# Installment Sales of a California Business

> How an installment sale of a California business is taxed under IRC 453 and California law, what can't be deferred, moving out of state, and securing the note.

Source: https://ridleylawoffices.com/installment-sale-of-business-california/

**Short answer:** An installment sale lets the seller of a business report gain as payments arrive, instead of all in the year of sale, whenever at least one payment arrives after that year. California follows the federal rules for individuals and corporations. Some of the gain can’t be deferred, including inventory and depreciation recapture, and moving out of California doesn’t take the gain on California business assets out of California’s reach.

- An installment sale is a disposition where at least one payment is received after the close of the tax year of the sale (IRC § 453(b)(1)).
- Depreciation recapture is recognized in the year of sale, whatever the payment schedule (IRC § 453(i)).
- Corporations follow IRC §§ 453, 453A, and 453B for California tax (Rev. & Tax. Code § 24667).
- California adds its own interest charge on large deferred obligations, figured at California’s top rate (Rev. & Tax. Code § 17560).
- California taxes installment proceeds a nonresident receives to the extent the income came from a California source (FTB Publication 1100).

Seller financing is common in small business sales, because buyers often can’t borrow the whole price and sellers can often get a better total price by carrying part of it. The tax rules decide how much of that deferral you get. The note and security documents decide whether you get paid at all. This page covers both, with California’s rules.

## What is an installment sale of a business?

It’s a sale where you receive at least one payment after the close of the tax year in which you sell ([IRC § 453(b)(1)](https://www.law.cornell.edu/uscode/text/26/453)). Seller notes, deferred payments, and many earn-outs create installment sales. The installment method is the default for qualifying gain (IRC § 453(a)). You don’t elect into it.

You can elect out and report the entire gain in the year of sale, but only on or before the due date of your return for that year, including extensions (IRC § 453(d)). A seller might elect out to use a loss or a low-income year. The election can be revoked only with IRS consent.

## How is the gain calculated?

Each principal payment is split between tax-free recovery of your basis and taxable gain. The split uses one ratio set at closing: gross profit divided by the total contract price (IRC § 453(c)). That ratio, the gross profit percentage, applies to every principal dollar you receive.

Interest is separate. It’s ordinary income when you receive it. If the note charges too little interest, the IRS can treat part of the principal as interest under the unstated interest and original issue discount rules, according to IRS Publication 537. Your CPA should confirm the note’s rate is high enough before it’s signed.

You report the sale on Form 6252 in the year of sale and in each later year you receive a payment, according to Publication 537.

## Which parts of a business sale can’t be deferred?

A business isn’t one asset. The IRS treats a sale of a business for one price as a sale of each asset, and you have to allocate the price and the payments among them before you know what can be reported on the installment method (IRS Publication 537).

| Asset or item | Installment method? | Authority |
| --- | --- | --- |
| Goodwill and going concern value | Usually yes | IRC § 453 |
| Equipment and other depreciable property | Only gain above depreciation recapture | IRC § 453(i) |
| Depreciation recapture | No. Recognized in the year of sale | IRC § 453(i) |
| Inventory | No | IRC § 453(b)(2)(B) |
| Assets sold at a loss | No. Losses can’t be reported on the installment method | IRS Publication 537 |
| Partnership or LLC interest (gain from unrealized receivables and inventory items) | No for that portion, yes for the rest | IRS Publication 537 |

Depreciation recapture is the trap. Under IRC § 453(i), recapture income is recognized in the year of the disposition, and only the gain above it goes on the installment method. A seller with heavily depreciated equipment can owe more tax in the year of sale than the down payment covers. Model this with your CPA before agreeing to a small down payment.

## What other federal rules apply?

A few rules catch sellers by surprise.

- **Selling to a relative.** If you sell to a related person and that person resells within two years, the resale can accelerate your deferred gain (IRC § 453(e)).
- **Large notes.** If installment obligations from sales over $150,000 that arose during the year and are outstanding at year end exceed $5,000,000 in face amount, an interest charge applies to the deferred tax (IRC § 453A).
- **Borrowing against the note.** If you pledge the note as security for a loan, the loan proceeds are treated as a payment on the note (IRC § 453A(d)).
- **Selling or settling the note.** If you sell the note, it’s paid off at less than face value, or you otherwise dispose of it, the remaining gain comes due ([IRC § 453B(a)](https://www.law.cornell.edu/uscode/text/26/453B)).
- **Death.** Passing the note at death isn’t a disposition under IRC § 453B(c). Your heirs report the remaining gain as they collect, as income in respect of a decedent.

