What Is a Seller’s Note in a Business Sale?

A seller’s note is a financial instrument in a business acquisition where the seller provides a portion of the financing to the buyer. This arrangement bridges potential funding gaps, allowing transactions to proceed. It often signifies a shared commitment to the business’s future, aligning buyer and seller interests. This method facilitates liquidity for the seller over time while enabling the buyer to acquire the business without securing full upfront external funding.

Defining a Seller’s Note

A seller’s note is a form of seller financing where the business seller acts as the lender to the buyer. Instead of paying the entire purchase price in cash, a portion is financed directly by the seller. This establishes a debt obligation from the buyer to the seller, typically repaid over an agreed period. The note formalizes these repayment terms.

This financing mechanism commonly arises when traditional third-party financing, such as bank loans, is unavailable, insufficient, or too costly. It can also expedite a sale process by removing complexities associated with external lenders. Buyers benefit from more flexible repayment terms and potentially less stringent collateral requirements than conventional banks. For the seller, it makes their business more attractive to a wider range of potential buyers.

The buyer makes regular payments directly to the seller, which typically include both principal and interest components. This structure allows the buyer to conserve capital for immediate operational needs or other investments. The seller receives a steady income stream over time, rather than a lump sum, which offers various financial planning advantages.

Core Elements of a Seller’s Note

The principal amount of a seller’s note represents the portion of the business’s purchase price that the seller finances for the buyer. This sum forms the basis upon which interest accrues and repayments are calculated. The interest rate, a negotiated percentage, determines the cost of borrowing for the buyer and the return on the financed amount for the seller. This rate can be fixed for the duration of the note or, less commonly, variable, adjusting periodically based on an agreed-upon index.

A detailed payment schedule outlines the frequency and amount of payments from the buyer to the seller. Common frequencies include monthly or quarterly installments, structured to include both principal and interest. Some notes may feature a balloon payment, where a significant portion of the principal becomes due at the end of the term, after smaller, regular payments. The term of the note specifies the total duration over which the debt will be repaid, often ranging from three to seven years, depending on the transaction size and negotiation.

Collateral and security interests are frequently included to protect the seller’s investment. This typically involves the buyer pledging specific assets of the acquired business, such as equipment, inventory, or accounts receivable, as security for the note. In the event of a default, the seller would have the right to seize and sell these pledged assets to recover the outstanding balance. A Uniform Commercial Code (UCC) filing may be made to perfect the seller’s security interest in the collateral, providing public notice of the lien.

Default clauses within the note specify events that would constitute a breach of the agreement, such as missed payments or failure to maintain collateral. These clauses outline the seller’s remedies, which can include demanding immediate repayment of the entire outstanding balance or initiating foreclosure on the collateral. Prepayment penalties might be included, requiring the buyer to pay an additional fee if they repay the note early, though this is less common in seller notes than in traditional bank loans. Conversely, a prepayment clause without penalty allows the buyer to repay the note early without incurring additional charges.

Subordination clauses are relevant when there are multiple lenders involved, such as a bank providing senior debt alongside a seller’s note. A subordination clause dictates that the seller’s note will be repaid only after other, senior creditors have been fully satisfied. This arrangement prioritizes other lenders, such as a commercial bank, in the event of a default or liquidation. The presence and terms of these core elements are tailored to each specific transaction, reflecting the negotiation between the buyer and seller.

Operational Mechanics

A seller’s note begins with the formal execution of the agreement at the business sale closing. At this point, the buyer receives ownership of the business, and the seller receives a promissory note detailing the financial obligation. Both parties sign the note, making it a legally binding contract that governs the repayment terms.

Following closing, the buyer begins making scheduled payments to the seller according to the note’s terms. These payments are typically made at regular intervals, such as monthly or quarterly. Each payment usually comprises both an interest component, calculated on the outstanding principal balance, and a principal component, which reduces the total amount owed. An amortization schedule, often an exhibit to the note, provides a breakdown of how each payment is applied to interest and principal over the note’s life.

Interest accrues on the outstanding principal balance of the note, typically calculated on a simple interest basis or compounded periodically, as specified in the note. The buyer’s accounting records will reflect the seller’s note as a liability, while the seller’s records will show it as a receivable. As payments are made, the buyer’s liability decreases, and the seller’s receivable is reduced. This process continues until the note reaches its maturity date or is fully paid off.

Should the buyer fail to make payments as agreed or breach other covenants, the default provisions of the note come into effect. The seller can then exercise their rights, which may include accelerating the debt and demanding immediate full payment. If the note is secured by collateral, the seller may initiate procedures to take possession of the pledged assets.

Tax Implications

The tax implications of a seller’s note affect both the seller and the buyer. For the seller, the principal payments received are generally considered a return of the original investment in the business or asset, and are therefore typically not taxed as ordinary income. Instead, the principal portion of each payment reduces the seller’s basis in the asset sold, and any gain realized from the sale is usually taxed as capital gains. This capital gains treatment often applies to the appreciation in value of the business or asset over the seller’s ownership period.

The interest portion of the payments received by the seller is typically taxed as ordinary income. This is because interest is considered compensation for the use of money and is not part of the original capital investment. The seller generally reports this interest income on their tax return in the year it is received or accrued, depending on their accounting method. Federal tax regulations, such as those related to original issue discount or imputed interest, may apply if the stated interest rate on the note is below a certain threshold, potentially requiring the seller to recognize interest income even if not explicitly received.

For the buyer, the interest payments made on the seller’s note are generally deductible as a business expense. This deduction reduces the buyer’s taxable income, effectively lowering their overall tax liability. The deductibility of interest can provide a notable financial benefit to the buyer, helping to offset the cost of financing the acquisition. However, the principal payments made by the buyer are not deductible, as they are considered a repayment of debt.

The seller’s note also impacts the buyer’s cost basis in the acquired assets. The total purchase price of the business, including the amount financed through the seller’s note, establishes the buyer’s initial cost basis in the assets. This basis is used for future depreciation or amortization deductions and for calculating gain or loss upon a subsequent sale of the assets. Given the complexities of tax law and individual financial situations, both sellers and buyers should consult with qualified tax professionals to understand the specific tax consequences of a seller’s note in their transaction.