This post uses hypothetical scenarios for illustrative purposes only. It does not describe any actual client, transaction, or representation, and is not legal advice.
Take a founder who closed a 2024 sale, calling counsel in April of last year, three days before his extended return was due. He had sold a software services business for $32 million the prior spring. The structure had been clean and common — $24 million in cash at close, a $4 million working capital escrow that had already largely resolved in his favor, and a $4 million seller note bearing interest at the long-term applicable federal rate, payable in equal annual installments over four years. His CPA had reported the gain on the installment method, deferring the gain attributable to the seller note as principal came in. So far, so textbook. What blindsided him was the section 453A interest charge on the installment sale — the annual federal surcharge that hits any founder carrying more than $5 million in deferred installment obligations at year-end.
His call was about a line on the return labeled “interest on deferred tax liability under section 453A.” The CPA had calculated it at a number he could not quite believe. His question was the same one I get from every founder seeing this for the first time. What is this, and why am I paying it.
What the section 453A interest charge actually does
Section 453A of the Internal Revenue Code imposes an interest charge on the deferred tax liability associated with certain installment obligations held at year-end. The provision applies to “nondealer” installment obligations — which covers the seller note a founder takes back in an M&A transaction — and it kicks in when the face amount of all such installment obligations from sales of more than $150,000, held by the taxpayer at the close of the taxable year, exceeds $5 million. Below the $5 million threshold, no interest charge. Above the threshold, the interest charge applies to the portion of the deferred gain that corresponds to the face amount in excess of the threshold.
The mechanics are mechanical, but the consequence is large. The taxpayer computes the deferred tax liability — the federal tax that would have been owed on the deferred gain if the installment method had not been elected — and then multiplies that deferred tax by the underpayment rate under § 6621(a)(2), which is the IRS short-term rate plus three percentage points. The applicable percentage — the fraction of the obligation attributable to face amount above the $5 million threshold — is then applied so the charge runs only on the portion above $5 million. That product is the interest charge, payable annually with the return, until the installment obligation is satisfied. The rate is not the rate on the seller note. It is the federal underpayment rate, which over the past two years has run between six and eight percent and is currently six percent for the second quarter of 2026.
The economic effect is to claw back a meaningful chunk of the time-value benefit of the installment method on any portion of the seller note above $5 million. A founder with a $10 million seller note expecting to defer roughly $2 million of federal tax across four years discovers that the deferral costs an annual interest charge running well into five figures. The founder did not borrow money from the government. The founder elected the installment method. The interest charge is the price the Code imposes for that election once the obligation exceeds $5 million.
Why most founders never see this coming
Two structural reasons. First, the founder’s tax counsel is engaged for the structuring exercise — § 338(h)(10) analysis, F-reorganization mechanics, § 1202 QSBS qualification, state-tax planning — and is typically not asked the modeling question of what the year-by-year cash tax cost of the chosen structure looks like. The structuring opinion comes in clean. The annual cash cost is left to the CPA.
Second, the CPA is preparing the return after the close has happened and the seller note is already in place. The CPA’s question is not “what should the structure be” but “how do I report what was done.” The CPA correctly elects the installment method, correctly computes the deferred gain, and correctly applies § 453A. The founder sees the line item on the return for the first time and asks the question that should have been asked at the LOI.
The result is a pattern I see often enough that I now flag it at the front of every founder engagement on a sale with any deferred consideration. The interest charge under § 453A is not a footnote. On a deal with a $10 million seller note, it is real money every year for the life of the note, and it changes the after-tax economics of the seller-note structure in ways that should have been priced into the deal.
The structural moves that mitigate
None of these are exotic. They are conversations the founder should be having with tax counsel at the LOI, not at filing season.
The first is the size question. Keep the aggregate face amount of all installment obligations arising in the year of sale at or under the $5 million threshold and the interest charge does not apply at all. On a deal with a $4 million seller note, no § 453A. On a deal with an $8 million seller note, the applicable-percentage mechanic in § 453A(c)(4) runs the interest charge only on the portion above $5 million. Splitting deferred consideration across two structures — some seller note, some genuinely contingent earnout — can change the analysis, but only if the contingent piece is structured in a way that takes it outside the face-amount mechanic, which is fact-specific. The architecture matters, and so does the documentation. The interplay between seller-note pricing and state-law usury limits is its own thread — the Florida usury analysis on seller notes and earnout kickers walks through how those rate caps can constrain the structure.
