Section 453 Structured Installment Sale
Carl E. Sera, CMT
March 27, 2023
A Structured Installment Sale is a type of tax-deferred transaction that allows businesses and individuals to sell assets while spreading the taxable gain over a period of time. You can learn more and see if it's right for you.
The profit from the sale of an appreciated commercial property, residence, or business is usually subject to capital gains tax. There could be significant tax implications depending on the size and nature of the transaction.
Before finalizing a real estate or business sale transaction, evaluating the tax consequences on the ultimate realized gain is critical. One way for sellers to reduce their capital gains tax rate is to spread the cash flows from the sale over a number of years through a structured installment sale.
Keep reading to learn more about Structured Installment Sales and how to use this strategy to defer capital gains taxes in 2023.
What is a Structured Installment Sale?
An Installment Sale allows an eligible Seller to defer the recognition of some or all of the gain on the disposal of qualified property. According to IRC 453, the Seller must be eligible to report the sale of property or company. The eligible property subject to the installment sale could be a highly prized real estate or property or a stake in a business or professional activity.
For a sale to constitute an Installment Sale, it must be a sale of qualified property where the Seller receives at least one payment after the tax year of the sale. And each installment payment received by the Seller consists of the following three components: (a) nontaxable recovery of the investment, (b) taxable gain, and (c) interest.
In addition, the Structured Installment Sale provides guaranteed income for qualifying property or business sales that are eligible for the installment method under IRC Section 453.
How Does a Structured Installment Sale Work?
For structured installment sales to be successfully implemented, the property or asset must first qualify for installment sale tax treatment as outlined in IRS Publication 537 because not all transactions will be eligible.
In addition, both buyer and seller will typically need to execute an acknowledgment statement and other disclosures as may be required by the provider of the structured installment sale product before any deal moving forward to ensure compliance with the issuer’s requirements for acceptance.
Parties will then formalize their intent to enter into an installment arrangement, usually through an addendum to the sales contract, the terms of which will also be incorporated into the accompanying non-qualified assignment that serves as the formal document necessary to perfect the transaction.
The non-qualified assignment document is crucial to the structured installment sales transaction. Because one of the keys to tax deferral hinges on avoiding constructive receipt of income in the year of the sale lest the seller be taxed on the entire gain all at once, this document outlines those sums that will be paid in the future.
And because the portion of the sales proceeds funds the present value of these future periodic payments one elects to defer, the seller can only recognize the income once it is received in the future. To the buyer, however, everything is the same as it would be for a cash sale.
Case Study of A Structured Installment Sale
After 25 years of operating as the sole owner of a successful real estate agency, Bill decided to sell a portion of the business to prepare for retirement. After consulting with his legal and tax advisors, they recommended the partial sale be structured as a stock sale.
Bill listed the sale price at $1,130,000 for a 40% ownership stake in his business (the adjusted basis of the stake was $200,000, and the selling expenses associated with the transaction were $64,000). Bill again consulted with his tax and legal advisors, who helped him determine that a structured installment sale would best suit him. A buyer was selected from the bids.
Because this tax-advantaged option would require cooperation from the buyer, Bill reduced the sales price by $27,500 to $1,102,500 in return for the buyer’s participation. The structured installment sale would supply Bill with periodic payments to supplement his retirement income and defer capital gain taxes on the sale beyond the transaction year.
Because of the lower sales price, the selling expenses were reduced to $60,000. As part of the Purchase and Sale agreement, the purchase price of $1,102,500 would be payable as follows: $202,500 in cash this year, with $150,000 payable annually for six years beginning next year.
If Bill had received the sale proceeds in a lump sum ($1,130,000), he would have to pay over $151,400 in capital gains taxes, assuming a marginal capital gains tax rate of 20% plus over $27,200 in NIIT. But, by utilizing a structured installment sale, he will pay about $22,365 of capital gains taxes this year on the $202,500 payment and about $16,380 in each of the following six years on the $150,000 annual payment.
What are the Benefits of Structured Installment Sales?
First, you get to defer the recognition of taxable gain until a future year. As deferral is almost always preferable to immediate recognition of income and the massive tax hit that comes with it, the seller has the opportunity to move payments out to the future when tax rates or brackets might be lower or when they might have other off-set deductions to reduce the tax bite further.
Second, you get a guaranteed rate of return from the trust company or life company. Like any other fixed annuity product, you get a fixed, guaranteed payment schedule at a stated interest rate.
Third, through the structured sale, you eliminate concerns about the buyer's ability to make future payments that are crucial to the seller in an installment sale. The funding trust company or life insurance company stands in place of the buyer and makes the payments directly to the seller.
Finally, this program allows for long-term financial security and flexible planning options. By using a structured sales annuity, you can elect to receive monthly, quarterly, annual, and semi-annual payments. You can also do other unique features such as balloon lump sums, increasing income streams, and deferred income streams that don't start until many years after the sale.
Are there any restrictions on Structured Installment Sales?
• No life, only payment streams. It must be "periodic certain" or "certain and life."
• Periodic payments may not be secured or pledged.
• Periodic Payments assumed by the Non-Qualified Assignment company must not be changed from the periodic payments by the Buyer before the Assignment.
• The periodic payments are non-transferable and non-commutable.
• The Seller cannot assign the installment sale payment stream to a factoring company.
• The Seller's estate must be the beneficiary.
Structured installment sales are a possible way to mitigate the taxes paid in selling highly appreciated personal, business, or investment property. It can also be utilized when selling a traditional business not related to real estate. Before you go ahead with such a sale, please consult with qualified professionals to decide whether this vehicle is right for you.
Sera Capital is a wealth management consulting firm specializing in all aspects and all available tax-efficient exit options for business owners, real estate investors, and developers. Our team works with you and your advisors to examine all available solutions, including 1031 Exchanges, Delaware Statutory Trusts, 721 UPREITS, Opportunity Zone Funds, and Section 453 Installment Sales, including Deferred Sales Trusts and Structured Installment Sales. We have two mottos. The first is “We help landlords and business owners exit tax efficiently,” and our second is “When you want out, call us in.”
If you want to explore your options, make a no-obligation appointment with us today. Discover the possibilities.