9007 / How can an installment sale be used to “fund” a buy-sell agreement?

Any disposition of property where at least one payment will be received after the close of the tax year of disposition may be treated as an installment sale.¹ Generally, however, the installment method of taxation (see below) is not available for sales between certain related parties unless they can clearly establish that the transaction was not intended to avoid tax.²

Gain on an installment sale is required to be reported under the installment method unless the taxpayer “elects out” of using the method by the due date for filing a return (including extensions) for the year of the sale. Taxpayers may elect out by reporting all the gain as income in the year of the sale on Form 4797 (Sales of Business Property), or on Form 1040, Schedule D (Capital Gains and Losses), and Form 8949 (Sales and Other Dispositions of Capital Assets).³

Installment sales are often used in the context of a buy-sell agreement where the business owners have not planned in advance to fund the purchase through the use of insurance or otherwise (see Q 8994 and Q 8995). Though installment sales may be used to purchase the interests of a departing business owner, they do not provide the immediate liquidity to the retiring owner or deceased owner’s estate that can be realized through a life insurance strategy or by using accumulated earnings to purchase the interest outright.

Planning Point: Practically, an installment sale may be the only means of purchasing a departing business owner’s interests if the buy-sell agreement was not funded in another manner.

Essentially, an installment sale requires the corporation (or shareholders if the buy-sell agreement is structured as a cross-purchase agreement, see Q 8999) to purchase the interests of the departing business owner using a note, under which it will pay for the interests over time. The departing business owner (or that owner’s estate) reports gain on the sale using the “installment method,” which means that the gain for any given year equals the part of the gain that is actually received (or considered to have been received) during that tax year. The departing business owner must also report as income the amount of the payments received in the year that are deemed to represent interest income. The portion that is deemed to be a return of the owner’s adjusted basis in the interests is excluded as in any other sale.⁴ See Q 8609, Q 8936 and Q 8959 for a discussion of determining basis in various contexts.