Jun 3, 2022
Installment Sale vs. Seller Financing In A Business Sale
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With installment sales and seller financing being two of the most widely championed business sale methods, it’s understandable why you might want to consider them when selling your business.
In that case, chances are that by now, you’ve already tried to learn the basics from various web publications. As such, you’re probably aware that both installment sales and seller financing methods are accompanied by a fair share of benefits and risks.
The problem, however, sets in when discerning the parameters between the two. As it turns out, the concepts of an installment sale and seller financing can get exceedingly confusing if you try to closely compare them. The deeper you research their differences, the more you discover instances of seller financing and installment sales being used interchangeably – which, in turn, begs even more questions.
So, what’s the deal between an installment sale and seller financing? What are the differences between an installment sale and seller financing in the business sales process? Most importantly, which of the two is more suitable for a seller looking to transfer their small business?
Well, for the sake of accuracy, we’d advise you to get tailor-made professional guidance directly from our seasoned business brokers. They have the expertise to customize the answers to your precise business sale circumstances.
Otherwise, here’s the generalized comparison of an installment sale vs. seller financing:
What Is An Installment Sale?
In the most basic sense, an installment sale refers to a transaction in which the seller allows the buyer to remit their payments over an extended period of time.
The Internal Revenue Service (IRS), however, goes into the finer details and describes an installment sale as any real property or business sale arrangement in which the seller receives at least one payment after the tax year of the sale.
Instead of getting a lump-sum payment for the sale of your business, the buyer proceeds to settle the purchase price in multiple periodic remittances. The sale price is split and spread out over a predetermined period of time, during which the buyer is expected to honor their end of the deal until the whole amount is cleared.
The legal guidelines for this type of sale are laid out in Publication 537 by the IRS. It gives business sellers the right to add interest charges to the principal amount as compensation for accommodating the payment deferrals. So, in the end, you get to earn a higher gross profit over the original sale price.
The IRS is heavily involved in the administration of installment sales because of the many tax implications they attract. In particular, the agency pays special attention to tax liability and benefits that accompany various types of installment asset sales. What’s more, it manages the tax rate for every taxable gain generated from an installment sale.
How an installment sale works when selling a business
The build-up to an installment sale begins from the moment your business listing hits the market. You can publish it on digital marketplaces under “installment sales,” or perhaps, showcase the listing as an advert on alternative selling platforms – including social media.
You could, however, make everything much easier by working directly with a business brokerage agency like Beacon. Our thorough pre-qualification process ultimately identifies the most suitable buyer for your business, upon which you can proceed to negotiate the purchase agreement.
The framework for the installment sale is laid out in an installment contract. It should spell out all the terms of engagement, including the business purchase price, assets to be transferred, down payment amount, interest rate, payment period, plus the installment amounts.
Unlike a lump sum sale where you receive a huge one-time payment, an installment sale typically takes years to complete. The first remittance is typically a downpayment, which is a substantially higher amount than the individual installments.
This is when you’re supposed to transfer the business and the agreed-upon assets to the buyer, who then proceeds to take ownership of the company ahead of the installment payments.
The IRS further requires you to report the transaction through its Form 6252, which ought to show that the first installment payment is due at least one year after the tax year of the sale.
Then for tax purposes, you’ll be expected to also detail the assets involved in the deal. One of the prime benefits of an installment sale is you’re bound to get a lower tax bill on the capital asset gains and interest income.
Keep in mind, though, that not all forms of asset sales are eligible for an installment arrangement.
The IRS allows you to charge installments on tangible business assets like real estate, as well as intangible items like goodwill, accounts receivable, and inventory. In this case, tax charges only apply to the gains that you make from the adjusted basis.
The privilege, however, doesn’t extend to financial instruments like stocks and bonds, as they do not qualify as capital assets under an installment sale.
All in all, you’ll notice that the buyer retains the transferred ownership interests throughout the payment period. Some dealings even go on to generate their installment payments directly from the newly-acquired business’s revenue. That means the deal is bound to remain alive as long as the company is profitable.
What Is Seller Financing?
Also known as “owner financing,” seller financing is a payment system in which the seller acts as the buyer’s principal lender. This saves the buyer the trouble of borrowing funds from traditional lenders such as banks, credit unions, or any other financial institutions.
One area where seller financing is particularly common is in real estate. Instead of applying for a traditional mortgage from a financial institution, the borrower simply carries on with the seller as the main creditor of the transaction.
It’s worth noting, however, that facilitation from the seller doesn’t necessarily mean direct funding. Rather, the seller essentially allows the buyer to pay for the transaction through multiple installments spread out over an extended period of time.
