Tax Implications of Selling a Small Business

Selling a business: tax structure overview

Asset sale (the business sells its assets):

• Each asset is sold individually, and the gain/loss on each is calculated separately
• Asset classes under IRC 1060 (residual method allocation):
  • Class I: Cash and cash equivalents
  • Class II: Actively traded securities
  • Class III: Accounts receivable, mortgages, credit card receivables
  • Class IV: Inventory
  • Class V: All other tangible and intangible assets (equipment, furniture, vehicles)
  • Class VI: Section 197 intangibles (except goodwill and going concern value)
  • Class VII: Goodwill and going concern value (the residual)
• Tax character by asset class:
  • Inventory: ordinary income
  • Accounts receivable (cash-basis seller): ordinary income (never reported as income before)
  • Equipment (depreciated): ordinary income to the extent of depreciation recapture (IRC 1245), capital gain above original cost
  • Real property: unrecaptured Section 1250 gain at 25%, remaining gain at capital gains rates
  • Goodwill: capital gain (long-term if business held > 1 year)
  • Non-compete agreements: ordinary income to the seller, amortizable to the buyer

Stock/interest sale (owner sells their shares or membership interest):

• Seller recognizes gain or loss on the stock/interest
• Character: capital gain (long-term if held > 1 year)
• No asset-by-asset allocation
• No depreciation recapture (that stays inside the entity)
• Buyer gets a cost basis in the stock, NOT in the underlying assets (no stepped-up depreciation)
• For S-Corps and partnerships: buyer may elect a Section 338(h)(10) election (S-Corp) or IRC 754 election (partnership) to get a stepped-up basis, but the seller is treated as if it were an asset sale for tax purposes

Form 8594 (Asset Acquisition Statement):

• Required for asset sales
• Both buyer and seller file, must report consistent allocations
• Failing to agree on allocation = IRS can determine it for both parties

Installment sale (IRC 453):

• Spreads the gain recognition over the payment period
• Each payment is allocated between return of basis, gain, and interest
• Cannot use for inventory or publicly traded stock
• Useful for managing the tax bracket: a $500,000 gain received all at once hits the top bracket; spread over 5 years, each year’s gain may fall in a lower bracket