We want to use a Section 453 installment sale to spread our tax liability over several years, but we are terrified of the buyer going bankrupt or defaulting before the note is fully paid. How do we secure this installment note using a bank letter of credit or escrow without triggering the IRS constructive receipt doctrine and losing our tax deferral?

Question

Tyler Smith · Accepted Answer

Spreading your tax liability over several years through a Section 453 installment sale is a smart tax strategy, but it exposes you to massive credit risk. If the buyer mismanages the company post-close and defaults, you are left holding an unsecured note from an insolvent entity. To mitigate this risk, you must secure the installment note. However, you must tread carefully because the IRS has strict rules regarding constructive receipt. If you secure the note with cash or an unrestricted escrow account that you can access upon default, the IRS may deem that you had constructive receipt of the full purchase price at close, triggering your entire tax bill immediately. To avoid this, you must structure the security arrangement as a non-negotiable, non-transferable bank letter of credit or a standby letter of credit. This letter of credit must draw only upon a documented default by the buyer. Another option is a third-party guarantee or securing the note with the stock or assets of the operating business itself. Work with an experienced transactional tax attorney to draft a security agreement that meets the safe harbor requirements of Treasury Regulation Section 15A.453-1. This protects your cash without destroying your tax deferral.