After years of hard work, you’ve built a successful small business. Now that it’s time to sell and move on to the next chapter, one important question is how the sale will affect your taxes.
Depending on how the transaction is structured, an installment sale may allow you to spread your taxable gain over several years rather than recognizing it all in the year the business is sold. This can potentially help you manage your tax liability and, in some situations, reduce the overall tax burden.
However, installment sales involve important tax rules and risks that should be considered before you agree to the terms of a sale.
How an Installment Sale Works
With an installment sale, you don’t receive the entire purchase price when the transaction closes. Instead, the buyer makes payments over an agreed-upon period.
Typically, the buyer makes a down payment at closing and provides a promissory note requiring additional principal and interest payments over time. As you receive principal payments, each payment generally consists partly of a tax-free return of your basis and partly of taxable gain. Interest is generally taxed separately as ordinary income.
Because the gain is recognized as payments are received, an installment sale can spread the tax liability over multiple tax years instead of concentrating it in the year of the sale.
Asset Sales Require Additional Planning
The tax rules become more complicated when a business sale is structured as an asset sale rather than a sale of an ownership interest.
Installment treatment may still be available for eligible assets included in an asset sale. However, the purchase price must be allocated among the business’s individual assets, and the gain or loss must generally be calculated separately for each asset.
If you’re considering an asset sale, it’s important to understand how the allocation of the purchase price can affect your current and future tax liability.
Potential Tax Benefits of an Installment Sale
An installment sale generally offers a tax-deferral benefit because you recognize much of the taxable gain as you receive payments rather than recognizing the entire gain immediately.
In many cases, installment sale gains qualify for the lower long-term capital gains rates or, for certain business property, may be treated as Section 1231 gain. Section 1231 gains are generally eligible for long-term capital gains tax treatment.
The 3.8% net investment income tax (NIIT) and state income taxes may also apply, depending on your circumstances.
Spreading the gain over multiple years may also affect the tax rate that applies to the gain in each year. If the installment payments keep your taxable income below certain thresholds, you may potentially avoid moving portions of the gain into the 20% long-term capital gains rate or triggering NIIT on some of the income.
2026 Long-Term Capital Gains Tax Thresholds
For 2026, the 20% long-term capital gains tax rate generally applies when taxable income exceeds:
- $545,500 for single filers
- $579,600 for heads of households
- $613,700 for married couples filing jointly
- $306,850 for married individuals filing separately
If your taxable income remains below the applicable threshold, your long-term capital gains may generally be taxed at the 15% rate.
Depending on your income level, some long-term capital gains may even qualify for a 0% federal tax rate. For 2026, the 0% rate applies to taxpayers with taxable income up to:
- $49,450 for single and married filing separately taxpayers
- $66,200 for heads of households
- $98,900 for married couples filing jointly
The exact tax treatment depends on your overall taxable income and other factors.
Potential Impact of the Net Investment Income Tax
The 3.8% NIIT can add another layer of tax planning complexity.
For 2026, taxpayers with modified adjusted gross income (MAGI) above $200,000 may owe NIIT on some or all of their investment income. The threshold is $250,000 for married couples filing jointly and $125,000 for married individuals filing separately.
By spreading taxable gain over multiple years, an installment sale may affect whether and how much of the gain is subject to NIIT in a particular year.
An Installment Sale Can Offer Benefits Beyond Taxes
Tax deferral isn’t the only potential advantage of an installment sale.
The structure may make it easier to complete a transaction or attract a buyer who doesn’t have enough cash to pay the entire purchase price upfront. Instead, the buyer can make a down payment and pay the remaining balance over time.
An installment arrangement may also address concerns about the future performance of the business.
For example, a buyer may be uncertain about how the business will perform after you leave, particularly if the company depends heavily on your involvement or if market conditions are changing. In some cases, the purchase agreement could include a contingent payment based on the business’s future performance.
This type of structure can potentially bridge the gap between what the seller believes the business is worth and what the buyer is willing or able to pay upfront.
Consider the Buyer’s Credit Risk
An installment sale also means that you become a creditor of the buyer. As a result, you should carefully evaluate the buyer’s ability to make the required payments.
Depending on the transaction, you may want to consider protections such as:
- Collateral securing the note
- Personal guarantees
- Appropriate default provisions
- Other forms of security for the unpaid balance
You should also determine whether your installment note will be subordinated to financing provided by the buyer’s bank. If the buyer defaults, the priority of your claim can affect your ability to recover the remaining balance.
Tax Pitfalls to Consider
Although an installment sale can provide tax-planning opportunities, it also comes with potential tax risks.
One important issue is depreciation recapture.
Depreciation Recapture May Be Taxable Immediately
Depreciation recapture generally arises when you sell property for which you previously claimed depreciation deductions.
Unlike the portion of a gain that qualifies for installment treatment, depreciation recapture generally must be recognized as gain in the year of the sale, regardless of how much cash you actually receive that year.
Depending on the type of property, depreciation recapture may be taxed at ordinary income tax rates, which can be as high as 37%. For certain depreciated real property, the maximum federal rate on depreciation recapture is generally 25%.
The 3.8% NIIT and state income taxes may also apply.
This can create a potential cash-flow problem. You could owe tax on depreciation recapture in the year of the sale even though much of the purchase price won’t be received until future years.
Adequate Interest Is Important
Another potential issue involves the interest charged on the deferred principal payments.
If an installment note doesn’t provide for adequate interest, the original issue discount (OID) rules may apply. These rules can result in part of what would otherwise be treated as principal being recharacterized as interest.
That can be unfavorable because interest income received by an individual is generally taxed at ordinary income tax rates, which can be higher than long-term capital gains rates.
The terms of the installment note should therefore be carefully structured before the transaction is finalized.
Future Tax Rates Can Affect the Outcome
Another consideration is the possibility that federal tax rates could change during the term of the installment note.
If future legislation increases long-term capital gains tax rates or the NIIT rate — or lowers the income thresholds at which those rates apply — you could ultimately pay more tax on your deferred gain than you would under today’s rules.
This is one of the risks that should be weighed against the potential tax-deferral benefits of an installment sale.
Every Business Sale Is Different
An installment sale can provide valuable tax-deferral and cash-flow opportunities when selling a business, but it isn’t appropriate for every transaction.
The tax consequences can depend on how the sale is structured, the assets involved, your tax basis, depreciation recapture, the terms of the installment note, your income in each tax year and future changes in tax law.
Before agreeing to an installment arrangement, consider working with your tax adviser and other professional advisers to evaluate the transaction as a whole.
If you’re preparing to sell your business, we can help you evaluate the potential tax consequences of an installment sale and identify other tax-planning opportunities that may be available.