Our CPA is pushing us to structure our exit as an installment sale under Section 453 to defer our capital gains tax liability, but we are worried about the risk of buyer default and depreciation recapture. How do we evaluate this tax strategy against the structural risks of leaving our money in the business post-sale?

Question

Tyler Smith · Accepted Answer

Using Section 453 for an installment sale is a powerful way to defer capital gains tax, but do not let tax savings blind you to structural credit risk. Under Section 453, you only pay tax as you receive the payments, which keeps you out of the highest tax brackets in the year of the sale. However, you face two major traps: depreciation recapture and buyer default.

Depreciation recapture under Section 1245 is taxed fully in the year of the sale, regardless of how much cash you actually received. If your business owns heavy equipment or significant physical assets, you might owe a massive tax bill on day one without the cash flow to cover it.

To de-risk this structure, you must secure the installment note. Do not accept an unsecured promise to pay. You need a first-priority security interest in the assets of the business, and ideally, a personal guarantee from the buyer or a letter of credit from their bank.

Additionally, write financial covenants into the note. These covenants should mirror bank covenants, such as maintaining a minimum debt service coverage ratio. If the buyer starts running the business into the ground, you must have the right to accelerate the note and seize the collateral before they file for bankruptcy. Tax deferral is worthless if the buyer defaults on the principal.