One of the more taxpayer-friendly provisions for deferring income recognition is the allowance of installment sale treatment under Section 453. Installment sales essentially allow certain taxpayers to defer recognizing all of the taxable income from a transaction upfront when a portion of the consideration will be received after the year of the transaction (subject to certain limitations). Installment sales are most often utilized when a taxpayer sells their business, and a portion of the proceeds is delayed through an indemnity escrow and/or a contingent earn-out.
Points to consider
But is deferring paying tax always the best alternative? What if tax rates go up, as many are currently anticipating? In some instances, it may make sense to elect out of installment sale treatment to take advantage of lower tax rates. Further, there are different mechanics to consider when evaluating whether or not to employ installment sale treatment. The installment sale rules require a taxpayer to calculate gain recognition each year in reference to the stated maximum selling price. This is essentially the total that the taxpayer could receive, including contingent earn-out payments that may be received in the future but have not been determined yet (if the maximum contingent amounts can be determined in the year of sale).
However, suppose a taxpayer elects out of installment sale treatment. In that case, the gain in the current year is generally determined by the fair market value of the property received as consideration. It is probable in many situations that the current year’s fair market value would be less than the stated maximum selling price. While both methods would ultimately result in the same amount of taxable income over time, each method could yield very different results when it comes to the timing and amount of tax paid. This is due to potential tax rate differences or capital loss limitations if future payments are not subsequently received.
Determining the best action
The installment sale rules are complicated, and each situation should be carefully analyzed while making these decisions. Although a tried-and-true tax strategy has been to delay paying tax when possible, there are certain circumstances where this may not be the best alternative. Your GBQ tax advisor is ready to help you navigate the installment sale rules and determine the best solution for you and your business.
Article written by:
Chris Dean, CPA
Director, Tax & Business Advisory Services