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The installment method can be used to defer some tax on capital gains, as long as you receive at least one payment for a piece of property after the year of the sale. It can't be used if the sale results in a loss.
Also, since 2001, accrual method taxpayers may once again use the installment method for sales when selling their businesses. This dramatically helps those selling a closely held business, who otherwise had to recognize the full tax liability of the sale in the year the business was sold instead of when payments were received.
The bad news is that payments for many (or even most) of the assets of your business are not eligible for installment sale treatment.
Assets eligible for installment treatment. Generally, anything on which gains must be treated as ordinary income will not be eligible for installment sale treatment. That includes payments for your inventory, for accounts receivable, and for property that's been used for one year or less. It also includes payments for any personal property or real estate to the extent of any depreciation that must be recaptured, based on deductions you've claimed over the years.
For all these items, you must pay tax on any gains in the year of the sale, even if you haven't yet received payments for the items.
Looking at it another way, in most cases only gain on assets that have appreciated in value beyond their original purchase price will be eligible for installment sale treatment. In most cases, that means real estate. For older businesses, gain on intangible assets such as business goodwill will also be eligible for installment sale treatment, because under the law prior to 1993, goodwill could not be depreciated or amortized (hence, there's no depreciation to be recaptured).
Using the installment method. To use the installment method, you must allocate the total purchase price you received among all the assets you've sold in the transaction.
Then, for each asset to which the installment method applies, you must compute your "gross profit percentage." This is basically your gross profit (your selling price minus: the tax basis of the property, selling expenses, and any depreciation recapture) divided by the selling price of the asset. Then, each time you receive a payment from the purchaser, the principal portion of the payment (i.e., everything but the interest) is multiplied by the gross profit percentage to determine the amount that must be reported as taxable gain for the year.
For more on how to use the installment method, see our case study.
Reporting installment sales. Installment sales are reported on IRS Form 6252, Installment Sale Income. A separate form should be filed for each asset you sell using this method. You must file this form in the year the sale occurs, and in every later year in which you receive a payment.
Special rules. If the buyer assumes any of your debt as part of the installment deal, the assumption is treated as a payment to you for purposes of the installment sale rules. If the buyer places some of the purchase price in an escrow account, it's not considered a payment until the funds are released to you, as long as there are some substantial restrictions on your ability to get the money.
If your deal includes an enrapt provision under which you may be entitled to additional payments based on future performance of the business, more special rules apply. Please see your tax advisor for details.
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