One often overlooked aspect of selling a small business (or any business, for that matter) is the tax code’s treatment of a non-interest bearing installment sale as a below market loan. In most circumstances, when an interest in a business is sold in exchange for a series of payments where at least one payment will be received after the tax year in which the sale occurs, such transaction qualifies for the “installment method” of reporting income pursuant to Section 453 of the Internal Revenue Code, and as a result, the selling taxpayer is able to “stretch out” the reporting of capital gains income over the period of the installment sale.
An aspect of an installment sale that is often overlooked, however, is that the installment payments must bear interest of at least the “applicable federal rate” (“AFR”) at the time of the transaction – presently at a low 1.57% for a “mid-term” installment sale (one that lasts 3-9 years). If the parties fail to incorporate an explicit interest provision (or if the stated interest is beneath the AFR rate) in the sales contract, the taxpayer must impute the equivalent of the AFR rate of interest in their taxable income each year as installment payments are received – which has the effect of converting a portion of capital gains from the sale (usually taxed at the lower capital gains tax rate for individuals) into interest income (taxed at higher ordinarily income tax rates). To remedy this situation, the buyer and seller can either agree that a portion of the existing sales price constitutes the appropriate amount of interest, or an astute seller may be able to negotiate additional interest payments from the seller as part of the deal.
For more information, please contact Var E. Lordahl of our Las Vegas, Nev. office at 702-550-4466.