Tax Implications of Seller Financing
Selling your business is a huge milestone. And while you’ll likely want to celebrate your accomplishment, it’s important to remember the tax obligations that come with the sale of your business.
And if you’ve offered the buyer seller financing, there are tax impacts to consider. Read on to discover the tax implications for seller financing.
What Is Seller Financing?
Also known as owner financing or installment sales, seller financing generally refers to situations where the seller provides financing to the buyer, allowing them to pay off a portion of the price of the business over time with interest. With seller financing, the buyer will often use a variety of financing options, including a traditional loan from a bank or other lending institutions or an SBA loan.
The terms for seller financing mirror those of a typical bank loan and include standard elements such as interest rate, repayment period, and foreclosure provisions in case of default.
Seller Financing: Tax Implications for the Seller
As a seller, the following are some tax implications you should consider when deciding to offer seller financing.
Capital Gains Taxes on the Sale of the Business
When selling a business, the type of tax you’ll most likely pay is capital gains tax.
According to the IRS, you have capital gains when you sell a business for more than its value.
For clarity, for asset sales, you’ll divide the purchase price between the different asset classes to determine your capital gains and resulting capital gains taxes.
The capital gains rates when selling a business depend on whether your profit is short-term or long-term.
- Short-term capital gains: This is a gain on the sale of property you held for less than a year. It’s taxed at the marginal ordinary income rates.
- Long-term capital gains: This is a gain on the sale of property you held for more than one year. Investments held for more than one year may benefit from long-term capital gains rates, as they are typically lower than the short-term rates, depending on the seller's tax filing status and taxable income.
Tax Implications of Receiving Payments Over Time
When a seller receives payments over an extended period for a business they sold, the IRS generally requires the seller to apportion each payment in two ways. Part of the payment should be allocated to recovering the original cost of the assets, while the other portion should be allocated to capital gains.
🛑 Note: Selling inventory as a part of your business sale won't qualify for preferential installment method tax treatment. When inventory is included in an asset sale, the seller may recognize ordinary income on the difference between the allocated purchase price and the inventory's tax basis. For the buyer, this allocated amount becomes their new cost basis in the inventory, which they'll use when calculating income as they eventually sell that inventory to customers.
And if you claim depreciation expense for equipment, you may be required to report depreciation recapture when you sell.
These calculations get very tedious. Therefore, keeping detailed records and consulting with your CPA or tax professional is essential when structuring an installment sale of your business.
Potential Tax Benefits of Installment Sales
When a seller receives installment payments from seller financing, it comes with several upsides, including:
- Tax deferrals: You can spread out paying capital gains tax over years as you receive payments. This lets you manage your tax liability, especially when your income fluctuates.
- Lower tax rates: Spreading out the capital gains tax recognition over years might keep you from moving to a higher tax bracket than if you had to recognize the entire gain in the year of sale.
- Flexibility: Offering installment payments when selling your business may make it easier and faster to sell. If the buyer doesn’t have to complete a lender’s due diligence requirements to secure traditional lending, they may be able to move quickly.
- Interest payments: Letting the buyer pay over time means you’ll receive interest income, boosting your bottom line.
Seller Financing: Tax Implications for the Buyer
Buyers should keep in mind the implications of accepting seller financing.
Interest Deductions on Installment Payments
Interest is a tax-deductible expense. This means the buyer can deduct their paid interest and reduce their taxable income.
But it also means you’ll pay more.
Depreciation Deductions
The buyer can claim depreciation on the property they bought immediately and based on the allocated purchase price. This will also lessen their tax obligations.
Seller Financing: Structuring the Deal
In structuring a seller financing deal, you’ll need to weigh several key elements.
One of these is the sale price. Sellers want to cash in on the value they built over the years but make the offer attractive to prospects. Price it too high—it remains unsold for a long time. Price it cheaply—you leave money on the table.
Second, you’ll need to think through the terms. These include the interest rate you'll charge, down payment requirements, and any buyer default provisions.
Third, you'll want to consider the tax implications. This is because the tax you’ll pay depends on how you structure the deal.
Last, you must balance tax considerations and the sale itself with your financial and business goals.
Tax Planning Strategies
There’s nothing as critical as tax planning when selling a business. Be sure to discuss your situation with an experienced CPA or tax attorney. You will need expert advice to maximize the value you receive from the sale of your business, and to avoid any tax surprises down the road.
We know that selling your business is a big decision. At BizBuySell, we’ve helped hundreds of thousands of business owners list and sell their business, capitalizing on the value of the businesses they’ve built.