We are planning to structure part of our transaction as an installment sale under Section 453 to spread out our tax liability, but our accountant warned us about depreciation recapture taxes being due immediately. How do we structure the cash-at-close and the note terms to avoid a tax-induced cash crunch?

Question

Tyler Smith · Accepted Answer

Section 453 of the Internal Revenue Code is a powerful tool for deferring capital gains, but it has a dangerous trap for asset-heavy businesses. Any depreciation recapture under Section 1245 or 1250 is fully taxable in the year of the sale, regardless of how much cash you actually receive at close. If you sell a business with significant equipment, vehicles, or capitalized software, you could face a massive tax bill on day one without the cash to pay it. To prevent this cash crunch, you must run a dedicated Thinking Time session to calculate your exact recapture liability before signing the letter of intent. Once you have this number, you must negotiate a working capital or cash-at-close allocation that ensures your initial cash proceeds are high enough to cover your total immediate tax liability. This includes the federal capital gains tax on the cash received, state taxes, and the full recapture tax. Do not accept a seller note where the first payment is deferred for twelve months if that note triggers an immediate tax obligation. Additionally, structure the seller note to pay interest monthly rather than accruing to the principal, providing you with the continuous cash flow needed to service any remaining tax obligations. You should also include a tax-acceleration clause in your promissory note. This clause states that if the buyer defaults or sells the company's assets, the remaining balance accelerates immediately, preventing you from being left with a deferred tax asset that you can never collect.