How Are Capital Gains on Selling a Business Taxed?

When a business is sold for a profit, that gain is subject to federal taxation. Understanding the tax implications is part of the selling process, as the structure of the sale and the nature of the assets involved directly influence the tax owed. The initial steps are determining the sale structure and calculating the total gain.

Determining the Type of Business Sale

The first step is to determine the transaction’s structure, which falls into two categories: a stock sale or an asset sale. In a stock sale, the owner sells their ownership interest in the business entity itself, such as corporate stock or LLC membership units. The buyer acquires the entire legal entity, including all of its assets and liabilities.

A stock sale results in a single transaction for the seller, generating a capital gain or loss. This gain is calculated on the difference between the sale price and the seller’s basis in their stock. The advantage for the seller is that the entire gain is treated as a capital gain, which is often taxed at lower rates than ordinary income.

An asset sale, by contrast, involves the business entity selling its individual assets to the buyer. The buyer can be selective, purchasing specific assets while leaving most liabilities with the seller. This structure is often preferred by buyers because it allows them to acquire assets with a “stepped-up” basis equal to the current fair market value, which can lead to greater depreciation deductions and protects them from inheriting the seller’s liabilities.

For the seller, the tax consequences of an asset sale are more complicated, as it is treated as the separate sale of each individual asset. The total sale price must be allocated among the various assets being sold. This allocation determines the character of the gain or loss for each asset, resulting in a mixture of tax treatments. Some gains may be taxed at lower long-term capital gains rates, while others, like those from inventory or depreciation recapture, are taxed at higher ordinary income rates.

Calculating the Total Gain or Loss

Regardless of the transaction type, the seller must calculate the total gain or loss. The calculation follows a basic formula: the amount realized from the sale minus the adjusted basis of what was sold equals the taxable gain or loss. This figure represents the total profit that will be subject to tax.

The amount realized is the total value received by the seller. This includes cash, the fair market value (FMV) of any property or services received, and the value of any of the seller’s liabilities that the buyer assumes. For example, if a buyer pays $1 million in cash and also assumes a $200,000 business loan, the seller’s amount realized is $1.2 million.

The adjusted basis is the seller’s investment in the property for tax purposes. For a stock sale, the basis is the original purchase price of the stock. For an asset sale, each asset has its own basis, which is its original cost.

This initial basis is increased by costs like capital improvements and decreased by deductions like depreciation. For example, if a business owner bought a machine for $50,000 and has claimed $20,000 in depreciation deductions, its adjusted basis would be $30,000.

Allocating the Purchase Price in an Asset Sale

In an asset sale, the allocation of the total purchase price among the various assets being transferred is a key step. This allocation determines the amount of gain or loss for each specific asset, which in turn dictates whether that gain is taxed as ordinary income or as a capital gain. Both the buyer and seller must agree on this allocation.

The Internal Revenue Code requires that the allocation follow a specific seven-class system, known as the residual method. The total purchase price is allocated sequentially to each class of assets up to the fair market value of the assets in that class. Any remaining amount after allocating to the first six classes is assigned to Class VII, which is goodwill and going concern value.

The asset classes are organized from most liquid to least liquid. The gain from selling assets in the first four classes is taxed as ordinary income.

• Class I: Cash and general deposit accounts.
• Class II: Certificates of deposit and government securities.
• Class III: Accounts receivable and other debt instruments.
• Class IV: Inventory held for sale to customers in the ordinary course of business.
• Class V: All assets that do not fit into the other classes, such as machinery, equipment, buildings, and land. Gain attributable to prior depreciation deductions on certain assets, known as depreciation recapture, is taxed at ordinary income rates, while any gain above the original cost is treated as a capital gain.
• Class VI: Section 197 intangibles, except for goodwill and going concern value, such as covenants not to compete and customer lists.
• Class VII: Goodwill and going concern value, the gain on which is taxed as a capital gain.

Special Tax Provisions and Exclusions

Specific provisions in the tax code can alter a seller’s final tax liability. These rules can provide benefits such as excluding gain from taxation entirely or deferring the recognition of that gain over several years.

One provision is the exclusion for Qualified Small Business Stock (QSBS) under Internal Revenue Code Section 1202. This rule allows a non-corporate taxpayer who has held QSBS for more than five years to potentially exclude 100% of the capital gain from the sale. The exclusion is limited to the greater of $10 million or 10 times the taxpayer’s adjusted basis in the stock. To qualify, the stock must be from a domestic C corporation that had gross assets of $50 million or less when the stock was issued, and the corporation must meet certain active business requirements.

Another provision is the installment sale method, governed by Section 453. This method applies when a seller receives at least one payment for their business after the tax year of the sale. It allows the seller to defer tax by recognizing a portion of the gain each year as payments are received. The installment method spreads the tax liability over the payment period, which can be beneficial for managing cash flow. However, this method cannot be used for all assets, as gain from the sale of inventory and gains from depreciation recapture must be reported in the year of the sale.

Reporting the Business Sale to the IRS

The final step is to report the transaction to the IRS on the appropriate tax forms. The specific forms required depend on the structure of the sale and the types of assets sold. Accurate and timely reporting is necessary to comply with federal tax law.

For an asset sale, both the buyer and the seller must file Form 8594, Asset Acquisition Statement. This form details the agreed-upon allocation of the purchase price across the seven asset classes. It is filed with each party’s federal income tax return for the year in which the sale occurred.

The gains and losses for individual assets are reported on Form 4797, Sales of Business Property. This form is used to separate gains treated as ordinary income from those that qualify as capital gains. The net capital gain or loss from Form 4797 is then transferred to Schedule D, Capital Gains and Losses, which is filed with the seller’s income tax return.