Not all business transactions are paid in full immediately. In fact, most business transactions are structured so that payments are made in installments that may span over several years. These are typically called "installment sales." Normally, a seller is taxed on gains made in the year of sale. However, tax law allows sellers who receive payments in installments to defer paying taxes until payments are actually received.
For the purposes of tax law, an installment sale has a slightly different meaning than what one would normally define it. An installment sale for tax purposes is:
- A disposition of property with at least one payment to be received after the close of the tax year in which the disposition occurs.
It is not required that the seller receives any payment in the year of sale or that there be more than one payment in order to be called an installment sale. For example: B sells a piece of land in Jan 12, Year 1 for $100,000. The contract calls for a payment of $100,000 in June 3, Year 2. This is an installment sale.
In order to determine how much taxable gain is recognized from each installment, a taxpayer must perform the following calculations:
- Compute the gross profit to be realized from the sale. Gross profit is the excess of the selling price over the adjusted basis of the property being sold. Selling expenses (unless you are in the business of selling that item as a dealer) and depreciation recapture income (this applies only if you have taken depreciation on your property) are added to the basis of the property.
- Compute the contract price from the sale. Contract price is the selling price reduced by any qualified indebtedness that the buyer assumes or takes subject to, and that is less than, the basis of the property being sold.
- Determine the gross profit percentage. Gross profit percentage is the ratio of the gross profit over the contract price. (Gross Profit/Contract Price)
- Determine how much payment is received during the tax year.
- Multiply the gross profit percentage by the total amount of payment received in the tax year. This is how much gain that needs to be reported in the year.
Generally, a payment includes cash or other property, including foreign currencies and marketable securities. An installment note from the buyer is not considered payment unless it is:
- Payable on demand; or
- Readily tradable.
A buyer assuming or taking property subject to the seller’s debt is not considered payment unless the debt exceeds the seller’s adjusted basis in the property being sold.
Tax laws are complex and ever-changing. Although there are various tax preparation softwares on the market that may help you with your tax problems, they cannot provide the same level of service that an experienced and knowledgeable business attorney can. If you are unsure about what constitutes your income or you need someone to represent you before the IRS, a tax attorney can help.