Part one of our three-part series on how businesses can be sold and acquired

If you’re buying or selling a business, you may imagine that the process will include a closing day with one big check that seals the deal. But lots of business sales and acquisitions don’t work that way. Many deals are structured as installment sales, where the buyer pays part of the price at closing and the rest over several years.

While installment versus lump sum are terms that describe how a business can be purchased, they don’t describe what exactly is being sold. In parts two and three of this blog series, we’ll look at asset sales and stock sales, which describe what actually changes hands (literally or figuratively). An installment arrangement can be layered on top of either one, so we’ll start there.

What Is an Installment Sale?

In an installment sale, the buyer pays a down payment at closing and signs a promissory note to pay the balance, with interest, over an agreed upon period. In this scenario, the seller becomes the bank, handing over the reins to the business while the buyer pays them back over time.

For tax purposes, a sale generally qualifies as an installment sale when you receive at least one payment after the tax year in which the sale closes. The note’s terms, including the amount, the interest rate, the payment schedule, and what happens if the buyer misses a payment, are all negotiated and written into the closing documents.

Installment Sale vs. Lump Sum

Here are some key differences between the two main types of business acquisitions: lump sum or installment.

Lump sum. The buyer pays the full price at closing. You walk away with your money, and the relationship with the buyer is largely over. There’s no waiting and no worry about whether the buyer can keep up with payments. The trade-off is that your gain is generally taxed in a single year, which can push you into a higher tax bracket and leave you with a higher tax liability.

Installment. You receive part of the price up front and the rest over time. Under the default tax rules, you generally report your gain as you receive payments rather than all at once, which can spread the tax bill across several years. The trade-off is that your payout now depends on the buyer’s ability to run the business and make payments.

Buyers often like installment deals because they need less cash up front, and sellers who offer financing may attract more potential buyers, or a better price, than sellers who insist on all cash.

The Installment Sale Process

An installment sale follows the same general path as any business sale, with some added steps for the financing piece:

1. Preparation and valuation. Gather your financials, understand what your business is worth, and get your records in order.
2. Finding a buyer and negotiating terms. Once you’ve identified a serious buyer, the two sides typically agree on a letter of intent outlining the price, the down payment, and the basic terms of the installment note. After that, a definitive Asset Purchase Agreement or Stock Purchase Agreement is prepared which includes all of the terms of the transaction.
3. Due diligence. The buyer reviews your finances, contracts, employees, liabilities, and more. If you’ll be financing part of the price, you should be doing some diligence of your own on the buyer’s finances and experience.
4. Drafting the documents. Beyond the purchase agreement, an installment sale requires the buyer to sign a promissory note and additional documents securing payment under the note, such as a deed of trust on real estate, or Security Agreements and UCC Financing Statements as well as a  personal guarantee from the buyer.
5. Closing. The down payment changes hands, ownership transfers, and the payment plan begins.
6. Ongoing payments. Unlike a lump sum, the deal isn’t truly over at closing. You’ll receive payments, track the balance, and report the sale on your tax returns for as long as the note is outstanding.

How long does it take? Many small business sales take several months from signed letter of intent to closing, and complex deals can take longer. Negotiating the note and its protections can add time. And then there’s the payout period under the terms of the Promissory Note, which commonly runs for several years, depending on what you and the buyer agree to.

Installment Sale Benefits

• Potential tax deferral. Spreading your gain over the years you receive payments may reduce the tax you owe in any single year.
• A larger pool of buyers. Offering financing makes your business accessible to qualified buyers who can’t pay all cash.
• Interest income. The buyer pays you interest on the unpaid balance under the terms of the Promissory Note, which adds to your overall return.
• Flexibility. Payment schedules can be tailored to your goals, whether you want steady income in retirement or a gradual transition out of the business.

Things to Keep in Mind

An installment sale is a great option for plenty of buyers and sellers, but it’s not right for all scenarios. Here are the issues we encourage business owners to think through:

Potential default. If the business struggles or the buyer simply stops paying, you may be left chasing the balance. That’s where well-written legal documents will really matter. Liens on business assets, personal guarantees, and clear default remedies in the note can make a big difference.

Tax complications. Depending on how the deal is structured, certain portions of your gain, such as depreciation recapture in some asset sales, may be taxed in the year of sale even though you haven’t received that money yet. Inventory sales also generally don’t qualify for installment treatment. We’ll dig into this in part two of the series.

Interest rules. In related family transactions, if the interest rate on the note is “too low,” the IRS can treat part of each payment as interest no matter what the Promissory Note states.

Tax rates. Deferred gain will be taxed at the rates in effect when you receive each payment, which may be higher or lower than today’s rates.

Continued connection. Your financial future remains tied to the company you sold. Sellers sometimes negotiate protections, like limits on what the buyer can do with the business while the note is outstanding, and some sellers are asked to stay on for a transition period.

Is an Installment Sale Right for You?

The answer depends on your goals, your tax situation, the buyer, and the structure of the deal. Here are some questions to take into your first conversation with an attorney and tax advisor:

• How much cash do I need at closing?
• How well do I know this buyer, and how confident am I in their ability to make payments?
• What security will protect me if payments stop?
• How will the sale be taxed, and how much of the gain could be due in the first year?
• Would an asset sale or a stock sale change the whole picture?

That last question is what we’ll be discussing in our next blog. We’ll look at asset sales, how they work, and why the tax and legal details can look very different from a stock sale.

Selling a business is one of the biggest financial decisions you’ll make. Our experienced corporate attorneys can help you understand your options, negotiate the terms, and protect your interests at every stage. Contact Davis Law Group today to get started.