Quick answer: An installment sale (seller financing) lets you sell your business and receive the purchase price in payments over several years instead of a lump sum. Each payment is divided into a return of basis (not taxed), capital gain (taxed at 0–20%), and interest income (taxed as ordinary income). Spreading the gain across years can save significant taxes by keeping you below the thresholds for higher capital gains rates and the Net Investment Income Tax.
The Tax Math — Why Installment Sales Save Money
Suppose you sell your business for $1,500,000 with a $200,000 cost basis — a $1,300,000 gain. In a lump-sum sale, the entire $1.3M gain might be taxed in one year. Your income exceeds the $583,750 threshold (2024, married filing jointly), pushing you into the 20% capital gains rate, plus the 3.8% Net Investment Income Tax (NIIT) — effectively 23.8% on the gain = $309,400 in federal tax. Under an installment sale — $300,000 down, $240,000/year for 5 years — you recognize roughly $260,000 of gain per year. You stay in the 15% capital gains bracket, below the NIIT threshold, potentially saving $50,000–$80,000 in taxes depending on your other income.
Gross Profit Percentage — How Each Payment Is Taxed
The IRS requires you to calculate a gross profit percentage: your total gain divided by the contract price. If the gain is $1,300,000 on a $1,500,000 sale, the gross profit percentage is 86.67%. Every payment you receive — other than interest — is multiplied by 86.67% to determine the taxable gain portion. The remaining 13.33% is return of basis (tax-free). Interest on the seller note is taxed separately as ordinary income. The seller note (promissory note) must charge at least the IRS Applicable Federal Rate (AFR) to avoid being recharacterized. Report installment sales on Form 6252 each year.
Risks of Seller Financing and How to Protect Yourself
The biggest risk: the buyer defaults, and you've already paid taxes on gain you haven't fully collected. If a buyer defaults, you can repossess the business — but regaining control of a poorly run company is complicated and costly. Mitigate this with: a substantial down payment (20–30%+), a strong personal guarantee from the buyer, a secured interest in the assets or stock, a life insurance policy on the buyer naming you as beneficiary for the outstanding balance, and a well-drafted purchase agreement with default provisions. Consult both a CPA and a transaction attorney before completing an installment sale agreement.
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