We are looking to structure our exit as an installment sale under Section 453 to spread out our capital gains tax, but the buyer is pushing for an escrow account funded by our initial proceeds to cover potential indemnity claims. How does putting these funds in escrow impact our ability to defer taxes under Section 453, and how do we structure the escrow to keep our tax deferral intact?

Question

Tyler Smith · Accepted Answer

Under Section 453 of the Internal Revenue Code, an installment sale allows you to defer taxes by paying them only as you receive the actual cash. However, if the buyer insists on placing a portion of the purchase price into a traditional escrow account to secure indemnity obligations, the IRS may view this as constructive receipt. If the IRS determines you have constructive receipt of those funds at close, you will owe taxes on the entire amount immediately, even if you cannot touch the cash in escrow for years.

To keep your tax deferral intact, you must structure the escrow agreement with strict contingencies. The escrow agent must not be your direct agent, and your right to receive the escrowed funds must be subject to real, substantial restrictions. For example, the funds should only be payable upon the expiration of the indemnity period and the resolution of any active claims.

Alternatively, you can negotiate to replace the traditional escrow account with a set-off provision in a seller note. Instead of putting cash in a third-party account, you accept a larger seller note where the buyer has the right to deduct valid indemnity claims directly from the principal balance. This avoids constructive receipt entirely, preserves your installment sale status under Section 453, and keeps your tax liability aligned with your actual cash receipts. Working with a qualified tax professional is essential to draft these agreements correctly.