Selling a business triggers federal capital gains tax, ordinary income tax, and potentially steep state income taxes. However, with the right planning, you can reduce or defer capital gains and keep more of your net proceeds.
1. The Sale Structure Determines Your Tax Liability
Business sales are typically structured as stock or asset sales, each with different tax outcomes.
Asset Sale of a Business
In an asset sale, the buyer selects specific business assets to purchase. This may include inventory, equipment, real estate, and intangible assets like goodwill or intellectual property. The IRS taxes each asset individually based on its classification as a capital asset, depreciable property, or inventory and its fair market value at the time of sale.
Buyers prefer asset sales. They can pick and choose which assets to acquire. They also get a step-up in the tax basis of acquired assets. This creates larger depreciation or amortization deductions and lowers taxable income in future years.
Sellers face mixed tax treatment. Depreciated assets trigger depreciation recapture, which is taxed as ordinary income. Capital assets like goodwill and real estate are taxed at more favorable capital gains rates. C corporation owners will face double taxation—once at the company level and a second time at the individual level.
Stock Sale of a Business
In a stock sale, the buyer purchases the seller’s ownership interest (e.g., corporate stock or LLC membership units). This includes all business assets, liabilities, and contracts. The IRS taxes the seller’s gain as the sale of a capital asset—usually at long-term capital gains rates if held for over one year.
Buyers typically avoid stock sales because they assume all known and unknown liabilities including lawsuits and tax issues. They also lose the ability to step up the tax basis of individual assets unless both parties make special tax elections (e.g., Section 338(h)(10)). These elections must be carefully structured and may trigger tax consequences for the seller.
Sellers prefer stock sales. They are generally taxed at lower capital gains rates, avoid depreciation recapture, and are administratively simpler. Stock sales help C corporation owners avoid double taxation.
Tax Strategy Insight
You may be able to negotiate a higher purchase price in an asset sale to offset the less favorable tax treatment. Our expert CPAs offer transaction advisory services that include modeling both deal structures to compare the outcomes.
2. Tax Consequences by Entity Type
Your business’s legal structure determines how the IRS taxes the sale and how much you keep after closing.
Most small businesses are structured as sole proprietorships, partnerships, LLCs, or S corporations. These are pass-through entities, meaning gains from the sale flow directly to the owners and are taxed at individual rates. Most assets sold qualify for long-term capital gains treatment, but certain portions like depreciation recapture, inventory, and receivables are taxed as ordinary income.
Watch Out: If your business was converted from a C corporation to an S corporation, the built-in gains (BIG) tax may apply if appreciated assets are sold within five years.
C Corporations
In an asset sale, the C corporation pays tax on the gain from sold assets. Then, shareholders pay personal tax when net proceeds are distributed. This makes stock sales more favorable for C corp shareholders, as they avoid corporate-level tax and shift the tax burden to shareholders typically at long-term capital gains rates.
However if a buyer insists on an asset sale, you should negotiate a higher price to offset the added tax cost.
Tax Strategy Insight
Entity structure isn’t just a tax issue—it’s a deal-structure issue. Waiting too long to plan your structure before a sale can limit your options and increase taxes. Our business structure consulting service helps business owners optimize their entity type years in advance to reduce taxes and increase sale flexibility.
3. Tax Considerations by Business Size
Business size often affects deal complexity and the scope of tax planning required. While tax rules apply across the board, small, medium, and large businesses each face distinct issues during a sale.
Small Businesses
Small businesses often use pass-through structures like sole proprietorships, partnerships, or S corporations. While the deal itself may be simpler, owners face a higher risk of tax surprises—like unexpected depreciation recapture or state taxes—if they do not get proper guidance.
Medium Businesses
Midsize companies typically have more flexibility in structuring deals to optimize tax outcomes. These sales may involve earnouts, installment payments, or partial equity rollovers, requiring careful planning to manage tax timing and character.
Large Businesses
Large business sales often involve mergers or acquisitions, with multiple stakeholders and legal entities. These deals raise additional tax considerations, such as stock option treatment, international tax compliance, and tax due diligence across subsidiaries.
Tax Strategy Insight
The larger and more complex your business, the earlier you should start tax planning—ideally 12–24 months before a sale. This gives your advisory team time to model deal scenarios, clean up records, and fix any red flags that could affect your business valuation and tax outcomes.
