Sale of a Disregarded Entity: An Asset Sale for Tax Purposes

When a business owner sells their company, the structure of the sale has tax consequences. For the owner of a single-member limited liability company (SMLLC), this is especially true. The Internal Revenue Service (IRS) by default treats an SMLLC as a “disregarded entity,” meaning for federal tax purposes, the entity is not considered separate from its owner. If the owner is an individual, the LLC’s activities are reported on their personal tax return as if it were a sole proprietorship.

This classification is central when the entire ownership interest in the LLC is sold. While legally the owner is selling a membership interest, the IRS treats the transaction as if the business sold all of its individual assets directly to the buyer. This asset-sale treatment recasts the single transaction into a collection of smaller sales, each with its own tax attributes.

Tax Implications for the Seller

The treatment of the sale as an asset sale requires the seller to perform a detailed allocation of the total purchase price. The price paid by the buyer must be distributed among all business assets being transferred, including tangible items like equipment and real estate, and intangible assets such as customer lists and goodwill. This allocation should reflect the fair market value of each asset at the time of the sale.

Once the purchase price is allocated, the seller must calculate the gain or loss for each asset individually. This is done by subtracting the asset’s tax basis (its original cost minus any depreciation taken) from the portion of the sale price allocated to it. The character of that income—whether it is ordinary or capital—depends on the type of asset sold.

The distinction between ordinary income and capital gain is important because they are taxed at different rates. The sale of assets like inventory or accounts receivable will generate ordinary income, taxed at the seller’s standard income tax rates. In contrast, the sale of capital assets held for more than one year, such as equipment or goodwill, results in a long-term capital gain, which is taxed at lower preferential rates.

For example, imagine an LLC is sold for $500,000. The seller might allocate $100,000 to equipment with a basis of $40,000, $50,000 to inventory with a basis of $30,000, and $350,000 to goodwill with a basis of $0. The $60,000 gain on the equipment and the $350,000 gain on goodwill would be capital gains, while the $20,000 gain on inventory would be ordinary income.

Tax Implications for the Buyer

The buyer in the sale of a disregarded entity also experiences the transaction as a purchase of assets. This provides a tax advantage through what is known as a “stepped-up basis.” The buyer allocates the total purchase price among the various assets acquired, and this allocated amount becomes the new tax basis for each asset. This basis is “stepped up” to the current fair market value, rather than the seller’s lower, often depreciated, basis.

This higher basis is valuable because it creates larger future tax deductions. For tangible assets like machinery or buildings, the buyer can begin claiming depreciation deductions based on the new, higher value. This reduces the buyer’s taxable income in the years following the acquisition.

An advantage for the buyer also relates to intangible assets. When a portion of the purchase price is allocated to assets like goodwill, customer lists, or a non-compete agreement, the buyer can amortize these costs. Under Section 197 of the Internal Revenue Code, the cost of these acquired intangibles can be deducted ratably over a 15-year period, allowing the buyer to receive a tax deduction for an asset that is otherwise not depreciable.

Reporting the Transaction

Properly reporting the sale is a requirement for both the buyer and the seller. The primary tool for this is IRS Form 8594, Asset Acquisition Statement. On this form, both parties document the agreed-upon allocation of the purchase price across distinct asset classes defined by the IRS.

Both the buyer and the seller must attach a completed Form 8594 to their federal income tax returns for the tax year in which the sale occurred. The allocations reported by both parties on their respective forms must be identical. Any discrepancy can trigger an IRS inquiry, so it is common for the final allocation to be negotiated and included as part of the purchase agreement.

For the seller, the results from the asset sale are reported on other tax forms. Gains or losses from the sale of depreciable business property are detailed on Form 4797, Sales of Business Property. This form helps determine how much of the gain is treated as ordinary income due to depreciation recapture and how much is capital gain, with the net capital gain then transferred to Schedule D, Capital Gains and Losses.