Many owner-financing contracts are, in fact, structured like a traditional mortgage agreement. Buyers proceed to make long-term payments that are inclusive of not only the principal amount but also the predetermined interest amount.
This is more or less the same concept that applies to the acquisition of businesses. While the structure and terms vary from one business to another, they all follow the same basic principle.
It seeks to cut out the middlemen who offer business purchase loans – like SBA loans – and, instead, offer buyers the chance to work directly with their business sellers.
A sale that would otherwise have been settled as a lump sum is broken up and divided into multiple remittances – beginning with a down payment, which is then followed up with installment payments at regular intervals.
In the meantime, the seller financing terms operate a lot like the standard conditions for bank loans. The buyer is taken as the borrower, who’ll settle the original business sale price along with the interest charges over the payment period.
How seller financing works when selling a business
For a seller-financing arrangement to proceed, the buyer and the seller of the company must agree on the terms beforehand. A promissory note is prepared, capturing all the conditions of the sale agreement – including the payment schedule, the principal amount, plus the accompanying interest charges.
At the time of the sale, it’s common for buyers to be required to make a down payment to indicate commitment. This could be in the form of a percentage share of the total purchase price – like, say, 15% of 30%.
Once that is settled, installments are expected at regular intervals over an extended period of time. You could, for instance, agree to receive them as monthly payments that stretch out over a number of years.
The interest rate, on the other hand, is ordinarily aligned with the prevailing market rates. For example, you might find business sellers charging the same as or maybe slightly lower than what conventional banks levy on their loans.
That said, a good rule of thumb is to keep the installment amounts within a reasonable fraction of the corresponding business revenue forecasts. That’s because buyers often rely on the revenue of the newly acquired businesses for their installment funds.
If you choose an adequately skilled entrepreneur as the buyer of your company, chances are they’ll keep it profitable long enough to fulfill their end of the bargain.
Otherwise, rushing the preliminary qualification procedures could land you the opposite, potentially compromising the company’s survival plus the whole payment process.
It’s worth noting, though, that business sellers don’t always have to bear the risk alone. In some owner-financing sales, the seller only facilitates about a third of the business acquisition cost, while conventional banks cater the rest.
In particular, such financial institutions tend to favor sales transactions that involve highly promising businesses. If your company has solid financials, banks may be willing to take seller financing as some form of buyer equity, consequently leaving room for additional lending.
Another thing to keep in mind is that just like regular bank loans, seller financing has an allowance for loan security.
This could be set up as stock pledges, in which a managing corporation is created with some of its voting rights going to the original seller. That gives you the privilege to actively protect your interests even after transferring the business. You could, for instance, come in to resolve payment defaults or imminent foreclosure.
Seller Financing vs. Installment Sale Methods
Now that we’ve reviewed both installment sales and seller financing methods of selling a business, now we’ll juxtapose them for a full comparison of their attributes.
Here is the resultant verdict.
Verdict – installment sale vs. seller financing
For business sellers who might be wondering which is better between an installment sale and seller financing, it turns out that they share way more similarities than differences.
The installment method and owner-financing both involve:
Selling of businesses through long-term payment schedules that are spread out over an extended period of time.
Deferral of payment beyond the transfer and change of ownership.
Business sellers charge an interest rate over the principal amount as profit for facilitating installment payments.
Setting up and signing a sales contract, which is then used as the rulebook for the transaction terms, plus the payment schedule.
Sellers receive special tax treatment from the IRS.
Buyers have the chance to raise installment payments directly from the proceeds of their newly-acquired business.
Buyers gain ownership and control of the company before the payment process is complete.
Based on these facts, while an installment sale is a form of seller financing, not all owner-financing arrangements would qualify to be declared an installment sale. In other words, seller financing is a business sale category, whereas an installment sale happens to be a subcategory of seller financing.
What does this mean for business sellers?
What this means for business sellers
Contrary to popular belief, seller financing and installment sale methods doesn’t mean you’re a desperate business seller. Choosing to be flexible with the payments could increase your risks as a seller, but it might prove to be worthwhile if you land an adequately qualified, low-risk buyer.
As a matter of fact, it’s because of these potential rewards for sellers and buyers that seller financing has grown in prominence among small business sale transactions. Real estate was initially the prime focus of owner financing, but the business selling process has now stolen the limelight.
Industry statistics even suggest that up to 90% of small business sale deals today involve some form of seller financing.
Business sellers are not the only facilitators, though. On average, they are taking up about 37% of the total business purchase price, with the rest primarily going to mainstream lenders like banks.