4. Goodwill Tax Considerations
Goodwill reflects your business’s brand, reputation, and customer relationships. It is taxed as a capital asset. Sellers qualify for long-term capital gains rates if they have held the business for over one year. Buyers can amortize goodwill over 15 years under IRS Section 197, which provides long-term tax savings.
Properly allocating goodwill in the sale agreement is essential. It affects both parties’ tax liability and must be backed by a reasonable valuation.
5. Depreciation Recapture
Depreciation recapture applies when you sell depreciated business assets like equipment, vehicles, or real estate. The IRS taxes the portion of your gain equal to prior depreciation as ordinary income up to a maximum marginal rate of 25%.
Example: You sell a warehouse for $1.2 million. You originally bought it for $600,000 and depreciated $200,000. That $200,000 is taxed as ordinary income. Only the remaining $400,000 qualifies for capital gains rates.
Tax Strategy Insight
Depreciation recapture can significantly raise your tax bill. Sellers often underestimate this tax. CPAs with transaction experience can help you model depreciation recapture ahead of a sale and develop strategies to reduce its impact.
6. Federal Capital Gains vs Ordinary Income Tax
The IRS taxes different parts of a business sale at different rates. Long-term capital gains tax rates are 0%, 15%, or 20%, while ordinary income tax rates are up to 37%.
- Capital Gains: Assets held for over a year like goodwill, real estate, trademarks, or business stock are usually taxed as long-term capital gains. These lower rates often create major tax savings for sellers.
- Ordinary Income: Certain sale components are taxed at higher ordinary income rates, including:
- Inventory
- Depreciation recapture on assets like equipment
- Accounts receivable (for cash-basis taxpayers)
7. Purchase Price Allocation
Purchase price allocation has a direct impact on your tax liability. In asset sales, the Internal Revenue Code requires buyers and sellers to assign portions of the purchase price to each business asset sold.
Tax Consequences of Allocation
The allocation determines what portion of the sale is taxed at ordinary income rates versus more favorable capital gains rates. For sellers, allocating more value to assets like goodwill and real estate may yield lower capital gains taxes. In contrast, allocating value to inventory, equipment, or receivables may trigger ordinary income tax.
IRS Compliance
If goodwill or going-concern value is involved, both parties must file IRS Form 8594 and report the same asset values using the residual method. Inconsistent reporting can trigger audits, penalties, or recharacterization of income. Accuracy and consistency are critical.
Strategic Planning Opportunity
Buyers and sellers often have opposing interests in allocation—what has tax benefits for one party may disadvantage the other. With early CPA involvement, sellers can negotiate terms that steer more value toward capital gains assets without violating fair market value principles.
8. State Tax Impact on Business Sales
Federal taxes are only part of the equation. Many states tax capital gains and business income—some heavily.
Residency and Location Matter
Where you live and where your business operates can both affect your state tax bill. High-tax states like California and New York may significantly increase your total liability. No-tax states like Florida, Texas, and Nevada offer big savings but only if you meet strict residency rules.
Multistate Exposure
If your business has nexus in multiple states through offices, employees, or sales, you could owe tax in each of these states. Even if you relocate, states may still tax the sale based on where the business activity occurred.
Tax Strategy Insight
Don’t overlook state taxes because they can significantly reduce your net proceeds! Even if you relocate to a no-tax state, the timing and documentation must be precise to avoid audits. Our multistate tax service helps you plan your move, establish clear residency, and minimize multistate exposure before the sale.
Reporting and Compliance Obligations
Selling a business triggers multiple IRS reporting requirements, especially if assets or ownership interests change hands. Key forms include IRS Form 8594 (for asset sales), Form 4797 (for depreciation recapture), and Schedule D (for capital gains).
State and local tax filings may also apply depending on where your business operates and where the buyer is located. Late or inaccurate filings can lead to penalties, delays in closing, or future audits.
Professional Insight
Don’t rely solely on the buyer’s legal team. Have your own tax advisor review deal documents to ensure reporting is accurate and all post-sale compliance steps are handled on time.
Consult an Expert Transaction Advisor
There are major tax implications when selling a business. Business owners must consider depreciation recapture, state income taxes, and how the deal structure affects overall liability. Asset vs stock sales, installment sales, and allocations all influence how much you owe and when you pay capital gains tax.
Strategic planning helps sellers reduce or defer capital gains tax on the sale and avoid costly mistakes. Working with a CPA who is experienced in business transactions ensures proper documentation, tax-efficient deal terms, and full compliance with IRS rules for legal and tax purposes. Professional guidance is essential for aligning your exit strategy with your long-term financial and tax goals.
