Installment Sales

The installment method can be used to defer some tax on capital gains, as long as you receive at least one payment for a piece of property after the year of the sale. It can't be used if the sale results in a loss.

Tip

Beginning in 2013, a new 3.8 percent net investment income tax may be imposed on individuals whose modified adjusted gross income exceeds $250,000 for joint filers, $125,000 for married taxpayers filing separately, and $200,000 for others. Trusts and estates with income over a certain amount are also subject to the NII tax. Form 8960, Net Investment Income Tax� Individuals, Estates, and Trusts is attached to the tax return. For 2013, the IRS has provided taxpayers the ability to rely on more than one set of net investment income tax rules. The best choice varies by taxpayers and depends on the taxpayer's unique situation. Consult your advisor to determine which approach would be best for you.

The bad news is that payments for many (or even most) of the assets of your business are not eligible for installment sale treatment.

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If a sale qualifies as an installment sale, you must report gain under the installment method unless you elect out of using the installment method. You make the election by reporting the full amount of gain in the year of sale using Form 4797 (for business) and/or Form Schedule D (for personal), rather than using the Installment Sales Form 6252. However, once you make the election, you can only revoke it with IRS consent.

The full amount of gain is the fair market value of the buyer's installment obligations, such as notes, mortgages or land contracts, minus the gain realized from the sale. (You are required to use the FMV, even if you could never sell the obligations.)

This gain is taxed as capital gain. Because you included the entire amount in your income in the year of sale, none of the principle payments are included in income in the year in which they are paid. However, the interest income is ordinary interest income in the year in which it is paid.

Assets eligible for installment treatment. Generally, anything on which gains must be treated as ordinary income will not be eligible for installment sale treatment. That includes payments for your inventory, for accounts receivable, and for property that's been used for one year or less. It also includes payments for any personal property or real estate to the extent of any depreciation that must be recaptured, based on deductions you've claimed over the years.

For all these items, you must pay tax on any gains in the year of the sale, even if you haven't yet received payments for the items.

Looking at it another way, in most cases, only gain on assets that have appreciated in value beyond their original purchase price will be eligible for installment sale treatment. In most cases, that means real estate. For older businesses, gain on intangible assets such as business goodwill will also be eligible for installment sale treatment, because under the law prior to 1993, goodwill could not be depreciated or amortized (hence, there's no depreciation to be recaptured).

Using the installment method. To use the installment method, you must allocate the total purchase price you received among all the assets you've sold in the transaction.

Then, for each asset to which the installment method applies, you must compute your "gross profit percentage." First you must determine your gross profit. This is your selling price minus your adjusted basis of the property, selling expenses, and any depreciation recapture. The selling price is the total cost of the property to the buyer, but does not include interest. The gross profit amount is then divided by the selling price of the asset. Then, each time you receive a payment from the purchaser, the principal portion of the payment (i.e., everything but the interest) is multiplied by the gross profit percentage to determine the amount that must be reported as taxable gain for the year.

For more on how to use the installment method, see our case study.

Reporting installment sales. Installment sales are reported on IRS Form 6252, Installment Sale Income. A separate form should be filed for each asset you sell using this method. You must file this form in the year the sale occurs, and in every later year in which you receive a payment.

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You can download Form 6252 to aid in your financial planning.

Special rules. If the buyer assumes any of your debt as part of the installment deal, the assumption is treated as a payment to you for purposes of the installment sale rules. If the buyer places some of the purchase price in an escrow account, it's not considered a payment until the funds are released to you, as long as there are some substantial restrictions on your ability to get the money.

If your deal includes an earnout provision under which you may be entitled to additional payments based on future performance of the business, more special rules apply. Please see your tax advisor for details.