Our buyer is pushing for an installment sale to fund part of the purchase price over three years, but we are worried about the tax implications and the risk of default. How do we structure this under Section 453 to manage our tax liability and protect our cash?

Question

Tyler Smith · Accepted Answer

An installment sale under Section 453 of the tax code is a powerful tool to defer your tax liability, but it comes with real buyer default risk. Under Section 453, you only pay capital gains tax on the principal as you actually receive the payments over time, rather than paying the entire tax bill upfront at closing. This keeps more money working for you, but you must structure the deal to ensure you actually get paid.

To mitigate default risk, never act as an unsecured lender to your own business. First, secure a first-priority lien on the assets of the business you are selling. If the buyer defaults on their payments, you must have the legal right to foreclose on the assets and take back control of the operations.

Second, require a personal guarantee from the buyer or a standby letter of credit from a reputable bank. This ensures that the debt is backed by more than just the future cash flows of the company.

Finally, include financial covenants in the promissory note. These covenants should require the buyer to maintain a certain debt-service coverage ratio and provide you with quarterly financial statements. If they breach these covenants, it triggers an immediate default, allowing you to take corrective action before the business is run into the ground.