Buying and Selling Businesses Using Structured Installment Sales
Advising business owners on the sale or purchase of a business represents one of the most important services an accountant can provide to clients. A successful business represents a lifetime’s work for the seller and a lifetime commitment for the buyer. Structured installment sales assist the buyer and the seller by reducing barriers to the transfer of a business.
Structured installment sales are subject to the statutory requirements of the installment method detailed in IRC Sec. 453 — Installment Sales.
How it Works
IRC Sec..453 affords sellers of both closely held business and appreciated real estate the ability to defer taxable income, possibly permitting a lower capital gains rate as well as reduction or avoidance of the tax on net investment income. This article discusses the structured installment sale’s impact on the sale and purchase of a business. For the business owner, exposing a lifetime of work by too great an emphasis on tax savings demands both risk aversion and tax benefits. Utilizing a structured installment settlement eliminates doubt of collection without violating the constructive receipts doctrine. All future periodic payments can be designed by the seller and guaranteed by an A-rated insurance company.
Two additional requirements are a part of the sale process for a successful structured installment sale. First, the sales proceeds must be paid directly to the insurance company and not to the seller. Second, the sales and purchase agreement must contain annuity language specifying the transfer of the installment obligation to the insurance company; the transfer is referred to as a non-qualified assignment. Both actions parallel those used by insurance carriers for the past 40 years when implementing a structured installment settlement for business clients and their attorneys.
Benefits for the Seller
A structured installment sale transaction increases the value of the company, removes the obstacles peculiar to a stock purchase and creates guaranteed retirement income while preserving and expanding tax benefits. The accelerated recapture of invested capital by the buyer due to accelerated depreciation methods available under the asset sale method increases the net present value of the company. Structured installment sales mitigate the impact of the tax on capital gains and net investment income while producing ordinary income during the period of tax deferral. An added benefit of the deferral period is the creation of retirement income for the business owner. This benefit is often overlooked until after the sale; however, it creates a cash flow stream to replace that which was formerly generated by the business. Structured installment settlements were created for the very purpose of protecting clients from the loss of irreplaceable assets needed to sustain their long-term needs by substituting a more dependable debtor, the insurance company, for the buyer.
Benefits for the Buyer
While the sellers are concerned about obtaining ample proceeds to justify a lifetime’s effort, buyers are concerned with the possible risk of paying more than the enterprise’s value would justify. Due diligence and careful analysis of the business must justify the risk assumed. A structured installment sale transaction reduces risks for the buyer in two ways. First, a stock sale is often the preferred option of sellers, but it requires a more intensive due diligence by buyers and their advisors because of hidden liabilities. A structured installment sale transaction converts the transaction to an asset sale, which reduces due diligence cost because only the purchased assets are analyzed. This benefit of reduced due diligence cost lends itself to the second benefit — the risk reduction of a structured installment sale.
Additionally, a step-up in the basis of purchased assets and the creation of deductible goodwill eliminates having a balance sheet of fully depreciated assets. Accelerated depreciation, additional first-year depreciation, and an election to expense depreciable business assets reduces the economic effect of the purchase obligation, increasing the net present value of the company. As a consequence, the business seller can increase the selling price of their company.
A structured installment sale smooths the negotiation process by creating flexibility in counter party demands. It also opens avenues and sale options typically unavailable or limited due to the assumption of risk by either party. Thus, as a sales tool, structured installment sales benefit both parties in the purchase and sales transaction while improving the negotiated result.
This article appeared in the January/February 2021 issue of New Jersey CPA magazine. Read the full issue.