Tax Treatment for the Sale of a Disregarded Entity

When a business is structured as a “disregarded entity,” its legal form is ignored for federal income tax purposes. The most common example is a single-member limited liability company (SMLLC), which the Internal Revenue Service (IRS) does not see as an entity separate from its owner. Consequently, all business income, deductions, and assets are reported on the owner’s personal tax return.

This status impacts how the business is treated when sold. A sale of a 100% ownership interest is not considered a sale of an equity stake, like corporate stock. Instead, the transaction is treated as a direct sale of the business’s underlying assets, which dictates the tax consequences for both the buyer and seller.

Seller’s Tax Consequences

From the seller’s perspective, the transaction is treated as if they personally sold each asset of the business. The first step is to calculate the total consideration received, which includes cash, the fair market value of any property or services, and any business liabilities the buyer assumes.

Once the total consideration is determined, it must be allocated across all tangible and intangible assets using the “residual method.” This allocation must be agreed upon by both the buyer and the seller. The assets are categorized into seven classes and the price is assigned based on their type and value.

The seven asset classes are organized in a specific hierarchy:

• Class I: Cash and general deposit accounts.
• Class II: Certificates of deposit, U.S. government securities, and other actively traded personal property.
• Class III: Accounts receivable and certain debt instruments.
• Class IV: Inventory held for sale to customers.
• Class V: All assets that don’t fit into other classes, such as machinery, equipment, and buildings.
• Class VI: Section 197 intangibles, except for goodwill and going-concern value.
• Class VII: Goodwill and going-concern value.

After allocating the sales price, the seller must calculate the gain or loss for each asset by subtracting its adjusted tax basis from the allocated sales price. The adjusted basis is the asset’s original cost minus any depreciation deductions taken. The tax treatment of the gain or loss depends on the nature of the asset sold.

The sale of inventory or accounts receivable generates ordinary income or loss. The sale of assets like machinery and equipment, known as Section 1231 assets, is more complex. While the gain may qualify for lower long-term capital gains rates, a rule known as “depreciation recapture” comes into play. Under Section 1245, any gain on these assets from prior depreciation deductions is taxed as ordinary income. Any remaining gain is treated as a capital gain, and gain allocated to goodwill is also taxed as a long-term capital gain, assuming the business was held for more than one year.

Buyer’s Tax Consequences

For the party acquiring the disregarded entity, the transaction is also viewed as a purchase of individual assets. This perspective provides tax advantages, primarily through the establishment of a new tax basis for each acquired asset. This allocation gives the buyer a “stepped-up basis” in each asset equal to its portion of the purchase price.

This means the buyer’s new basis in the assets is their current fair market value, not the seller’s old, often heavily depreciated, basis. The primary advantage of this stepped-up basis is its impact on future tax deductions. The buyer can claim depreciation or amortization deductions on the newly acquired assets based on their higher purchase price, which reduces the buyer’s taxable income in subsequent years.

This treatment is valuable for intangible assets, specifically goodwill. The amount of the purchase price allocated to goodwill can be amortized, or deducted, over a 15-year period. This allows the buyer to receive a tax deduction for a portion of the premium paid for the business’s reputation and customer base.

Reporting the Transaction

Both the buyer and the seller must report the sale to the IRS to ensure consistency. The central document for this is Form 8594, Asset Acquisition Statement Under Section 1060. Both parties must attach a completed Form 8594 to their federal income tax returns for the tax year in which the sale occurred. The form documents the allocation of the purchase price across the seven asset classes, and the amounts reported by both parties should match the purchase agreement.

The seller uses Form 4797, Sales of Business Property, to report the sale of most business assets, such as machinery and buildings. This form is where the calculation of ordinary income from depreciation recapture and any capital gains are determined. The net capital gains are then transferred to Schedule D (Form 1040), while ordinary income from inventory is reported as part of the business’s regular income.

The buyer’s reporting is focused on utilizing the new asset basis. While the buyer’s main duty at the time of the transaction is filing Form 8594, that allocation becomes the foundation for future filings. Starting in the year of acquisition, the buyer will file Form 4562, Depreciation and Amortization, to claim annual deductions on tangible and intangible assets.