Tax Implications of Selling Your Small Business: Asset Sale vs Stock Sale

Sale structure comparison:

Asset sale (buyer purchases individual assets):

• The buyer acquires specific assets: equipment, inventory, customer lists, trade name, goodwill, noncompete agreement.
• The purchase price is allocated across IRC 1060 asset classes (Class I through VII).
• Seller’s tax treatment by asset class:
  • Equipment (Class V): ordinary income on depreciation recapture (IRC 1245), capital gain on any amount above original cost
  • Inventory (Class IV): ordinary income (not capital gain)
  • Accounts receivable (Class III): ordinary income on collection above basis
  • Covenant not to compete (Class VI): ordinary income (AND self-employment tax for sole proprietors)
  • Goodwill (Class VII): long-term capital gain (15-20%)
  • Trade name (Class VI): long-term capital gain
• Buyer’s benefit: the buyer gets a stepped-up basis in all assets and can depreciate the purchase price (equipment over 5-7 years, goodwill over 15 years under IRC 197).
• The buyer almost always prefers an asset sale.

Stock sale (buyer purchases ownership interest):

• The buyer acquires the entity’s stock or membership interests.
• Seller’s tax treatment: the entire gain is long-term capital gain (15-20%) if the stock has been held for more than 1 year.
• No depreciation recapture at the seller level (recapture stays inside the entity).
• No self-employment tax on any portion.
• Buyer’s disadvantage: the buyer inherits the entity’s existing asset basis (no step-up) and cannot depreciate the purchase price.
• The seller almost always prefers a stock sale.

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.

Purchase price allocation (Form 8594): Both buyer and seller file Form 8594 reporting the allocation. The allocations must match. Disagreements over allocation are common (the seller wants more allocated to goodwill for capital gains treatment; the buyer wants more allocated to equipment for faster depreciation).