As you probably know already, Congress passed (and the President signed) a tax law late last year that eliminated the option of installment sale treatment for businesses that use the accrual method of accounting. This was a major blow to all forms of small business acquisition and sale since many, including most insurance agencies, account for revenues and expenses using the accrual method. If you account for income as received and expenses as paid, you are probably using the cash method and are exempt from this rule. If, however, you account for receivables when billed (not when cash is received) and expenses when incurred rather than when paid, you are probably on an accrual basis and you are affected by this law.
The impact of this ruling is that the profit from any sale where payments are received over time, i.e. installments, must be accounted for by the seller IN THE YEAR OF THE SALE, regardless of how the payment timetable is structured. In effect, a $2 Million sale that earns a long-term agent a $1 Million profit over his basis (his investment in the company) will incur taxes on $1 Million in the year of the transaction, regardless of how the payments are received.
In order to avoid undue hardship on the seller regarding payment of a huge tax liability, it has been suggested that the buyer increase any downpayment in this first year in an amount sufficient to pay the seller’s tax burden. After the first year, no tax would be due on the profit received, since it was paid in year one. The only taxable income would be the interest accrued on the debt. However, if cash flow issues exist, the entire transaction will be much more difficult. The seller will be forced to find the money to pay the taxes from other sources.
There is some good news however. Revenue Procedure 2000-22 was passed recently after a great deal of pressure from small business and small business advocates in the United States. Rev. Proc. 2000-22 exempts small businesses from the onerous requirements to seek IRS approval before changing accounting methods. (A small business is defined as one who has had average annual gross receipts of $1 Million or less in the last three years or from the date of inception, if the business is less than three years old.) Once a small business is using the cash method of accounting, it is qualified to use the installment method of accounting for its sale and, thereby, take a proportion of the profits each year (as paid by the buyer) for tax purposes. Further, Rev. Proc. 2000-22 actually exempts small businesses (under $1 Million gross revenue rule) from the requirement to use accrual accounting when they would otherwise have no choice.
If you intend to sell your business and you can qualify under this new Revenue Procedure, you will change your accounting method by using Form 3115 (Application for Change in Accounting Method) and noting “Rev Proc 2000-22” on the top of the form. An amended tax return will need to be prepared to reconcile any accounting changes brought on by the election. However, you will then be automatically converted to a Cash accounting basis and can continue your sale transaction using the installment method if you choose to do so.
The picture is not hopeless if you are larger than $1 Million average gross revenues. You may still be able to avoid the requirement to pay the full tax burden of your sale in the year of its occurrence by transacting partial sales each year, maintaining active participation and/or control, and only selling the remainder of your business if the original transaction was successful in the transition. Call us for further discussion on this issue.