Professionals also agree that, indeed, seller financing and installment sales are becoming more relevant than ever. A nationwide survey of business brokers revealed that by 2015, an overwhelming 82% were already terming “seller financing” as “essential” or “important” to completing transactions in the modern business sale environment.
Why is that?
For the sake of clarity, here’s a brief breakdown of the benefits of seller financing and installment sale approaches:
#1. More potential business buyers
If you’re having trouble finding the right buyers for your business, perhaps you might want to adjust the payment scheme and open it up to seller financing or an installment sale.
The reason is, that not many people can afford to pay your asking price in a one-off lump sum amount.
A stable small business in one of the US prime cities would go for at least $500,000 or so.
Beacon’s business sale listings alone already feature several of them. We have, for instance, a full-service auto repair shop in Cook County, Illinois asking for $500,000; an established landscaping business in Albany County asking for $750,000, and a construction company valued at $750,000 in Merrimack County.
Compare that with $61,455, which is the average salary for small business entrepreneurs in a country where the personal saving rate is currently at only 11.9%.
Among these many finance-constrained entrepreneurs could be your perfect buyer, who possesses the right skills to take your business to the next level. They may not be able to raise a lump sum amount, but at least they’d be willing to work with owner financing and installment sale approaches.
#2. Higher selling price and gross profit
By expanding the scope of prospective buyers through the inclusion of an installment sale plan, you’ll essentially be inviting more market interest towards your business. This should, in turn, raise the demand for your seller-financed business – which would then mean additional wiggle room for the pricing. Greater demand almost always translates into better pricing rates.
An installment sale would further top that off by adding interest income to the principal amount. While an installment amount would understandably appear small against a lump sum payment, the total cumulative remittances will always exceed the selling price on short-term plans.
In terms of scale, it just so happens that fractional-owner financing options usually deliver a gross profit of 15% over the corresponding lump sum asking price.
It goes even higher if you extend the repayment period. As business buyers try to reduce their installments by negotiating for longer repayment periods, your profit margin will increase courtesy of the additional interest charges.
#3. Tax Implications
The moment you start filing your installment sale via Form 6252, you’ll notice that it garners special tax treatment, which could persist for several years.
Ff Consider that instead of a huge lump sum amount, you’ll receive payments in small bits over multiple tax years. That means you’re not obligated to file the overall expected gross gains as your taxable income. Rather, the IRS accommodates a system of reporting gains known as an “installment method.”
This is where you limit your tax liability to the gains that you’ve received in that specific tax year, and then leave the pending payments for the subsequent tax years. You can think of it as a way to defer and spread out your capital gains tax across multiple tax years.
By separating the income tax liability by tax years, you should be able to stay within your original tax bracket – which eventually means retaining a favorable tax rate.
On the other hand, a lump-sum payment would dump just enough tax liability on you to warrant an upgrade of the tax bracket. This is how you might find yourself attracting astronomically higher tax rates than you’re normally used to.
That said, it’s worth noting that although seller financing is widely renowned for its positive tax benefits, it can be a mixed bag for some taxpayers.
Consider, for example, business sellers who happen to dispose of real property that has depreciated. In case of the selling price exceeds the asset’s adjusted basis, the IRS would tax the transaction as ordinary income instead of an actual capital gain.
Over To You: How To Manage Installment Sale And Seller Financing Risks
All in all, the key takeaway here is – when selling a business, all installment-sale transactions are a form of seller financing, but not all types of seller financing are structured as an installment sale.
Whichever you choose for your business sale, at least you’re bound to attract more potential buyers, increase the business selling price, raise the gross profit, as well as qualify for favorable tax consequences.
Keep in mind, however, that the benefits here are not guaranteed for everyone. It all depends on how you choose to handle and structure the entire seller financing or installment sales process.
Considering the risks, you may not want to pursue these options alone. While we’ve tried to simplify the concepts as much as possible, don’t let our guide mislead you into treating the whole exercise as a DIY.
An installment agreement or loan between a buyer and seller is subject to endless dynamics and modalities, most of which require professional administration to maintain unambiguity, favorable collateral, sufficient insurance coverage, and so forth.
Moreover, this is a business sale process that could take you years, during which you cannot afford to neglect any of the finer details in the sales contract. Even the seemingly inconsequential paperwork matters a lot.
All of that can be expertly facilitated by Beacon's team of advisors. Work with us, and not only do you get exposure through our marketplace for Main Street businesses, but we'll also provide personal support throughout every step of the transaction.
Get started today with a free business valuation, which helps you pre-qualify the best type of business buyers before proceeding with sale negotiations, due diligence, and seller financing.
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.