How Capital Gains Work When Selling a Business

Selling a business involves complex tax considerations, especially regarding capital gains. Sellers must understand these implications to anticipate tax obligations. A capital gains tax is generally triggered on the profit from selling business assets or ownership interests. This tax applies to the difference between the sale price and the asset’s adjusted cost basis.

Understanding Capital Gains on Business Sales

A capital gain occurs when a capital asset sells for more than its adjusted basis. For a business, capital assets typically include property held for investment or personal use. However, inventory or property held for sale to customers are excluded, generating ordinary income or loss upon sale.

Assets like real estate and depreciable property used in the business can receive capital gain treatment under specific tax rules, such as Section 1231, if held for over one year. While inventory sales result in ordinary income, selling the business itself, which includes various assets, often leads to capital gains. Classifying each asset sold is crucial, as it determines whether the gain or loss is capital or ordinary.

Asset Versus Stock Sales

Two primary structures exist when selling a business: an asset sale or a stock sale. Each has distinct capital gains tax implications. In an asset sale, the seller transfers specific assets like equipment, intellectual property, or real estate. The buyer selects the assets, and liabilities generally remain with the seller.

For the seller, capital gains are recognized on each individual asset’s sale, with tax treatment depending on its classification. This can result in a mix of ordinary income and capital gains. Buyers often prefer asset sales because they receive a “stepped-up basis” in the acquired assets, allowing depreciation based on the purchase price.

Conversely, in a stock sale, shareholders transfer their ownership shares to the buyer. The buyer acquires the entire company, including all assets and liabilities. Selling shareholders recognize capital gains on their stock, generally a capital asset.

A key distinction for C corporations in a stock sale is “double taxation.” The corporation pays tax on its income, and then shareholders pay capital gains tax on their stock sale proceeds. S corporations avoid this, as income and losses pass directly to shareholders. Buyers in a stock sale receive a “carryover basis,” inheriting the seller’s original asset basis, which may limit new depreciation.

Identifying Business Assets and Their Basis

A business sale involves various assets, each with an adjusted basis impacting capital gain calculations. Assets include tangible items like machinery and real estate, and intangible assets such as goodwill and patents. Inventory is also a common asset.

An asset’s adjusted basis is its original cost, plus improvements, minus depreciation. For example, if equipment was purchased and depreciation claimed, its adjusted basis decreases. This basis directly influences the gain or loss realized upon sale.

In an asset sale, the total sale price must be allocated among all transferred assets. This allocation is reported to the IRS on Form 8594, “Asset Acquisition Statement Under Section 1060.” Both buyer and seller must file this form and agree on the allocation for consistent tax reporting. The IRS specifies asset classes for this allocation, from cash (Class I) to goodwill (Class VII). This allocation impacts the seller’s capital gain calculation and the buyer’s depreciation schedule.

Calculating Capital Gains and Applicable Rates

Capital gains from a business sale are calculated as the sale price minus the asset’s adjusted basis. For example, selling an asset with a $400,000 basis for $800,000 results in a $400,000 capital gain. This gain is subject to federal income tax, with rates depending on whether it’s short-term or long-term.

A short-term capital gain, from an asset held one year or less, is taxed at ordinary income rates (10% to 37%). A long-term capital gain, from an asset held over one year, benefits from lower, preferential tax rates.

For individuals, federal long-term capital gains tax rates are generally 0%, 15%, or 20%, based on taxable income and filing status. In 2025, individual filers with taxable income up to $48,350 generally pay 0%. The rate increases to 15% for income between $48,351 and $533,400, and to 20% for income above $533,400. Corporations generally pay capital gains at the ordinary corporate income tax rate of 21%.

Special Capital Gains Rules

Several tax rules can modify capital gains from a business sale. Depreciation recapture applies to gains on depreciated assets. When Section 1245 property, like equipment, is sold at a gain, previously claimed depreciation is “recaptured” and taxed as ordinary income up to the gain amount. This can result in higher ordinary income rates instead of capital gains rates.

For real property, Section 1250 recapture applies. If accelerated depreciation was used, “additional depreciation” exceeding straight-line is recaptured as ordinary income. Even with straight-line depreciation, a portion of the gain up to total accumulated depreciation, called “unrecaptured Section 1250 gain,” is taxed at a maximum 25% rate. This 25% rate applies before standard long-term capital gains rates for any remaining gain.

The Section 1202 Qualified Small Business Stock (QSBS) exclusion allows non-corporate shareholders to exclude a significant portion, or all, of capital gain from eligible stock sales. To qualify, the stock must be from a domestic C corporation with gross assets not exceeding $50 million at issuance, and at least 80% of its assets must be used in a qualified active business. The stock must also be held for at least five years, with an exclusion cap generally the greater of $10 million or 10 times the stock’s adjusted basis.

The Net Investment Income Tax (NIIT) is an additional 3.8% tax on certain capital gains from a business sale. This tax applies to individuals, estates, and trusts with incomes above specific thresholds, affecting capital gains considered “net investment income.” An installment sale allows sellers to defer capital gain recognition. With at least one payment received after the sale year, sellers report gain gradually as payments arrive, rather than all at once. This deferral can help manage taxable income and potentially keep the seller in a lower tax bracket. However, any depreciation recapture must still be recognized in the year of sale, even in an installment sale.