We are considering structured installment payments over three years to defer our capital gains taxes under Section 453, but we are worried about buyer default and IRS rules. How do we structure this installment sale to protect our proceeds while staying fully compliant?

Question

Tyler Smith · Accepted Answer

Structuring a portion of your purchase price as an installment sale under Section 453 of the Internal Revenue Code is a highly effective way to defer your tax liability. Instead of paying capital gains on the entire purchase price in the year of sale, you only pay tax on the cash principal as you actually receive it. However, this tax benefit introduces major credit risk if the buyer defaults on their payments.

- First, you must secure the installment obligation. Never accept an unsecured promissory note. Insist on a pledge of the stock of the acquired company as collateral. If the buyer defaults on their payments, you must have the legal right to seize the stock and retake operational control of the business. Additionally, require a personal guarantee from the buyer's principals or a parent company guarantee if the buyer is an acquisition vehicle with no assets of its own.

- Second, be aware of the interest rules. Under Section 453A, the IRS imposes an interest charge on the deferred tax liability if your total installment obligations exceed five million dollars. Work with your CPA to run the numbers and ensure the interest cost does not wipe out your tax deferral benefits.

- Finally, use your weekly Level 10 Meeting™ and monthly financial reviews during the payout period to monitor the company's financial health. If you see their key performance indicators slipping, you can address the operational issues before they lead to a payment default.