Taxes When You Sell a Business

Selling a business is often a once-in-a-lifetime event, and it can also generate the largest tax bill most business owners will ever face. The structure of the deal — asset sale versus stock sale, allocation of purchase price, installment sale versus lump sum — can mean the difference of hundreds of thousands of dollars in taxes, so understanding the rules well before you negotiate is essential.

The most fundamental decision in a business sale is whether it's structured as an asset sale or a stock sale. In an asset sale, the buyer purchases the individual assets and liabilities of the business rather than the ownership interest. Sellers generally prefer stock sales (or membership interest sales for LLCs), because the entire gain is taxed as a capital gain — eligible for favorable long-term rates if the interest has been held for more than a year. Buyers generally prefer asset sales, because they can step up the tax basis of acquired assets to fair market value, allowing them to depreciate those assets fresh — creating future tax deductions. This tension between buyer and seller preference is one of the main negotiating points in deals.

If the sale is structured as an asset sale (which is the more common structure for small business transactions), different types of assets are taxed differently. The allocation of the purchase price among asset classes — inventory, equipment, customer lists, goodwill, covenants not to compete — determines the tax treatment of each dollar received. Equipment that has been depreciated may trigger depreciation recapture taxed as ordinary income (up to 25% for real property, at your marginal rate for personal property). Covenants not to compete and consulting agreements are taxed as ordinary income. Customer lists and goodwill — often the largest component of a business sale — are taxed as capital gains if they belong to the business. Both buyer and seller must report the agreed asset allocation to the IRS on Form 8594.

If you've owned the business through a C corporation, the tax treatment is particularly painful in an asset sale: the corporation pays corporate income tax on the gain from selling the assets, and then when the remaining proceeds are distributed to you as a shareholder, you pay personal capital gains tax on the distribution — a form of double taxation. S corporation and LLC sellers generally only pay a single level of tax (though the allocation among asset types still matters). For C corporation stock sales, sellers pay capital gains tax once, while buyers get no step-up in the underlying assets — which is why C corporations can be hard to sell at the same price as an equivalent flow-through business.

If your business qualifies as a C corporation that has been a Qualified Small Business (QSBS) since its founding and you've held the stock for more than five years, you may be eligible to exclude up to $10 million of gain (or 10 times your cost basis) from federal income tax entirely under Section 1202. This exclusion can make the QSBS exclusion the most valuable tax provision available to successful startup founders. For founders who don't qualify for QSBS, an installment sale — receiving the purchase price over several years rather than all at once — can spread the gain over multiple years and potentially keep you in lower tax brackets each year.