We are structuring our exit as an installment sale to spread out our tax liability under Section 453, but our CPA warns us about depreciation recapture and inventory rules that could trigger an immediate tax bill. How do we structure the deal allocations to prevent a massive cash-flow crunch on day one?

Question

Tyler Smith · Accepted Answer

Selling your business using an installment sale under Section 453 of the tax code is an excellent way to defer capital gains taxes, but it can also be a massive tax trap if you do not structure the deal allocations correctly. The IRS does not allow you to defer taxes on depreciation recapture or inventory under an installment sale.

If your transaction has a million dollars in depreciation recapture from equipment or software, you must pay those taxes in full in the year of the sale, even if you only received a small fraction of the purchase price in cash at closing. This can leave you with a massive cash-flow crunch where your tax bill exceeds your day-one cash proceeds.

To prevent this, you must negotiate the asset purchase agreement allocation carefully. Work with your CPA to allocate more of the day-one cash payment to the assets subject to immediate recapture, such as equipment and inventory. Allocate the deferred installment payments to goodwill, which qualifies for capital gains treatment and can be deferred over the life of the seller note.

Schedule structured Thinking Time with your advisory team to run tax models before signing the letter of intent. Knowing your exact cash-in-pocket after taxes on day one ensures you do not pay a massive dumb tax to the government on a poorly structured deal.