Tax Implications of Selling Your Small Business

By Yarik Yarosh, CPA ·September 5, 2026 ·Updated September 23, 2026 ·9 min read

Written by Yarik Yarosh, CPA (US & Canada) September 5, 2026 · FL CPA license AC61704 · CPA Ontario

Selling a business is the largest taxable event most small business owners will ever face. The tax treatment depends on whether the sale is structured as an asset sale or a stock/membership interest sale, how the purchase price is allocated among the business assets, and whether the seller has depreciation recapture, ordinary income, or capital gains. Structuring the sale correctly can save the seller $50,000-$200,000+ in taxes on a $1 million sale.

✓Key takeaway

Two ways to sell a business:

Asset sale (most common for small businesses):

The buyer purchases the individual assets of the business (equipment, inventory, customer list, trade name, goodwill)
The purchase price is allocated among the assets using Form 8594 (Asset Acquisition Statement)
Each asset class has a different tax rate for the seller:
Inventory: ordinary income (up to 37%)
Equipment with depreciation recapture (IRC 1245): ordinary income (up to 37%)
Real property (unrecaptured IRC 1250 gain): up to 25%
Goodwill and going concern value: long-term capital gains (15-20%)
Personal goodwill (attributable to the owner’s reputation and relationships): capital gain, and for S-Corp owners this is particularly valuable because personal goodwill is owned by the individual (not the S-Corp), avoiding double taxation
Covenant not to compete: ordinary income
Consulting agreement: ordinary income + SE tax
The buyer benefits from an asset sale because they get a stepped-up basis in the assets (higher depreciation deductions)

Stock/membership interest sale:

The buyer purchases the owner’s stock (C-Corp or S-Corp) or LLC membership interest
The seller reports one capital gain: sale price minus basis in the stock/interest (for an LLC interest taxed as a partnership, the part tied to depreciation recapture is ordinary income)
Generally long-term capital gains rate (15-20%) if held over 1 year
The buyer does NOT get a stepped-up basis in the underlying assets (unless a Section 338(h)(10) election is made for S-Corps)
Simpler for the seller; less favorable for the buyer
For S-Corps, the gain flows through to the shareholder’s personal return

IRC 338(h)(10) election: allows a stock sale to be treated as an asset sale for tax purposes. Both parties must agree. The buyer gets the asset sale tax benefits (step-up, depreciation). The seller is taxed as if they sold assets (depreciation recapture, ordinary income on certain allocations). This is a compromise structure often used in M&A.

The purchase price is allocated across seven asset classes under IRC 1060 (Class I: cash, Class II: actively traded securities, Class III: accounts receivable, Class IV: inventory, Class V: equipment and furniture, Class VI: intangibles and covenants, Class VII: goodwill and going-concern value). Both buyer and seller file Form 8594 reporting the allocation, and the allocations must match.

Qualified Small Business Stock (QSBS, IRC 1202):

If the business is a C-Corp whose stock was acquired at original issuance after September 27, 2010 and on or before July 4, 2025, and the owner held the stock for more than 5 years: up to $10 million (or 10x basis) of gain is EXCLUDED from federal tax. For stock acquired after July 4, 2025, the exclusion is 50% after 3 years, 75% after 4 years and 100% after 5 years, capped at $15 million (or 10x basis)
The C-Corp must be in a qualified trade or business with gross assets of no more than $50 million ($75 million for stock issued after July 4, 2025) at all times before and immediately after the issuance
This exclusion can eliminate ALL federal tax on the sale for qualifying businesses
QSBS does not apply to S-Corps, partnerships, or LLCs

Installment sale (IRC 453):

If the buyer pays over time (seller financing), the seller can report gain as payments are received
Spreads the capital gains tax over multiple years
Can keep the seller in a lower bracket in each year
Interest on the installment note is ordinary income to the seller
Not available for inventory or depreciation recapture (those are recognized in Year 1 regardless)

What does the tax look like on a $1 million business sale?

Hypothetical example

Round numbers. An S-Corp owner sells a service business (no inventory, no real property) for $1,000,000. The business has been operated for 10 years. Owner’s basis in S-Corp stock: $100,000. The NIIT lines assume the owner was passive in the business; an owner who actively ran it may owe little or none of the 3.8% in either structure.

Scenario 1: Stock sale.

