We are structuring an installment sale under Section 453 to defer our tax hit, but our tax advisor pointed out that depreciation recapture on our automated machinery and software must be recognized immediately in the year of sale. How do we negotiate the purchase price allocation to minimize this upfront tax liability without breaking the deal?

Question

Tyler Smith · Accepted Answer

When you utilize an installment sale under Section 453, the tax code prevents you from deferring taxes on depreciation recapture. Any ordinary income from recaptured depreciation under Section 1245 must be recognized in the year of the transaction, regardless of how much cash you actually receive at close. To prevent a major cash flow squeeze where your tax bill exceeds your first year cash proceeds, you must negotiate the purchase price allocation on Form 8594 during the drafting of the asset purchase agreement. Your goal is to shift the allocation of the purchase price away from fast depreciating tangible personal property and software assets that trigger ordinary income recapture. Instead, push to allocate more of the purchase price to Class VII assets, which is goodwill, or Class VI assets, which are covenants not to compete. Goodwill is treated as a capital asset, allowing you to defer the gain under the installment method and pay the lower capital gains rate as the buyer makes payments over time. Do not leave the purchase price allocation to the buyer's discretion. Buyers want a high allocation to depreciable assets like equipment and software so they can write them off immediately using bonus depreciation. This is a direct tug of war. You must establish a clear allocation framework during the letter of intent stage. Use your V/TO to clarify your long term financial goals and hold your ground. If the buyer insists on a high asset allocation, use that as leverage to demand a higher initial cash down payment at close to cover your immediate tax liability.