Installment Sales of a California Business

By Eric Ridley, attorney, Ridley Law. Updated October 2026.

Estate size this page covers: any business sale with seller financing. The interest charge on deferred tax starts when the notes from a year’s sales pass $5 million, and the estate planning variations below (sales to grantor trusts and self-cancelling notes) matter most above the 2026 federal exemption of $15 million per person.

What carrying the note does for a seller’s tax bill

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.

Take Rob, a hypothetical owner of a Thousand Oaks insurance agency, who sells the 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.

One changed fact would cost him. 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.

How the installment method works

The method applies on its own, so a seller who wants a different result has to opt out. A sale is an installment sale if you receive at least one payment after the close of the tax year in which you sell (IRC § 453(b)(1)), and seller notes, deferred payments, and many earn-outs create one. 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.

Each principal payment is split between tax-free recovery of your basis and taxable gain, and one ratio set at closing does the splitting. That ratio, the gross profit percentage, is gross profit divided by the total contract price, and it applies to every principal dollar you receive (IRC § 453(c)). In Rob’s sale it’s 83.33%.

Interest is taxed separately from the gain, and the rate on the note matters. 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 get taxed up front anyway

The installment method works asset by asset, and some assets don’t qualify. 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 catches sellers with heavily depreciated equipment, who can owe more tax in the year of sale than the down payment covers. 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. Model this with your CPA before agreeing to a small down payment.

When the IRS treats you as paid before the buyer pays

Several rules count a seller as paid, or charge for the delay, even though the buyer hasn’t paid in full.

Selling to a relative who then resells

A family sale can lose its deferral if the buyer resells the property. If you sell to a related person and that person disposes of the property before you’ve received all your payments, the amount realized on the second sale is treated as received by you at that time (IRC § 453(e)(1)). For anything other than marketable securities, the rule reaches only a second disposition within two years of the first (§ 453(e)(2)(A)). The two years stop running while the buyer’s risk of loss is substantially diminished by a put, another person’s right to acquire the property, or a short sale (§ 453(e)(2)(B)). For marketable securities there’s no time limit.

“Related person” is broad, and it reaches trusts and entities you control. It covers anyone whose stock would be attributed to you under the family and entity attribution rules of § 318(a), other than option attribution, and anyone with a § 267(b) relationship to you, which includes trusts and entities you control (§ 453(f)(1)). The exceptions are narrow: a sale of stock back to the issuing corporation isn’t a first disposition, transfers after the death of either party don’t count, involuntary conversions are excluded, and the rule doesn’t apply if you show the IRS that neither sale had tax avoidance as a principal purpose (§ 453(e)(6), (7)).

Selling equipment or a building to a family company

An owner who sells depreciable property to a family-controlled company on a note generally gets no deferral. An installment sale of depreciable property between related persons treats all payments as received in the year of sale, unless you show the IRS that avoiding federal income tax wasn’t a principal purpose (§ 453(g)). Selling equipment or a building to a family-controlled company on a note is how owners usually trigger it.

Notes large enough to carry an interest charge

Large notes carry an interest charge on the deferred tax. Section 453A applies to a note from any sale over $150,000, but the interest charge applies only in a year when the face amount of all such notes that arose during the year and are still outstanding at year end exceeds $5,000,000 (IRC § 453A(b)). The charge is the applicable percentage of the deferred tax liability, times the underpayment rate for the month the tax year ends (§ 453A(c)(2)). The deferred tax liability is the unrecognized gain times the top rate, which for long-term capital gain means the 20 percent rate in § 1(h) (§ 453A(c)(3)). The applicable percentage is the part of the year’s notes above $5 million divided by the total (§ 453A(c)(4)). The charge applies for each year a covered note is outstanding at year end.

California runs a parallel charge, so a California seller pays interest to both governments. For a note covered by § 453A, California increases its own tax by interest figured the federal way, using the maximum rate under § 17041 instead of the federal rate (Rev. & Tax. Code § 17560(e)). The top bracket on the FTB’s 2025 rate schedule is 12.3 percent. The IRS underpayment rate for October through December 2026 is 7 percent (IRS quarterly interest rates).

