Selling Your Business: Tax Basics for Owners of Small Companies

Owners often focus on the headline price and only later ask what they will keep after tax. The after-tax result depends on choices made both in the deal and long before it. Understanding the moving parts lets you ask better questions of your advisers and negotiate with a clearer picture.

The starting point: what is being sold

Tax treatment starts with the form of the transaction:

Asset sale: the seller entity sells its assets. Gain or loss is computed asset by asset. For pass-through entities, the results flow to owners' returns. For C-corporations, the corporation is taxed, and shareholders are taxed again on the liquidating distribution.
Stock or membership interest sale: the owners sell their ownership interests. Gain is generally the amount realized minus basis in the interest. Special rules apply to partnership interests and to S-corps with an election for asset treatment.

See buying a business: asset vs stock for the structural comparison.

Character of gain

Not all gain is taxed the same way.

Long-term capital gain: generally applies to gain on assets held more than a year, and often includes goodwill, at federal rates that are lower than ordinary rates. Sellers also may face the net investment income tax on certain gains depending on their involvement in the business.
Ordinary income: applies to depreciation recapture on equipment (Section 1245 recapture), inventory and receivables in some situations, and other items. It also applies to consulting or employment payments and certain non-compete payments.
Unrecaptured Section 1250 gain: depreciation taken on real property is taxed at a maximum rate of 25 percent rather than the standard capital gain rates.
State taxes apply on top and vary widely.

This is why the purchase price allocation matters: it determines how much of the price falls into each category.

Basis matters

Gain equals amount realized minus adjusted basis. Sellers who have been depreciating assets aggressively have low basis and thus higher gain and recapture. Sellers of ownership interests need accurate basis in the entity. See tax basis basics and S-corp shareholder basis.

Installment sales

If part of the price is paid over time (a seller note), the seller may be able to report gain as payments are received under the installment method, deferring tax. Limits and exceptions apply: depreciation recapture is generally recognized in the year of sale regardless of payments, inventory and publicly traded stock are excluded, and interest is charged to sellers with large installment obligations in some circumstances. The installment method also carries the credit risk that the buyer might not pay while the seller may already have paid some tax. See earnouts and seller financing.

Earnouts and contingent payments

When part of the price depends on future performance, the tax treatment can be complex. The seller may report contingent payments when received under installment rules and may need to impute interest. Some earnout payments tied to continued employment can be treated as compensation. Written agreements should be precise, and advisers should review them.

Non-compete and consulting agreements

Buyers often want a non-compete. Amounts allocated to a non-compete are generally ordinary income to the seller and amortizable over 15 years to the buyer. Consulting or employment payments are also ordinary income, and subject to payroll or self-employment taxes. Sellers often prefer to allocate more to goodwill, and buyers prefer allocations that produce faster deductions, so negotiate with tax effects in mind.

S-corp and C-corp considerations

S-corp sellers: asset sales pass through to owners, with character depending on the assets. If the S-corp was formerly a C-corp, the built-in gains tax may apply to sales within the recognition period after conversion. See changing entity type.
C-corp sellers: an asset sale triggers corporate tax and then shareholder tax on distribution. A stock sale avoids the first layer. Some owners may qualify for special treatment on qualifying small business stock. See QSBS basics.

LLC and partnership sellers

Sale of an interest in a partnership generally produces capital gain, with an ordinary income portion for the seller's share of unrealized receivables and inventory. Sales of all interests in a single-member LLC are treated as asset sales for tax.

Steps to take before a sale

Clean up the entity and records. Buyers pay more for clean books and documented compliance. See entity cleanup guide and catching up on books and returns.
Understand your basis and tax position by asset and by entity.
Model the after-tax results of different structures with an adviser.
Consider timing: the tax year, installment structure, and interactions with other income.
Review entity type and possible elections, such as whether a conversion might help, keeping in mind that some conversions have waiting periods.
Plan for state taxes and residency.
Evaluate retirement plans and benefits for wind-down.
Address real estate and related-party leases in the deal. See owning your building in a separate LLC.
Consult an attorney and a tax professional before signing a letter of intent.
Plan for the proceeds: reinvestment, estate plans, and charitable options are best considered before closing.

Reporting and forms

Asset sales generally require Form 8594 (Asset Acquisition Statement) filed by both parties, along with Form 4797 (sales of business property), Form 8949 and Schedule D (capital gains), and Form 6252 for installment sales. Entity-level returns report the sale and provide K-1 information to owners. The final year of an entity that sells all its assets and dissolves may involve final returns. See dissolving an LLC.

Common mistakes

Signing a letter of intent before considering tax structure.
Focusing on price and ignoring allocation.
Not tracking basis.
Ignoring depreciation recapture in planning.
Underestimating state taxes.
Waiting until a buyer appears to clean up records.
Failing to consider installment sale risk.
Not planning for the tax due on closing and keeping sufficient cash.
Assuming all proceeds qualify for capital gain rates.

Sales are one-time events with large stakes, and early planning changes outcomes. For help planning the tax side of a sale, AE Tax Advisors can assist, and a discovery call is a good first step.