## How does California tax an installment sale?

California generally follows the federal rules, so the same deferral applies to your state gain. Here is how the conformity works for each type of seller.

For individuals, California’s personal income tax adopts Subchapter E of the Internal Revenue Code, which covers accounting periods and methods of accounting ([Rev. & Tax. Code § 17551](https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=RTC&sectionNum=17551)). The installment method in IRC § 453 sits in that subchapter.

For corporations, California applies IRC §§ 453, 453A, and 453B directly ([Rev. & Tax. Code § 24667](https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=RTC&sectionNum=24667)).

California adds its own interest charge on large deferred obligations. For an installment obligation covered by IRC § 453A that is outstanding at year end, the California tax is increased by interest determined under the federal method, using the maximum California rate instead of the federal rate ([Rev. & Tax. Code § 17560](https://leginfo.legislature.ca.gov/faces/codes_displaySection.xhtml?lawCode=RTC&sectionNum=17560)). The corporate rules make the same substitution (Rev. & Tax. Code § 24667).

The rate matters too. California taxes capital gains as ordinary income, with no lower rate, according to the FTB. Spreading gain over several years can keep more of it out of the top California brackets. Your CPA should run the numbers year by year.

## Can I move out of California and avoid tax on the payments?

Usually not for a California business. The FTB’s Publication 1100 says California taxes installment gains a nonresident receives from the sale of tangible property and intangible property sourced to California. It taxes real property based on where the property is located.

Publication 1100 also says installment gains from intangible property are generally sourced to the recipient’s state of residence at the time of the sale. That’s why the timing of a move matters. In the FTB’s own example, the gain on stock sold while the seller was a California resident stays taxable by California after the seller moves, while the interest received as a nonresident doesn’t.

A business sale mixes tangible assets, goodwill, and sometimes real estate, and each piece is sourced separately. If you’re planning to leave California, talk to your CPA before you sign, not after you move.

## Does the FTB withhold on installment payments?

Only when the sale includes California real property. If real estate is part of the deal, the FTB’s Form 593 instructions call for withholding of 3 1/3 percent of the down payment during escrow, and the buyer withholds on the principal portion of each later installment unless the seller has the FTB’s approval to elect out. The same instructions say no withholding is required when the sales price is $100,000 or less.

## How do I protect myself as the seller?

By treating the note like a bank loan, because you’re the bank. Tax deferral is worthless if the buyer stops paying. The documents that protect you are negotiated before closing, starting in the [letter of intent](https://ridleylawoffices.com/letter-of-intent-buy-business-california/).

- **Promissory note** with a fixed schedule, a default interest rate, late charges, and an acceleration clause
- **Security agreement** giving you a lien on the business assets, perfected with a UCC-1 filing at the Secretary of State
- **Pledge of the shares or membership interests**, in an entity sale
- **Personal guarantee** from the buyer’s owners, and ask whether the buyer’s spouse should sign too
- **Covenants**: financial statements to you each quarter, insurance naming you, no sale of the business without paying you off, and a cross-default if the buyer defaults on the lease
- **Subordination terms**, if a bank also lends, stating when you can be paid and when you can enforce

Due diligence runs both ways here. Before you carry paper, check the buyer’s credit, experience, and other debts the way a lender would. The [due diligence checklist](https://ridleylawoffices.com/due-diligence-checklist-buying-business-california/) shows what buyers review, and a seller carrying a note should ask for much of the same about the buyer.

If the buyer defaults and won’t cure, collecting is a lawsuit or a foreclosure on collateral. That’s work for litigation counsel, and I refer it out.