On a $25 million note, the year-one federal charge comes to $280,000 and the California charge to about $172,200. That’s the price of deferring tax on $20 million of note principal above the threshold, and it shrinks as the note is paid down. Whether the deferral is worth it depends on what the seller earns on the tax money kept in hand, which is a calculation for your CPA.

Borrowing against the note

Borrowing against the note gives you cash and a tax bill at the same time. If the sales price was over $150,000 and the loan is secured by an installment note covered by § 453A, the net loan proceeds are treated as a payment on the note, as of the later of the time the debt becomes secured or the time you receive the money (§ 453A(d)(1)). The amount is capped at the unpaid contract price, and later note payments up to that amount aren’t taxed again (§ 453A(d)(2), (3)). A loan counts as secured by the note if any arrangement lets you satisfy the loan with the note (§ 453A(d)(4)). The IRS cites this rule against the monetized installment sale described below.

Selling, giving away or forgiving the note

Getting rid of the note before it’s paid generally brings the deferred gain due. Disposing of the note triggers it: a sale or a payoff at a discount is measured by the amount realized, and a gift or other non-sale disposition is measured by the note’s fair market value (IRC § 453B(a)). Canceling the note counts as a disposition, and when the buyer is a related person the note’s value is treated as at least its face amount (§ 453B(f)). Giving the note to an irrevocable trust for your children is a disposition. A transfer to your spouse, or to a former spouse incident to divorce, doesn’t count as one unless it’s a transfer in trust (§ 453B(g)).

Death doesn’t count either. Passing the note at death isn’t a disposition under IRC § 453B(c), and your heirs report the remaining gain as they collect, as income in respect of a decedent.

Monetized installment sales

The monetized installment sale is a promoted structure that fails under the pledge rule and the proposed listed-transaction treatment. The pitch converts a cash sale into an installment sale. The seller sells to an intermediary for a note, the intermediary sells to the real buyer for cash, and a third party lends the seller the sale price less fees on a nonrecourse basis, with the loan funded or secured by the buyer’s cash. In 2023 Treasury and the IRS proposed identifying these transactions, and substantially similar ones, as listed transactions, which would require disclosure by participants and material advisors and carry penalties for failing to disclose (REG-109348-22, I.R.B. 2023-35). The proposed rule lists the IRS’s arguments against the deferral, including that the note is secured by the sale proceeds, that the loan isn’t a bona fide loan, and that the § 453A(d) pledge rule treats the loan proceeds as full payment. More detail is on my page on the monetized installment sale.

Keeping the note out of your estate

A seller whose estate is above the 2026 federal exemption of $15 million per person also has to think about what the note does to the estate tax.

Selling to a grantor trust instead

A sale to a trust you’re treated as owning for income tax produces no gain for the installment method to defer. The note stays in your estate and the growth on what you sold stays outside it. The reason is in Rev. Rul. 85-13, as the IRS summarized it in Rev. Rul. 2007-13: a grantor treated as the owner of a trust is treated as owning its assets, and an exchange of the grantor’s note for trust assets isn’t recognized as a sale for federal income tax. So a sale of a business interest to an intentionally defective grantor trust produces no gain for § 453 to defer. California follows the federal grantor trust rules through Subchapter J (Rev. & Tax. Code § 17731). The mechanics, the seed gift and the cases are on my page about the sale to an intentionally defective grantor trust.

Self-cancelling notes

A self-cancelling installment note, or SCIN, is a note that’s canceled if the seller dies before it’s paid off. The seller charges for that risk with a higher price or interest rate. The idea is that nothing is left in the estate if the seller dies early. Two appellate cases mark the limits.

