to be structured.
For instance, your accounts receivable and company inventory must be paid for in full within the first year of the sale - while intangible business property, such as goodwill, can have their installments spread out over multiple years.
And that’s not all. The IRS further supplements these rules with special tax treatment for both business buyers and sellers. Installment sale transactions now have unique tax benefits and risks, with different types of assets and payment structures attracting varying sets of tax liability.
Pros And Cons Of Selling Your Business Via Installment Sale
In the many years that Beacon has served business buyers and sellers, we’ve witnessed pretty much everything that comes with the installment sale process. So far, this long-term payment method has proven to be a double-edged sword, offering benefits along with a fair share of drawbacks.
Business owners in particular, are encouraged to familiarize themselves with both positive and negative expectations as these could potentially make the difference between generating great profits with a negative outcome.
Here’s a taste of both worlds to give you the much-needed headstart:
#1. Higher business purchase price
A lump-sum payment could give you a tidy amount for your business - especially if the valuation was done on Beacon’s 150-plus data analysis points.
However, it turns out that even the best possible lump sum value cannot outshine the total gross profit that you otherwise stand to gain from a corresponding installment business sale. And the reason is pretty simple: installment payments are structured to go beyond the pricing ceiling set by your business valuation.
If your business is found to be worth $500,000, for instance, the best you can do on the lump sum method is to negotiate with the buyer to maintain the sale price. This will give you a cool half a million dollars all right, but that’s as good as it gets.
On the other hand, with an installment sale, you get to generate additional interest income from the principal valuation amount. Although you won’t see half a million dollars in one bulk payment, you can be almost certain that individual installments will ultimately add up to a much higher purchase price.
A well-calculated interest rate could squeeze out millions of dollars in profit from a business that would otherwise have sold for $500,000.
#2. More prospective business buyers
Sure, you can easily find prospects who are possibly interested in your business. But, as you’ll come to find out, the bulk majority of them won’t have the resources for one lump sum payment.
The U.S. might be the richest country on the globe, but its citizenry is not that bankable. Combined, households here have a median bank account balance of $5,300, while their average savings add up to $41,600.
Now compare that with the current standard selling price for a small business. For instance, if you check out our listings, you’ll notice that a small auto repair shop in Los Angeles goes for about $150,000 while buying a New York landscaping business would set you back a whopping $750,000.
Such restrictive business sale prices usually lock out most aspiring business buyers, including passionate entrepreneurs who happen to possess the type of skills that you might be looking for.
These are opportunities that you could easily tap into by opening your business sale to installment payments. This alone would embolden many qualified buyers who’d otherwise shy off from lump-sum payments.
As a result, you’d have a much wider base of leads to pursue, which would translate into even better selling rates for your businesses. Plus better chances of finding a suitable new owner.
#3. Long-term cash flow stream
As it turns out, the thing that makes lump-sum payments attractive is the same one that could be said to be its Achilles’ heel.
You see, receiving a huge payout may feel great for some time, but it only comes once. That’s why it’s called a one-time payment.
Now, the problem with one-time payments is exactly that. If you use it up, you won’t get an additional disbursement to bail yourself out of any developing problems.
With an installment sale income though, you’ll be guaranteed long-term capital gains. Whereas the amount per transaction tends to be lower than a lump sum payment, at least you can count on them to keep flowing continuously for months or even years.
Therefore, the installment payments may feel like ordinary income. A business owner could even use them as retirement income for years after selling off their company.
#4. Lower capital gains tax rates
When it comes to filing capital gains taxes from your installment business sale, you don’t necessarily have to report it all at once. RC Section 453 by the IRS allows you to space out your tax filing according to the payment schedule.
This means that only the installments that have been paid out are counted as taxable income for a specific period. The rest are then meant to be filed separately at a later date in the future.
To put it into perspective, imagine a business seller who has set up an installment sale scheme that spreads out the payments over several years. Although the installments will ultimately add up to a tidy sum, the seller is not obligated to declare that cumulative amount in their tax return.
Instead, the capital gains tax liability for each tax year is supposed to be filed separately from the rest. The tax returns should only cover the installments received in that specific year, and any subsequent gains ought to be reported in future tax years, and so forth.
The good thing about this approach is that it helps you maintain your original tax bracket even with the installment payments coming in. A lump sum amount would, otherwise, compel the IRS to upgrade your tax bracket, which would consequently attract higher tax rates.
Consider a single person generating a capital gains tax of about $20,000 from their annual installment payments. That means that, in every tax year, they’d qualify for 0% tax on the long-term capital gains.