## A worked example: a Thousand Oaks insurance agency

Rob sells his agency’s assets for $1,200,000. The buyer pays $400,000 at closing and signs a five-year note for $800,000 at an interest rate his CPA confirms is adequate. Assume, for simplicity, that the price is all goodwill and Rob’s basis in it is $200,000.

| Item | Amount |
| --- | --- |
| Contract price | $1,200,000 |
| Gross profit ($1,200,000 minus $200,000 basis) | $1,000,000 |
| Gross profit percentage | 83.33% |
| Gain reported in year of sale ($400,000 x 83.33%) | $333,333 |
| Gain reported each later year ($160,000 principal x 83.33%) | $133,333 |

Instead of reporting $1,000,000 of gain in one year, Rob reports about a third of it in the year of sale and the rest over five years, plus interest as ordinary income. California follows the same schedule. The note is under $5,000,000, so neither the federal nor the California interest charge applies.

Change one fact. If $150,000 of the price were for office equipment Rob had fully depreciated, that $150,000 would be recapture income under IRC § 453(i), all of it taxed in the year of sale. His year-one tax would climb even though his cash didn’t.

His note, the security agreement, and a personal guarantee go into his living trust along with the rest of his assets, and his successor trustee has the authority to collect or enforce the note if he can’t. See [business succession planning in California](https://ridleylawoffices.com/business-succession-planning-california/).

## Frequently asked questions

### Is seller financing a good idea when selling a business?

It can be, if the buyer is creditworthy and the documents give you real security. It often raises the total price and spreads the tax. The cost is the risk that the buyer fails and you have to take the business back or sue.

### What interest rate should a seller note carry?

High enough to avoid the IRS’s unstated interest and original issue discount rules, and high enough to compensate you for the risk. Your CPA can tell you the federal minimum for the month of the sale. The business terms are negotiated.

### Can I use the installment method for inventory?

No. IRC § 453(b)(2)(B) excludes inventory from the installment method. Gain on inventory is reported in the year of sale, even if you’re paid later.

### What happens if the buyer pays off the note early?

The remaining gain becomes taxable in the year you’re paid. That’s usually fine, since you have the cash. If the buyer pays less than face value to settle the note, IRC § 453B(a) treats that as a disposition, and gain or loss is figured on the difference.

### Is an earn-out an installment sale?

Often, yes, because payments come after the year of sale. When the total price or the payment period isn’t fixed, Treasury regulations treat the deal as a contingent payment sale with its own rules for recovering basis (Treas. Reg. § 15a.453-1(c)). Your CPA should review the earn-out language before it’s final.

### Does California tax installment payments if I retire to another state?

Often, yes. The FTB’s Publication 1100 says California taxes installment gains a nonresident receives from tangible and intangible property sourced to California. The answer depends on what you sold and where you lived at the time of the sale.

### What if the buyer defaults?

Your note and security agreement decide your remedies. Enforcing them is a litigation matter, and I refer those cases to litigation counsel.

More in this series

- [How to sell a small business in California](https://ridleylawoffices.com/how-to-sell-a-business-california/)
- [How to value a small business in California](https://ridleylawoffices.com/how-to-value-a-small-business-california/)
- [The letter of intent to buy a California business](https://ridleylawoffices.com/letter-of-intent-buy-business-california/)
- [Due diligence checklist for buying a California business](https://ridleylawoffices.com/due-diligence-checklist-buying-business-california/)
- [ESOPs for California business owners](https://ridleylawoffices.com/esop-california/)
- [All business owner guides](https://ridleylawoffices.com/business-guides/)

I draft and review seller notes, security agreements, guarantees, and the purchase agreements they belong to at my hourly rate of $500. See [fees](https://ridleylawoffices.com/fees/) or my [business law](https://ridleylawoffices.com/business-law-attorney/) page.

[Talk to Eric](https://ridley.click/eric-60)

Book a consultation at [ridley.click/eric-60](https://ridley.click/eric-60) or call 805-244-5291. I work with business owners in Ventura, Santa Barbara, and Los Angeles counties by Zoom or phone.

**Please read:** This page is general information about California law as of September 2026. It isn’t legal, tax, or financial advice, and reading it doesn’t make you my client. Tax treatment and the right structure depend on facts this page can’t see, so talk with your CPA as well. An attorney-client relationship starts only with a signed engagement agreement.