Do You Pay Tax When You Sell a Business?

When you sell a business, the profit is subject to taxation. Your tax liability depends on the nature of the business and the sale itself. The process involves calculating your gain, understanding how the business’s legal structure affects taxes, and knowing the difference between an asset and a stock sale.

Calculating the Total Taxable Gain

To determine your tax obligation, you must calculate the gain or loss from the sale using a direct formula: the final sale price minus your adjusted basis in the business. A gain occurs when you sell the business for more than its adjusted basis, and this profit is what the Internal Revenue Service (IRS) considers taxable income. The tax rate applied to this gain depends on factors like how long you owned the business.

The sale price includes more than just cash. It is the total of all cash, the fair market value of any property or services received, and any business liabilities the buyer assumes as part of the deal. For instance, if a buyer pays you $500,000 and also takes over a $100,000 business loan, the total sale price is $600,000.

Your adjusted basis represents your total investment in the business for tax purposes. It starts with the initial cost to acquire or start the business, then is increased by additional capital investments and decreased by deductions you have taken, such as for depreciation. For example, if you bought equipment for $50,000, invested $5,000 in upgrades, and claimed $10,000 in depreciation, its adjusted basis would be $45,000.

How Business Structure Impacts Taxation

The legal structure of your business is a primary determinant of how the sale is taxed. In a sole proprietorship, the business and owner are a single legal entity. The sale is therefore treated as a sale of its individual assets, with the owner reporting all gains or losses on their personal tax return.

For a partnership or a multi-member Limited Liability Company (LLC), the sale can be treated as the individual partners selling their respective interests, resulting in a capital gain or loss for each partner. Alternatively, the partnership can sell its underlying assets, with the gain or loss passed through to the partners. The tax treatment can be affected by certain assets like inventory or unrealized receivables.

An S Corporation sale can be structured as either a stock or asset sale. In either case, the gain or loss from the sale is passed through to the shareholders, who report it on their personal tax returns. This structure avoids tax at the corporate level.

C Corporations face a challenge known as double taxation in an asset sale. The corporation first pays income tax on the gain from selling its assets. When the remaining proceeds are distributed to shareholders, they pay tax again on that income. A stock sale avoids this, as only the shareholders pay capital gains tax on their profit.

Asset Sale vs Stock Sale Tax Consequences

A stock sale is the transfer of ownership shares to the buyer. This transaction results in a long-term capital gain for the seller if the stock was held for more than one year. Long-term capital gains are taxed at lower rates than ordinary income.

An asset sale involves selling the business’s individual assets and liabilities rather than its ownership shares. This structure requires the seller to categorize the gain or loss from the sale across different asset types. Some assets like goodwill generate capital gains, while others like inventory generate ordinary income, which is often taxed at higher rates.

A consequence of an asset sale is depreciation recapture. When a depreciated asset is sold for more than its adjusted basis, the IRS recaptures the previous tax benefit by taxing a portion of the gain as ordinary income. For personal property like equipment, the gain is taxed as ordinary income up to the amount of depreciation claimed.

Buyers often prefer asset sales because they can “step-up” the basis of the assets to their fair market value. This higher basis allows the buyer to claim larger depreciation deductions in the future. These competing interests make the choice between an asset and stock sale a common point of negotiation.

Allocating the Purchase Price in an Asset Sale

In an asset sale, the buyer and seller must agree on an allocation of the purchase price among the various assets being transferred. This agreement is reported on IRS Form 8594, Asset Acquisition Statement, which both parties must file with their tax returns. The allocations reported by the buyer and seller must be identical.

The IRS requires assets to be categorized into seven classes, with the purchase price allocated in a specific order:

• Class I: Cash and bank deposits.
• Class II: Actively traded personal property and certificates of deposit.
• Class III: Accounts receivable.
• Class IV: Inventory.
• Class V: Furniture, fixtures, and equipment.
• Class VI: Intangible assets like patents or non-compete agreements.
• Class VII: Goodwill and going-concern value.

The amount allocated to Class VII is what remains of the purchase price after allocating to the first six classes. Gain attributed to goodwill is taxed at more favorable long-term capital gains rates.

Reporting the Business Sale on Your Tax Return

You must report the business sale to the IRS on specific tax forms. The required forms depend on the assets sold and the structure of the deal. This final step ensures you correctly report your tax liability from the sale.

The sale of capital assets, such as corporate stock or goodwill, is reported on Schedule D (Capital Gains and Losses). This form is filed with your personal Form 1040 tax return and is used to differentiate between short-term and long-term capital gains.

The sale of business property, particularly assets subject to depreciation, is reported on Form 4797, Sales of Business Property. This form is used to calculate any ordinary income from depreciation recapture. The results from Form 4797 are then transferred to other parts of your tax return.

If you receive payments over multiple years in an installment sale, you must also file Form 6252, Installment Sale Income. This form is filed for each year you receive a payment to report the taxable portion of the gain for that year.