The second is the pledge question. Section 453A contains a separate, harsher provision — sometimes overlooked even by sophisticated practitioners — under which the proceeds of any borrowing secured by the installment obligation are treated as a payment received on the obligation, accelerating recognition of the corresponding gain. A founder who takes back a seller note and then pledges that note as collateral for a borrowing to fund a new venture or a tax payment can trigger gain recognition on the deferred portion. The lesson is that the seller note has to stay unencumbered. The founder who needs liquidity has to find it somewhere else.
The third is the election-out question. The installment method is the default for installment obligations, but the seller can elect out under § 453(d) and recognize the entire gain in the year of sale. For some founders — those expecting tax rates to rise, those near the end of a § 1202 QSBS five-year holding period that is being satisfied at close, those who have substantial losses in the year of sale to absorb the gain — electing out is the better answer than paying the § 453A interest charge for four to seven years. For QSBS-eligible founders in particular, the new OBBBA four-year tier rules for section 1202 shift the election-out calculus meaningfully. The election-out has to be made on a timely-filed return for the year of sale and is irrevocable without IRS consent. It is not a decision to defer to filing season.
The fourth is the all-cash question. If the buyer is willing to pay all cash at close — or to substitute a higher cash component for the seller note — the founder avoids both the installment-method election and the § 453A interest charge entirely. The cost is the price concession the buyer typically wants in exchange. That concession, against the present value of paying the § 453A interest charge for the life of the note, is sometimes a fair trade and sometimes not. It is a calculation, not a default.
How this interacts with the rest of the structure
Two interaction points matter and rarely get flagged together. The first is the working capital escrow. The escrow itself does not trigger § 453A — the gain attributable to the escrowed amount is generally either recognized currently as part of the year-of-sale gain or, if the escrow is properly structured to impose substantial restrictions on the seller’s right to receive, deferred under the installment method until the escrow releases. Either way, the escrow alone usually does not push a deal across the $5 million § 453A threshold. The seller note is what pushes a deal across.
The second is the earnout. The treatment of a contingent earnout under § 453A is more nuanced than founders are usually told. Under the contingent-payment regulations at Temp. Reg. § 15a.453-1(c), a contingent payment sale with a stated maximum selling price is generally treated as having a face amount equal to that maximum — and the IRS has taken the position in private rulings that such an earnout counts toward the § 453A threshold. An earnout that is uncapped, or where the maximum amount truly cannot be determined at the close of the year of sale, is harder to fit into the § 453A face-amount mechanic. The point is not that an earnout is a clean way out of § 453A. The point is that the structural choice between “fixed seller note” and “capped earnout” and “uncapped earnout” — which the founder usually sees as a question of risk allocation — also drives where the deal sits on the § 453A spectrum, and the analysis is fact-specific enough that it deserves a tax-counsel sign-off rather than a rule of thumb.
What I tell founders at the LOI
The conversation I now have with every founder where the LOI contemplates more than $5 million of deferred consideration is short. What is the structure of the deferred piece? Is it a fixed seller note, a contingent earnout, or some combination? Has anyone modeled the § 453A interest charge for the life of the obligation? Would the founder rather take a smaller all-cash number or a larger deferred number with the interest charge baked in?
Those are not questions the merger agreement answers. They are questions the founder should answer before the merger agreement is even drafted. The structural choices are wide open at the LOI and largely fixed by the time the definitive agreement is in markup. Our founder-side M&A practice page walks through more of the LOI dynamics, and the simple merger agreement template for entrepreneurs shows how the seller-note and earnout pieces actually sit in the document.
The underlying authority is 26 U.S.C. § 453A, which is the statute every founder with deferred consideration in a sale should make their CPA model before the LOI is countersigned.
If you are a founder approaching an LOI on a sale of your company where the structure includes deferred consideration above $5 million — a seller note, an earnout, an unsecured installment piece — feel free to reach out to my firm manager, Magda, at Magda@montague.law, or fill out our contact form. Mention you read this post.
