How an Installment Sale of Closely Held Stock Works

An installment sale is a disposition of property where at least one payment is received after the tax year of the sale. This method allows a seller to defer tax on a gain, recognizing it over several years as payments are collected. For owners of closely held corporations, whose stock is not traded on public markets, this strategy is useful. The payment structure for these private transactions is often spread over time, making the installment method a common approach to manage the sale’s tax implications and cash flow.

Core Mechanics of an Installment Sale

Under the installment method, gain is recognized proportionally as payments are received. To determine the taxable portion of each payment, three figures must be calculated. The first is the gross profit, which is the selling price of the stock minus its adjusted basis. The adjusted basis is the original cost of the stock, plus any additional capital contributions, less any distributions that were a return of capital.

Next, the contract price is determined, which is the total amount the seller will receive from the buyer. In a simple transaction, the contract price is the same as the selling price. The final component is the gross profit percentage, calculated by dividing the gross profit by the contract price. This percentage represents the portion of each principal payment that must be reported as taxable gain.

For example, a seller agrees to sell their stock for $2 million. Their adjusted basis is $400,000, resulting in a gross profit of $1.6 million. With a contract price of $2 million, the gross profit percentage is 80%. If the buyer makes a $500,000 down payment in the year of the sale, the seller recognizes a taxable gain of $400,000 (80% of $500,000). If the buyer pays $150,000 in principal the following year, the seller reports a $120,000 gain.

Special Rules and Limitations

Special rules apply to transactions with related parties. A related party includes immediate family members (spouse, children, grandchildren, parents) and corporations or partnerships where the seller has over 50% ownership. These rules are designed to prevent improper tax deferral within a family or controlled group.

The “second disposition rule” under Internal Revenue Code Section 453 applies if a related-party buyer resells the stock within two years of the original purchase. If this occurs, the original seller must recognize the remainder of their deferred gain in the year of the second sale. For example, if a mother sells stock to her son on an installment plan and he sells it one year later, the mother must report her remaining gain at that time.

Another rule under Internal Revenue Code Section 453A applies to larger transactions. If the total face value of a seller’s installment obligations from sales during the year exceeds $5 million, the seller must pay interest to the IRS on the deferred tax liability. This interest charge compensates the government for the delayed tax payment and is calculated using the underpayment rate for the last month of the tax year.

Pledging an installment note as collateral for a loan also has immediate tax consequences. If a seller does this, the net proceeds of the loan are treated as a payment on the installment note. This action triggers the recognition of gain on that portion of the note.

Information and Documentation for the Sale

Executing an installment sale requires gathering specific information and preparing legal documents. Because the stock of a closely held corporation is not publicly traded, establishing a credible fair market value is a primary step. This often requires a formal business valuation from a qualified appraiser to substantiate the selling price for the IRS.

The seller must also determine their adjusted basis in the stock, which is subtracted from the selling price to calculate the total gain. The basis starts with the original purchase price and is adjusted for events like additional capital investments or non-dividend distributions.

A legally binding promissory note is required and must detail:

• The total sale price
• The schedule of principal and interest payments
• The maturity date
• The stated interest rate

If the note does not carry a sufficient interest rate, the IRS may impute interest, which recharacterizes a portion of the principal payments as interest income for the seller.

A security agreement is also standard to protect the seller if the buyer defaults. This agreement outlines the collateral securing the debt, such as the stock itself or other assets. The seller must also identify if the buyer is a “related party” to understand how special rules may apply.

Reporting the Sale to the IRS

The sale must be reported to the IRS using Form 6252, Installment Sale Income. This form is filed with the seller’s annual income tax return for the year of the sale and for every subsequent year a payment is received. The form tracks the sale over its term to ensure the gain is reported correctly.

In the year of the sale, the seller uses Part I of Form 6252 to provide transaction details. This includes a description of the property, the sale date, and information about the buyer, including if they are a related party. The seller also enters the figures needed to calculate the gain for that year.

For each subsequent year a payment is received, a new Form 6252 is filed, primarily using Part II. The completed form is attached to the seller’s tax return, like Form 1040. The gain calculated on Form 6252 is transferred to Schedule D, Capital Gains and Losses, to be taxed at the appropriate rate. Any interest received on the note is reported separately as interest income on Schedule B.