You sold your business, took $200,000 at closing, and financed the other $300,000 with a promissory note at 3% over five years. The cash feels small, but the tax, bookkeeping, and collection risk are not — and the IRS has a specific rule that rewrites your interest rate if you get it wrong.
Seller financing is the bridge that lets small deals close when a bank thinks the collateral is too thin or the buyer is too new. The seller becomes the bank, the buyer signs a note, and payment arrives over months or years. The accounting makes that future cash visible, and the tax rules make sure the interest component is not disguised as capital gain.
How Seller Financing Shows Up on Your Books
Seller Side: You Sold and You Are Now the Lender
At closing, you derecognize the business assets, recognize the cash received, and record a note receivable for the financed portion. If you sold the stock of a small corporation and the buyer's note is the consideration, the pattern is:
Dr Cash $200,000
Dr Note Receivable $300,000
Dr Discount on Note (if imputed)
Cr Business Assets (net)
Cr Gain on Sale
The note is an asset, not revenue. You will collect it over time, and each payment splits into principal and interest.
Do not record the entire $300,000 face amount as gain on day one if the note has unstated or below-market interest. The IRS will impute interest, and your books should too: the note's carrying amount is the present value of future payments at the applicable federal rate (AFR), not the undiscounted face.
Buyer Side: You Bought and You Owe
The buyer records the acquisition at the present value of payments, plus cash paid. The note is a liability: Dr Business Assets $500,000 / Cr Cash $200,000 / Cr Note Payable $300,000 (or discounted). Each payment later splits into interest expense and principal reduction.
Installment Payments: Principal vs. Interest
Every monthly payment is two things:
- Principal: Repayment of the financed price. For a seller who reports the sale on the installment method, each principal dollar is gain recovered proportionally.
- Interest: Compensation for the use of money. Taxable as ordinary income to the seller, deductible as interest expense to the buyer to the extent business interest rules allow.
Example: $300,000 note, 5-year amortization, 5% stated interest, $5,666 per month. Year-one collections total $68,000, of which $14,500 is interest and $53,500 is principal. The seller's installment gain reportable in year one is based on the $53,500 principal portion times the gross profit ratio, not on the full $68,000.
If you miss the split and book the entire payment as revenue or as a reduction of the note, your gain and your interest income will both be wrong.
Imputed Interest: When the IRS Rewrites Your Rate
This is the rule that blindsides sellers who offer "0% financing" or "3% to be nice." Under Sections 483 and 1274, if a debt instrument issued for property provides for no interest or interest below the AFR, the IRS will impute interest at the AFR and recharacterize part of the sale price as interest.
When it applies:
- The note term exceeds six months and the stated interest is below the AFR
- The sale price exceeds $3,000 (which is essentially every deal)
- The parties are not dealing in a tax-free reorganization where another rule governs
The AFR is published monthly by the IRS in three tiers: short-term (≤3 years), mid-term (>3 to ≤9 years), and long-term (>9 years). For a five-year note originated in mid-2026, the mid-term AFR is the benchmark. If your note says 0% or 2% and the mid-term AFR is 4.5%, the IRS will treat the note as if it bore 4.5% and recalculate the sale price downward and the interest upward.
What changes:
- Seller: Less capital gain on the sale, more ordinary interest income over the note term. You wanted a long-term capital gain at closing; you get less gain now and more interest taxed at ordinary rates later.
- Buyer: Lower purchase price (lower basis in assets or stock), but deductible interest expense over time (subject to business interest limitation under Section 163(j)).
Safe harbor: If you issue the note with interest at or above the AFR and provide for adequate stated interest (interest paid at least annually), imputed interest does not apply. The simplest fix is to write the note at AFR or higher and state the rate explicitly.
The Installment Sale Election
A seller who finances more than one year generally reports the sale under the installment method under Section 453, unless they elect out. The installment method lets you report gain proportionally as you collect principal.
- Calculate the gross profit ratio: (Sale price minus basis) / Sale price. If you sold for $500,000 with $300,000 basis, ratio is 40%. Each $1,000 of principal collected is $400 of gain.
- Interest is separate: All stated or imputed interest is ordinary income in the year received, not part of the installment gain.
- Electing out: You can elect to report all gain in the year of sale. That can be beneficial if you are in a temporarily low tax bracket or want to avoid the interest on deferred tax.
Trap: If the note is secured, sold, or factored, or if the buyer pays early in a way that makes the obligation essentially liquid, the installment method may be unavailable. Pledging the note for a loan can also trigger gain.
Bookkeeping That Survives an Audit and a Default
Seller notes are the asset most likely to require a reserve.
- Track each payment with an amortization schedule. Book the split every month:
Dr Cash $5,666/Dr Discount Accretion (if imputed)/Cr Interest Income $X/Cr Note Receivable $Y. Do not wait until year-end to allocate. - Watch for impairment. If the buyer misses payments, is delinquent, or the business performance slips, evaluate collectability. Under ASC 326 (CECL for many small entities under simplified approach), you may need an allowance for credit losses.
Dr Bad Debt Expense/Cr Allowance for Credit Losses — Seller Note. That allowance is based on expected loss, not just past due status. - Default and collateral: If the note is secured by the business assets or stock, and the buyer defaults, repossession is not free money — it is a taxable event. You recover the collateral and recalculate gain or loss. Document the fair value of what you recover.
- Keep the note and the accounting separate: A seller note, a consulting agreement, and an employment agreement with the former owner are three separate arrangements. Commingling them invites the IRS to reclassify earnout or interest as compensation.
Paper the Note Like a Bank Would
Before you become the bank, be as disciplined as one:
- Written promissory note with stated principal, interest rate at or above AFR, payment schedule, maturity, and prepayment terms
- Security agreement and UCC filing if secured by business assets, or stock pledge if secured by the company's shares
- Acceleration and cure provisions: What triggers default, how many days to cure, and whether a missed payment accelerates the full balance
- Personal guarantee if the buyer is a thinly capitalized entity
That paperwork is not just for collection — it is the evidence that the interest rate is adequate and the sale price is not inflated to hide interest.
Keep Your Finances Organized From Day One
Seller financing turns a one-day sale into a multi-year accounting relationship. The sellers who collect every dollar are the ones who booked the note at present value, split every payment on time, and wrote the rate above the AFR before the IRS had to.
Beancount.io keeps that relationship in plain text: a note receivable with an amortization schedule, a gain ratio that ties to the sale, and an allowance that reflects reality, all version-controlled and reconcilable to the bank. Get started for free and make the financing that closed the deal as clean as the business you built to sell.