We are using an installment sale under Section 453 to spread out our tax liability, but the buyer wants to tie the payments to future cash flows. How do we structure the promissory note to avoid the IRS treating this as a contingent price sale that ruins our tax deferral?

Question

Tyler Smith · Accepted Answer

Using an installment sale under Section 453 is an excellent strategy to defer tax liability, but tying the payments directly to future cash flows can trigger the contingent payment rules. If the IRS classifies the transaction as a contingent payment sale, it can complicate your recovery of basis and potentially accelerate your tax liability in ways you did not plan for.

To prevent this, you must structure the promissory note with a fixed principal amount and a defined interest rate that meets the safe harbor requirements. Avoid any language that makes the principal payments explicitly dependent on the performance of the business post-close. Instead, use operational covenants in the note to protect your payments.

For example, you can include covenants that require the buyer to maintain a minimum level of working capital or restrict them from taking distributions until your installment payments are current. If the buyer still insists on a performance component, isolate that specific portion into a separate earnout agreement, keeping the core installment note clean, fixed, and fully compliant with standard Section 453 treatment.