Cash vs installment sale
When structuring a transaction, one major decision that comes into play is whether or not to structure the transaction as a straight cash sale, or to have payments made on an installment basis. A major reason why many sellers find an installment basis to be attractive is the deferral of the tax liability associated with the installment method. However, there are several factors to consider here, not the least of which are cash flow and risk of loss. No analysis is complete without considering all relevant information.
First and foremost, the seller must determine whether or not he is able to finance the sale of an asset, and for how long. Cash flow modeling taking into account all pertinent information should help to conclude on this. Was the asset being sold a major income-producing asset? Unless the seller is in an excellent cash position, financing the sale may not be a viable option.
Secondly, the seller should evaluate the risk that he is taking on in the financing. Proper due diligence must be performed in order to determine if they potential buyer is credit worthy. In turn for taking on the risk of financing, the seller may be able to demand a higher purchase price, or otherwise dictate the transaction in terms favorable to him.
Once a seller has decided that structuring a transaction as an installment sale is attractive from a practical business standpoint, the tax considerations start to come into play. Generally, the installment method is tax advantageous for the seller, with very little tax impact to the buyer. The reason for this is that the taxable gain from the sale of the asset will be spread over the term of the financing. To be eligible for the installment method, at least one of the payments of the purchase price must be received in a tax year subsequent to the year of sale. When this is the case, there is no need to elect the installment method, as it automatically applies. There are instances where installment sale treatment does not apply (e.g. related party sales, dealer sales, sales of publicly traded stock), but as long as the property involved is sold at a gain, the installment sale should be an option. It should also be noted that the installment sale method is the default where deferred payments are involved, and the seller must elect out of the installment method in order to force straight cash sale treatment.
Now that it’s been determined that a transaction is eligible for the installment method, the advantage related to the deferral of the taxable gain should be measured. Each deferred payment received is allocated ratably between basis recovery and taxable gain. The allocation will depend on the gross profit percentage, which is the ratio of the gross profit from the sale to the contract price. If the total purchase price is $100, and the seller’s tax basis is $25, the gain would be $75, and the gross profit percentage would equal 75%. Thus, 75% of each deferred payment would be taxable gain in the year received, and 25% would be nontaxable return of basis.
In the following example, we are going to assume that an asset, the gain on which is eligible for long-term capital gains treatment, is sold for $200,000, and that the seller originally purchased the asset for $120,000. We will use an interest rate of 4%.
As is shown above, the net cash received after 10 years is $216,600 and the total tax liability of $27,400 is spread out over the same time period. One might question the low interest rate. It is advantageous to the seller to maximize the purchase price, while minimizing the interest rate in order to take advantage of the reduced capital gains rate. However, income tax regulations require a minimum interest rate equal to the applicable federal rate, which has been floating around 4% for the 3rd quarter of 2010.
When a depreciable asset is sold, the tax answer changes. Any gain subject to accelerated depreciation recapture is taxed at ordinary income tax rates, and is taxable in the year of sale (not subject to deferral). In the case of IRC §1245 property, this would equal all accelerated depreciation previously taken to the extent of the gain. IRC §1245 property generally includes all personal property (machinery and equipment, computers, furniture) and other tangible property (except buildings and structural components of buildings) that has been used as an integral part of manufacturing, production, or extraction or as a means of furnishing transportation, communications, electrical energy, gas, water or sewage disposal services. For IRC §1250 property, the recapture would be the excess of any accelerated depreciation over straight-line depreciation to the extent of the gain. IRC §1250 property includes all real property (land and buildings) that is not IRC §1245 property, including intangible real property, such as a leasehold of land. Any remaining gain on IRC §1250 property caused by the remaining depreciation previously taken is ratably included in income and taxed at the unrecaptured 1250 gain rates (25% in 2010). Further gain is subject to capital gains rates, but only after all unrecaptured 1250 gain is included in income. This is illustrated in the following examples (all examples assume the asset was held by the seller for longer than 12 months).
In cases where depreciable assets subject to accelerated depreciation are sold, the seller should require a significant payment in the first year in order to cover any tax liability, and to avoid a negative cash flow.
In each of these cases, the negotiated purchase price should be analyzed in order to determine whether or not the present value of future cash flows is sufficient to make the deal attractive. Interest and taxes must be included in the calculation so that a true cost vs. benefit analysis can be performed.
Taking example 1 above, the present value of the net future cash flow (using 6%) of $216,600 is approximately $120,000. If the true fair market value of the asset in this case is $200,000, a straight cash sale using $200,000 as the purchase price would result in net cash of $188,000 – significantly higher than the present value of the future cash flow shown in the example. Therefore, the seller would require a much higher purchase price for an installment sale in order to gain the same economic benefit. The same holds true for the other two examples shown above. This does not take into account the other significant consideration in determining the purchase price on an installment sale – the risk being assumed by the seller.
One final item for immediate consideration is the potential increase in Federal income tax rates beginning in 2011. Effective January 1, 2011, the maximum Federal individual ordinary income tax rate will increase from 35% to 39.6%, and the long-term capital gain rate will increase from 15% to 20%. This will result in a substantial increase in the tax burden on deferred payments, along with a drastic change to cash flow models. As a result, the installment sale method has become less attractive to sellers in 2010, and a higher purchase price for buyers is required. Many sellers are electing out of the installment sale method in order to lock in the lower long-term capital gain rate of 15%. Congress is currently considering extending the current income tax rates, however no change has been implemented as of the writing of this article.
When determining whether or not the installment sale method is preferable, there are many items to consider. Cash flow, risk, present and future income tax rates, and interest rates must all be evaluated extensively. This article is not meant to be inclusive of all tax rules related to installment sales, and alternative minimum tax is not considered. As with any transaction, a tax advisor should be consulted in order to determine what is best for you.
Mark R. Heath, CPA joined McKonly & Asbury in 2004 as a Senior Tax Manager, became a Principal in 2007, and Partner in 2009. Serving as leader of the Tax Department, he brings a wealth of experience in Federal, State, and
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