We want to structure our transaction as a Section 453 installment sale to defer taxes, but our CPA warns that our heavy equipment inventory means we will face immediate depreciation recapture taxes in the year of sale. How do we structure the initial cash down payment to avoid a post-closing cash crunch?

Question

Tyler Smith · Accepted Answer

Under Section 453 of the Internal Revenue Code, installment sale reporting allows you to defer taxes on your capital gains, but it does not apply to depreciation recapture under Section 1245 or Section 1250. Any accumulated depreciation on your equipment, machinery, or vehicles is recaptured as ordinary income and taxed in full in the year of the sale, regardless of how much cash you actually receive at closing.

If you agree to a low down payment and a large seller note, your tax bill in year one could easily exceed the cash you received at closing. To prevent this cash-flow disaster, you must negotiate a minimum cash down payment that is mathematically tied to your immediate tax liability.

Calculate the exact dollar amount of your ordinary income tax from depreciation recapture, plus any state taxes and the capital gains tax on the cash portion of the sale. Your purchase agreement must specify that the initial cash payment at closing must be, at minimum, equal to this total tax liability plus a twenty percent liquidity cushion.

Additionally, structure the promissory note so that the early payments are weighted more heavily to help cover your ongoing tax payments. You must be unsentimental during this negotiation. If the buyer cannot or will not pay enough upfront cash to cover your immediate tax obligations, you are effectively paying out of pocket to sell your own company. Do not let tax rules turn a successful exit into a short-term liquidity crisis.