What’s more, the gains still wouldn’t impact their income tax rates. If they’ve been making $150,000 per year, for instance, they’d remain squarely within the tax bracket of taxpayers earning $86,375 - $164,925 per annum. Hence, even with the extra $20,000 capital gains, their tax liability for that year would only add up to about $14,751 plus 24% of any excess above $86,375.
Now, contrast that with the tax liability of a single person who happens to receive lump sum capital gains that stretch well above $500,000. This would place them right in the tax bracket of long-term capital gains above $459,750 – which typically charges a steep tax rate of 20% on the capital gains.
Another tax benefit that comes with business installment sales is tax deferral. By separating the resultant tax liabilities by tax year, this system further allows you to defer the taxes, as well as carry forward your tax credits and deductions to be applied in future tax returns.
You could even defer the taxes to the point of staying below the Net Investment Income Tax (NIIT) threshold – which, according to Section 1411 of the Internal Revenue Code, would otherwise attract additional tax charges of 3.8%.
#1. The business is transferred without full payment
Although the installment sale method requires business buyers to make a downpayment in the beginning, the amount is excessively disproportionate to the sale privileges that they get in return.
The business buyers get to take over the entire company without clearing the purchase price in full. They then proceed to run the business and even capitalize on the value it offers, while sellers are forced to wait for years to receive full compensation.
#2. The outcome depends on the post-sale success of the business
Unfortunately, even when you choose to wait patiently for the installment payments, it turns out that they are never quite guaranteed.
The caveat in many instances is that you only get to receive the funds if the business survives through the payment period. Otherwise, if it collapses and possibly loses its revenue streams, your payments would die off with the business.
As such, business sellers are always advised to be extremely careful when picking out their buyers. Instead of blindly proceeding with the highest bidder, you might want to methodically pre-qualify each prospective candidate who hopes to take over the business.
At least then you'll be able to identify solid leads with the right credentials to sustain the business now and in future years.
#3. Attracts tax risks
Even with sellers leveraging installment sales for tax purposes, keep in mind that they don’t always offer a tax haven. As you proceed to enjoy its many tax benefits, you’ll also be exposing yourself and the business to some tax risks.
You could, for example, get caught out by some of IRS’ unfavorable tax rules – such as the infamous one on depreciation recapture. It obliges you to file all the gains that you make from selling any depreciable capital property, upon which everything should be captured and reported as ordinary income in the year of sale.
This is how you find yourself struggling with a huge tax bill as the business is being passed on to its new owner. And if you think that the down payment might bail you out, it turns out that the tax liability could even exceed your cash proceeds.
The Bottom Line – Are Installment Payments Ideal For Your Business Sale?
Where a business installment sale rides on the same foundation as the regular installment method, the two are not as identical as they might seem.
The former isn’t just about installment payments. It’s far more complicated than that thanks to all the specialized principles it applies to business sellers and buyers.
It’s also evident that the chances of making errors here can be pretty high if you fail to take the right precautions.
You could be chasing the capital tax benefits only to discover later that your type of asset sale has its own special tax filing guidelines.
Another major risk is, of course, failing to thoroughly pre-qualify buyers. This is how some business sellers end up unknowingly compromising the future of their companies.
Then last but not least, there’s the all-important question of pricing the business plus its accompanying installments:
How do you go about calculating the value of the business?
What should you consider when creating the interest rates?
How do you negotiate the pricing and sale terms with business buyers?
How can you capture this in the business sale document?
And how do you piece together all the complex legal parameters, the IRS tax guidelines, plus the considerations for asset prices?
Well, if you want insights into all these matters, we encourage you to check out other detailed guidelines on our blog. However, when it comes to putting it all into action, you might want to leave everything to the experts, like a tax advisor, CPA, financial analyst, or business appraiser.
Fortunately for you, Beacon has all that expertise and intelligence under one roof. Our advisors will assist you accordingly throughout your business sale process. We’ll help you identify not only the best selling formula for your business, but also the most appropriate types of buyers, the right purchase agreement terms, plus a seamless business transition procedure.
You can come on board right now and we’ll get you started with a complimentary free business valuation.
Explore your options
Get a 100% confidential and complimentary business valuation.
Davis Porter is an extensively published business author who, for over a decade now, has deeply specialized in B2B commerce, finance, digital marketing, and business tech. While he was always intrigued by the intricacies of entrepreneurship, it is his Business Management degree that ultimately sparked his burning fascination for examining and resolving incessant challenges in business/finance.
Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.