Sale price: $1,000,000
Basis in stock: $100,000
Long-term capital gain: $900,000
Federal capital gains tax (20%): $180,000
NIIT (3.8%): $34,200
State tax (varies): approximately $45,000-$90,000 depending on state
Federal tax: $214,200

Scenario 2: Asset sale (buyer’s preference). Purchase price allocated per Form 8594:

Equipment (fair market value, fully depreciated): $50,000 (depreciation recapture, ordinary income)
Customer list/relationships: $150,000 (amortizable intangible, capital gain to seller)
Trade name: $100,000 (amortizable intangible, capital gain)
Goodwill: $600,000 (capital gain)
Covenant not to compete: $50,000 (ordinary income)
Consulting agreement (1 year): $50,000 (ordinary income + SE tax)

Tax calculation:

Equipment recapture: $50,000 x 37% = $18,500
Covenant not to compete: $50,000 x 37% = $18,500
Consulting agreement: $50,000 x 37% (income tax) + $50,000 x 15.3% (SE tax) = $26,150
Capital gains (customer list + trade name + goodwill): $850,000 x 20% = $170,000
NIIT on capital gains: $850,000 x 3.8% = $32,300
Federal tax: $265,450

The asset sale costs $51,250 more in federal tax because ordinary income items (equipment recapture, covenant not to compete, consulting agreement) are taxed at ordinary rates (up to 37%) instead of capital gains rates (20%).

Negotiation leverage: The allocation is negotiated between buyer and seller. The buyer wants more allocated to depreciable/amortizable assets (faster deductions). The seller wants more allocated to goodwill (capital gains rate). The final allocation must be reported consistently by both parties on Form 8594.

Common negotiation: reduce the consulting agreement and covenant not to compete (ordinary income to seller) and increase goodwill (capital gains to seller). The total price stays the same; the allocation shifts the tax burden. As an example, shifting $100,000 from a covenant not to compete to goodwill saves the seller approximately $17,000 in income tax (the spread between 37% and 20% rates) on that single reallocation. A covenant payment generally isn’t self-employment income, so there’s usually no SE tax to save.

Installment sale option: If the buyer pays $200,000 at closing and $200,000/year for 4 years (with 5% interest):

Year 1 capital gain: $200,000 x ($900,000 / $1,000,000) = $180,000
Tax on Year 1 gain: $180,000 x 23.8% = $42,840
Each subsequent year: same calculation
Interest income: approximately $32,000 over 4 years (ordinary income)
The installment method keeps the seller in the 20% capital gains bracket each year (instead of bunching $900,000 into one year, which could trigger the highest brackets)

Tax planning before the sale:

Maximize retirement contributions in the sale year (Solo 401(k), defined benefit plan) to offset ordinary income portions
Time the sale to minimize state tax (some sellers relocate to no-income-tax states before selling; states may still tax the gain if the business operated in their state)
Consider a charitable remainder trust (CRT) for a portion of the sale proceeds to defer capital gains
If the business qualifies for QSBS (a C-Corp that met the gross assets test when the stock was issued: $50M, or $75M for stock issued after July 4, 2025): up to $10 million excluded from federal tax ($15 million for stock acquired after July 4, 2025), or 10x basis if greater

Illustrative numbers only, not a real client and not advice for your facts.

How does depreciation recapture work when I sell business assets?

When you sell a depreciable business asset for more than its adjusted basis, the IRS recharacterizes a portion of the gain as ordinary income rather than capital gain. For personal property (equipment, vehicles, furniture), IRC 1245 recaptures all prior depreciation as ordinary income up to the amount of gain. For real property, IRC 1250 recaptures only the excess of accelerated depreciation over straight-line as ordinary income, though “unrecaptured Section 1250 gain” is taxed at a maximum 25% rate. This means the first dollars of gain on a business asset sale are often taxed at higher ordinary income rates, not the preferential long-term capital gains rates.

Can I offset capital gains with capital losses from other investments?

Yes. Capital losses first offset capital gains of the same type (short-term losses against short-term gains, long-term against long-term), then any remaining net loss offsets gains of the other type. If net capital losses exceed capital gains, you can deduct up to $3,000 of the excess against ordinary income ($1,500 if married filing separately). Unused losses carry forward indefinitely to future tax years, maintaining their character (short-term or long-term). The wash sale rule (IRC 1091) prevents you from claiming a loss if you repurchase substantially identical securities within 30 days before or after the sale. Tax-loss harvesting before year-end is a common strategy to realize losses that offset gains elsewhere in the portfolio.

Related guides:

How is a C-Corp stock sale taxed if it qualifies for QSBS?

Qualifying section 1202 stock lets you exclude part or all of the gain, and any taxable part of that gain is taxed at a maximum 28%. For stock acquired after July 4, 2025, the exclusion is 50% after three years, 75% after four and 100% after five or more. Stock acquired on or before July 4, 2025 keeps the old rule: it has to be held more than five years.

The exclusion is capped per company at $15 million for stock acquired after July 4, 2025 ($10 million for earlier stock), or 10 times your basis if that’s higher. The gross assets test is now $75 million, measured at all times before and immediately after the stock is issued. You have to acquire the stock at original issue from a domestic C corporation, and many service businesses can’t qualify at all, including health, law, consulting, accounting and financial services. If 1202 doesn’t apply, stock held more than one year gets the normal 0%, 15% or 20% rates.

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Cite this page

Yarik Yarosh, CPA. "Tax Implications of Selling Your Small Business." Blue Cloud CPA, September 5, 2026, updated September 23, 2026. https://bluecloudcpa.com/guides/small-business-selling-business-tax-implications

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.