Tax Implications of Selling Your Small Business

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 with depreciation recapture (IRC 1250): 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
• 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 the owner held the stock for 5+ years: up to $10 million (or 10x basis) of gain is EXCLUDED from federal tax
• The C-Corp must be an active business with gross assets under $50 million at the time of 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)