Understanding seller financing tax implications
May 1, 2023 ⋅ 8 min read
While there’s no one right way to sell a business, seller financing is a common approach to acquiring a business. It involves you (the owner) to finance a portion of the purchase price. Seller financing often makes your small business more attractive to buyers and increases the chances your business sells quickly.
However, it's important to understand potential tax implications when using seller financing. With seller financing, the buyer pays you directly over time, and you still own the asset until the buyer pays off the loan. We’ll break down everything you need to know about seller financing and what it could mean for your taxes.
What Is Seller Financing?
Also known as “owner financing,” seller financing is when the owner/ seller of a small business, provides all, or a portion, of the financing needed to purchase the property.
Instead of utilizing down payments, bank mortgages, or other traditional funding sources, a buyer may be able to make installments directly to their seller to facilitate the sale of their property. Both parties reap rewards from this type of arrangement.
Buyers can access a business that might otherwise be impossible for them to purchase due to down payments often being difficult to secure.
Sellers can benefit from capital gains related to income tax savings. It cuts out the middleman and makes the sale process much more straightforward. However, unlike traditional bank loans, seller financing comes with certain risks that both parties need to consider before entering into the arrangement.
Typically, when using seller financing, the buyer and seller will prepare a promissory note which includes the details of the arrangement, including the payment schedule, the principal amount, and any interest charges. The buyer will often make a direct “down payment” to the seller — between 10% and 30% of the total purchase price.
Does seller financing defer capital gains?
Seller financing can be used to defer capital gains taxes on the sale of a business or property. Deferring your capital gains tax means that you don't have to pay taxes on the money you make from the sale until a later date. Typically, when a business is sold, the seller will pay taxes on the entire profit. But if they finance the sale, some of that gain is deferred until the future.
It's important to note, however, that the seller will eventually have to pay taxes on the profit from the sale, so it's important to understand the tax implications of seller financing before entering into an agreement.
How does seller financing avoid taxes?
Seller financing can be used to avoid taxes in certain circumstances. For example, if the seller finances a portion of the purchase price and then structures the loan as an interest-only loan, they may be able to avoid capital gains tax on that portion of the sale.
In addition, if both parties agree to structure the purchase agreement so that the buyer pays the seller a certain percentage of their own income taxes, then that portion can also be avoided. If the loan is structured so that the buyer pays back principal and interest, then all of the profits from the sale are taxed at ordinary income tax rates instead of capital gains tax rates.
That being said, you should absolutely work with a tax professional when selling your business to structure the right deal. At Baton, we are happy to recommend one of the many professionals that we work with.
What is an installment sale?
An installment sale is another type of business sale structure in which the seller allows the buyer to pay in installments over a period of time. With installment sales, buyers often get more beneficial terms than when taking out a loan from a third-party lender. In some cases, installment sales also involve seller financing.
Instead of paying for your business with a lump sum, the buyer will spread that payment out over a predetermined amount of time.
Over time, installment payments reduce the buyer's liability with each payment being applied or divided between principal and interest amount. These installment payments are viewed as taxable income. Installment sales help facilitate transactions while providing additional benefits to both the buyer and seller.
When structuring an installment sale, the buyer and seller will create an installment contract with the terms of the agreement, including the down payment, payment period, interest rates, and installment amounts.
Cost savings of installment sales
The cost savings of an installment sale can be sizeable. For sellers, they don't have to pay capital gains taxes on the entire sum of the sale until all payments have been received. This helps free up more cash in their pocket right away.
Buyers benefit from lower interest rates and longer repayment terms that are often offered with an installment purchase. Additionally, buyers can often use their income to qualify for the installment purchase and may have a better chance of getting approved than they would with a traditional loan.
Finally, both parties benefit from avoiding the hassles of waiting for traditional financing approval processes or dealing with appraisals that sometimes disrupt the sales process.
Tax benefits of installment sales
There are many tax benefits associated with an installment sale. As we mentioned above, for sellers, they can defer capital gains taxes until the entire amount of the sale has been received. This allows them to keep more money in their pocket now and pay less in taxes overall when the time comes.
Buyers can often claim certain deductions on their income taxes for the interest they pay on their installment payments and, in some cases, may even be able to deduct all of the interest payments. Both parties benefit from avoiding double taxation which can sometimes happen with a traditional loan.
Seller financing versus installment sale methods
Seller financing and installment sales are two of the most common forms of financing used in real estate transactions, and share many more similarities than differences.
Seller financing involves the seller providing the purchase money to their buyer and acting as both a lender and a seller throughout the transaction. The installment sale method, on the other hand, relies on a pre-arranged installment plan that gets agreed upon by both parties at the time of sale.
Both options can offer buyers more leeway when it comes to payment terms, making them a good option for those wishing to acquire a business without paying all upfront cash or relying solely upon traditional bank financing. However, seller financing carries greater overall risk for sellers while installment sales require more planning and attention to detail during the purchase negotiation.
What are the benefits of seller financing?
Seller financing offers a range of benefits that make it an attractive option for both buyers and sellers.
The process is easier than going through a bank loan, allowing for faster closings.
Because there are fewer participants in the transaction, contracts tend to be simpler and less expensive than traditional mortgage lending agreements.
Seller financing can also help buyers who may have trouble qualifying for a loan from a bank as it allows them to be evaluated directly by the seller.
Ultimately, seller financing can offer advantages that result in smoother transactions and better deals for both the buyer and seller.
What is the downside of seller financing for the seller?
Seller-owner financing is a great way to sell a property, as it can serve as an alternative to cash purchases and provide the seller with certain advantages. However, there are some downsides, especially for the seller.
There is greater responsibility on the seller who must be in charge of mortgage payments if the buyer defaults.
If the seller still carries a loan on the property when entering into a seller-owner finance agreement then there could be penalties for prepayment or originating additional debt.
Although there is potential for income via interest collected in these contracts, sellers can face problems balancing liquidity should full payment not be received from buyers in cases of either late or non-payment of installment at maturity.
If the business does not perform, the seller may not recoup their money.
How to sell your business with Baton
No matter how you decide to sell your business, you should understand all of your options and the potential tax implications that could come with your business sale.
Wherever you are in the process, Baton is here to help. We offer free business valuations to help you understand if it’s the right time to sell, and provide guidance to help you maximize your valuation, including tax guidance. Additionally, if you’re ready to sell, Baton is here to help with veteran acquisition advisors. Get started today and see how much your business could be worth tomorrow.