We are structured as an S-corp and accepting a large seller note, but our accountant warned us about immediate tax liabilities on deferred payments under Section 453. How do we structure the installment sale to avoid paying taxes on cash we have not received yet?

Question

Tyler Smith · Accepted Answer

When you accept a seller note as part of your transaction structure, you are entering into an installment sale under Section 453 of the Internal Revenue Code. This allows you to defer paying taxes on the gain until you actually receive the cash payments. However, there is a dangerous trap: depreciation recapture.

Under tax law, any depreciation recapture on tangible personal property or real estate is taxed immediately in the year of the sale, regardless of how much cash you actually received at close. If your business has significant equipment or inventory, this can create a major cash squeeze.

To manage this risk, you must work with your tax advisor to structure the purchase agreement allocation carefully. Negotiate to allocate the purchase price to assets that do not trigger heavy immediate recapture taxes.

During your thinking time sessions, model your net cash flow after taxes for year one of the transition. Ensure the cash received at close is more than sufficient to cover your total immediate tax liability, including any accelerated recapture taxes.

You should also structure the seller note to include a tax distribution clause, requiring the buyer to make accelerated interest or principal payments if your tax liability exceeds the cash received.