A SCIN can hold up in court even when the seller dies soon after, if the sale is real. A father sold a restaurant and office properties appraised at $830,000 to his son for a SCIN fully secured by a mortgage, and died about five months later (Estate of Costanza v. Commissioner, 320 F.3d 595 (6th Cir. 2003)). The Tax Court found the sale wasn’t bona fide. The Sixth Circuit reversed, holding the family presumption against intrafamily notes was rebutted by a real expectation of repayment, a life expectancy of 5 to 13.9 years and full security, and it relied on Estate of Moss (1980) for the rule that a bona fide SCIN isn’t included in the gross estate. It sent the case back on the IRS’s alternative argument that the note was worth less than the property, which would make the difference a gift.

A SCIN can remove the unpaid principal from the estate, but it doesn’t erase the income tax on the gain. In Frane v. Commissioner, 998 F.2d 567 (8th Cir. 1993), the father sold stock to his four children on 20-year SCINs and died after two installments. The Eighth Circuit held the cancellation at death was a taxable event and that the deferred gain was income in respect of a decedent taxed to the estate under IRC § 691(a)(5).

Private annuities

A private annuity, where a family member promises lifetime payments in exchange for the property, is less settled, and it shouldn’t be treated as a deferral tool without a written tax opinion. In October 2006, Treasury and the IRS proposed regulations that would tax the entire gain at the time of the exchange, with the annuity valued under § 7520 (71 FR 61441). The Federal Register shows no final rule, and the current text of Treas. Reg. § 1.1001-1 has no such provision.

Where California changes the picture

California follows the federal installment rules, so the deferral you get federally applies to your state gain too. What California adds is an interest charge on large notes, a source rule that follows the gain when a seller moves away, and ordinary rates up to 13.3 percent on the gain.

Conformity, rates and the parallel charge

California treats the installment method the same way for individuals and corporations, through different code sections. For individuals, California’s personal income tax adopts Subchapter E of the Internal Revenue Code, which covers accounting periods and methods of accounting, and the installment method in IRC § 453 sits in that subchapter (Rev. & Tax. Code § 17551). For corporations, California applies IRC §§ 453, 453A, and 453B directly (Rev. & Tax. Code § 24667).

The interest charge follows the same pattern, at the § 17041 maximum rate. 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). The corporate rules make the same substitution (Rev. & Tax. Code § 24667).

The rate makes spreading the gain worth considering. California taxes capital gains as ordinary income, with no lower rate, according to the FTB. The rate runs up to 13.3 percent, the 12.3 percent top bracket plus a 1 percent tax on taxable income over $1,000,000 (Rev. & Tax. Code § 17043). 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.

Moving away after the sale doesn’t take the gain with you

Usually a California seller can’t avoid the tax on a California business by moving. 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.

The timing of the move matters for stock. 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. 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. Gain on real property is sourced where the property sits. A nonresident’s gain on intangible property is still California income if the property has a business situs here (Rev. & Tax. Code § 17952), and the Court of Appeal applied that idea to goodwill in 2009 Metropoulos Family Trust v. Franchise Tax Bd. (2022), where nonresident trusts were taxed on their share of an S corporation’s gain from selling a subsidiary.

A business sale mixes tangible assets, goodwill, and sometimes real estate, and each piece is sourced separately. A seller who means to leave should plan the move and the sale together, and talk to the CPA before signing, not after the move. The residency rules are covered in leaving California and the taxes that follow you. For the planning that should happen before a letter of intent, see estate planning before selling a business.

Withholding when real estate is in the deal

Withholding on installment payments applies 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.

Protecting yourself as the person holding the note

Treat 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.

• 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 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.

Rob’s 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.

Working with Ridley Law

On a large sale I draft the note, the security documents and the trust side of the plan, and I coordinate with the CPA who models the § 453A charge and the California sourcing. I work alongside your CPA and, where the matter calls for it, co-counsel. Work at this level is built for each family and quoted in writing before any drafting starts.

The first call is free and runs 30 minutes, by phone or Zoom. Book my 30-minute call or call 805-244-5291. The rest of the high-net-worth planning picture is on my ultra-high-net-worth estate planning page, and structures that fail in court are collected in strategies that backfire.

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.