Day 3: Earnouts and Installment Sales – Spreading Out Payments for Tax Efficiency

5 Tax Issues to Consider Before Selling Your Business to Reduce the Tax Burden

Day 3: Earnouts and Installment Sales – Spreading Out Payments for Tax Efficiency

Most business owners assume that when they sell, they’ll receive one large lump sum and walk away with a pile of cash. But in reality, many deals include earnouts or installment payments—which can have huge tax implications (both positive and negative).

If you don’t plan ahead, you could get slammed with a massive tax bill in year one, even though you haven’t received all the money yet.

Option 1: Installment Sales – Spreading Tax Over Multiple Years

An installment sale allows you to defer taxes by spreading out the payments over multiple years. Instead of paying capital gains tax on the entire sale price upfront, you only pay taxes as you receive the money (IRC § 453).

🚀 How It Works:

✅ Buyer pays you over several years (instead of all at once).

✅ You only pay capital gains tax on the amount received each year.

✅ This can keep you in a lower tax bracket, reducing your overall tax burden.

💡 Example:

• Lisa sells her business for $10 million but structures the deal to receive $2M per year over five years.

• Instead of reporting a $10M gain in one year, she only reports $2M per year.

• This keeps her in the 15% capital gains tax bracket, instead of jumping to the 20%+ bracket with a lump sum.

📌 Key Rule:

• Interest must be charged on deferred payments, or the IRS may reclassify some income as interest and tax it as ordinary income.

🚨 When an Installment Sale Might Not Work:

• If you expect capital gains tax rates to increase, it might be better to take the lump sum now.

• If you’re selling a C-Corp, installment sales won’t avoid the double taxation issue.

Option 2: Earnouts – How to Reduce Risk and Taxes

An earnout is a deal structure where part of the sale price is contingent on the business meeting future financial targets. This can be useful when buyers and sellers disagree on valuation.

🚀 How It Works:

✅ Seller gets an initial payment at closing.

✅ Additional payments (earnouts) are made over time if the business meets revenue or profit targets.

✅ This defers capital gains tax because you only pay tax on money received each year.

💡 Example:

• Tom sells his business for $5 million up front + a $2 million earnout if revenue grows 15% over two years.

• He only pays capital gains tax on money received each year.

• If the earnout isn’t met, he avoids paying tax on money he never got.

📌 Key Rule:

• If an earnout is tied to employment post-sale, the IRS may classify it as compensation, meaning ordinary income tax applies (37%) instead of capital gains tax (15-20%).

🚨 When an Earnout Might Not Work:

• If the buyer mismanages the company, you may never receive the full earnout.

• It complicates your financial planning since future payments are uncertain.

Tomorrow’s Topic: Using QSBS to Eliminate Taxes Entirely

What if you could pay ZERO tax on your business sale? That’s possible under the Qualified Small Business Stock (QSBS) exclusion—and we’ll cover it in detail tomorrow.