By Jessica I. Marschall, CPA
April 26th, 2025
Selling a small business can be one of the most significant financial transactions a business owner will experience. When the buyer is unable to pay the full purchase price upfront, installment sales can serve as a viable solution, allowing the seller to spread the gain over multiple years while maintaining a steady stream of income. However, careful attention must be paid to tax reporting, document preparation, and the classification of assets such as goodwill. This article outlines how small business owners should properly treat an installment sale and what tax documents are required to maintain compliance with IRS rules.
1. What is an Installment Sale?
An installment sale is a sale of property where at least one payment is received after the tax year of the sale. For small business owners, this often means accepting a downpayment at closing with the remaining balance paid over several months or years.
Under Internal Revenue Code (IRC) Section 453, sellers are allowed to report the gain proportionally as payments are received rather than recognizing the entire gain in the year of sale.
2. Required Tax Forms
The key tax document for an installment sale is IRS Form 6252, Installment Sale Income. This form reports:
- Description of the property sold.
- Date acquired and date sold.
- Selling price and contract price.
- Adjusted basis and gross profit.
- Gross profit percentage.
- Payments received during the year.
The gross profit percentage is critical because it determines how much of each payment must be recognized as taxable gain. Form 6252 must be attached to the seller’s Form 1040 each year payments are received.
In addition to Form 6252:
- Form 4797 may be required if depreciable property is sold and depreciation recapture under IRC Section 1245 or 1250 must be recognized.
- Form 8949 and Schedule D are necessary to report the sale of capital assets such as goodwill.
- Schedule B must be used to report interest income if applicable.
3. The Role of Goodwill in a Sale
Goodwill represents the intangible value of a business such as its reputation, customer base, and operational processes. In an asset sale, the IRS requires that the total sales price be allocated among the various tangible and intangible assets transferred, following the residual method outlined in IRC Section 1060.
If the parties agree and document it properly, a substantial portion of the purchase price may be allocated to goodwill. Goodwill is taxed at long-term capital gains rates provided the seller held the business for more than one year. This is generally favorable compared to ordinary income tax rates that apply to depreciable property recapture.
Without a formal valuation, sellers and buyers may still allocate value to goodwill based on reasonable estimates, taking into account the ongoing operations, customer relationships, and the business’s name recognition. The allocation must be mutually agreed upon and ideally documented in the sales agreement.
The acquiring entity is then able to book the Goodwill to their balance sheet and amortize over 15 years.
| Category | What It Includes |
| Class I – Cash | Cash, bank accounts |
| Class II – Marketable Securities | Stocks, bonds, etc. |
| Class III – Receivables | Accounts Receivable (rare if sold) |
| Class IV – Inventory | Inventory (if any) |
| Class V – Tangible Property | Furniture, Equipment, Leasehold Improvements |
| Class VI – Intangible Assets | Licenses, Contracts, Trademarks |
| Class VII – Goodwill | Goodwill, going concern value |
Goodwill is the last bucket — it is the “plug” number after assigning value to the specific tangible assets.
4. Recognition of Interest Income
When the seller finances part of the sale, the IRS requires that a portion of each payment be treated as interest income. If the installment contract does not specify an interest rate, the IRS will impute interest at the Applicable Federal Rate (AFR). This usually comes as a shock to taxpayers who managed a DIY installment agreement, and is an unwelcome surprise to both parties and their bookkeepers.
Interest income must be separately reported on Schedule B of the seller’s Form 1040. It is important to structure the agreement clearly to specify any interest component to avoid unexpected income recognition.
5. Key Steps to Ensure Compliance
- Draft a Sales Agreement that clearly allocates the purchase price among tangible assets, intangible assets (such as goodwill), and notes any applicable interest rate.
- Determine Adjusted Basis of assets sold, accounting for any depreciation taken.
- Complete Form 6252 carefully, ensuring the correct gross profit percentage is calculated.
- Report Depreciation Recapture on Form 4797 if necessary.
- Track Payments Received each year and allocate properly between principal and interest.
- Maintain Clear Documentation in case of IRS examination, including the signed sales agreement and supporting calculations.
Treating an installment sale correctly can significantly benefit a small business owner by spreading the tax burden over several years and taking advantage of lower capital gains rates for goodwill. However, strict compliance with reporting requirements is critical. Engaging a qualified CPA familiar with installment sales, asset allocation, and IRS regulations is highly recommended to maximize tax benefits and avoid costly mistakes.
