We are structured as an S-Corporation and want to use a Section 453 installment sale for a large seller note, but the buyer's bank is demanding we subordinate our note and accept a cash sweep that could trigger an un-funded tax liability. How do we structure the subordination agreement to protect our tax deferral?

Question

Tyler Smith · Accepted Answer

Under Section 453 of the Internal Revenue Code, you only pay taxes on the installment payments as you actually receive them. However, if the buyer's senior lender inserts a restrictive subordination agreement that forces a cash sweep, you might find yourself with a technical default or a deemed payment that triggers a tax bill without any actual cash in hand.

To protect yourself, you must negotiate a carve-out in the subordination agreement with the senior lender. This carve-out must explicitly permit the buyer to make scheduled principal and interest payments to you under the seller note, provided the senior debt is not in active default.

You should also include a tax gross-up distribution clause in your note agreement. This clause mandates that if the senior lender blocks a scheduled payment due to a financial covenant breach, the buyer is still contractually obligated to pay you a minimum amount equal to your tax liability incurred on any accrued but unpaid interest or principal.

Make this tax protection a major priority on your issues list during negotiations. Bring your Integrator and financial team into your EOS Level 10 Meeting to run scenario tests on the buyer's cash flow projections. If the projections show a high risk of senior covenant breaches, you must push for a lower subordination percentage or require the buyer to secure the note with personal guarantees or external collateral.