Can a Section 453 installment sale be used to sell a business owning depreciable property to a related party?

Question

Tyler Smith · Accepted Answer

Using a Section 453 installment sale to sell a business owning depreciable property to a related party presents significant challenges and limitations.

Core Restriction: Section 453(g)

Under Internal Revenue Code Section 453(g), installment sale treatment is generally not allowed for the sale of depreciable property between related persons. The primary purpose of this rule is to prevent related parties from achieving a "basis step-up" for depreciation deductions for the buyer, while the seller defers gain. This arrangement could create an unfair tax advantage for the related group as a whole.

In such transactions, all payments to be received are treated as received in the year of the disposition. This means the seller must recognize all gain in the year of sale, even if they have not yet received cash. This directly contradicts the core benefit of deferring capital gains tax on business sales with earnouts or contingent payments inherent in a typical installment sale.

Defining "Related Persons"

For the purposes of this rule, "related persons" are broadly defined and include, but are not limited to, the following relationships:

• An individual and a corporation in which the individual owns more than 50% of the stock.
• Two corporations that are members of the same controlled group.
• A partnership and a person owning more than 50% of the capital or profits interest in the partnership.

This definition is crucial when considering whether a seller can use Section 453 if the buyer is a related party, like a family member or controlled entity.

Limited Exception

There is a limited exception to Section 453(g). This exception applies if the seller can establish, to the satisfaction of the Secretary, that the avoidance of federal income tax is not one of the principal purposes of the disposition. However, this exception is notoriously difficult to meet and rarely applies in practice.

Therefore, sellers considering such a transaction must be aware that traditional Section 453 deferral benefits will likely not apply to the portion of the sale attributable to depreciable property when dealing with a related party. Careful planning and professional advice are crucial to navigate these complex rules and avoid common pitfalls and mistakes.

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