If You Sell a Business, How Is It Taxed?
Dylan Gans
March 19, 2025 ⋅ 13 min read
This article was originally written in March 2025 and has since been updated with new discoveries and research in October 2025.
Selling a company isn’t one tax event; it’s a series of choices that determine your final bill. A common question is, if you sell a business, how is it taxed? The short answer: It depends on the deal structure and how the purchase price is allocated.
What you sell, how that price is allocated, and whether you use an asset sale or a stock sale all shape your tax implications, your effective tax rate, and your after-tax proceeds. This guide walks through the practical decisions most sellers face and ends with a checklist to review before you sign an LOI.
Start Here: Asset Sale vs Stock Sale
The first decision, structure, sets the rules of the road. Most main-street and lower middle market deals close as asset sales, while some corporate owners sell company stock.
Structure decides which pieces of what you receive fall under capital gains rates and which are taxed as ordinary income. It also determines the buyer’s future depreciation or amortization, thereby affecting negotiation leverage on price and terms, while clarifying who pays tax when selling in your jurisdiction.
In recent exits, structure proved to be the biggest tax lever. In one sale, the seller favored a stock sale to optimize capital gains treatment and avoid pushing value into ordinary income buckets.
The buyer wanted a step-up in basis, so both sides modeled after-tax outcomes early and used price and terms to land on a mutually acceptable result. The lesson is consistent: Treat structure as a financial model, not a preference, because it changes real, after-tax dollars.
Relatable examples:
Local services company (asset sale): An HVAC owner sells trucks, tools, inventory, and customer agreements. More value allocated to goodwill/going concern tends to be capital gains; inventory and a non-compete are often ordinary income.
Clean C-corp with long contracts (stock sale): A specialty manufacturer with multi-year customer contracts and certifications sells stock to maintain contracts and permits; the buyer pressures on price to offset the lack of step-up.
SaaS with recurring revenue (asset sale + allocations): Buyer wants a step-up to amortize intangibles; seller models the impact of allocating between software IP, customer lists, and goodwill to manage ordinary-income items.
Shop with owned real estate (hybrid): The buyer acquires operating assets, while the building remains with the seller and is either leased back or sold separately, altering both parties’ tax profiles.
Use these patterns to frame your own modeling: Compare after-tax proceeds under an asset sale vs. a stock sale, then use price, earnout, or seller note to bridge differences.
How Tax Works in an Asset Sale
If your deal is an asset sale, the tax consequences are driven by how the total price is spread across specific asset classes. Two things happen at once: You recognize gain or income by asset type, and the buyer gets assets with a tax basis that supports deductions over time. Since this is where many sellers accidentally increase their tax bill, it pays to understand the moving parts before an LOI hardens the numbers.
Purchase Price Allocation and Form 8594
The IRS requires buyers and sellers to allocate the price across defined classes and to file matching Form 8594 statements with their returns. The allocation controls how much of your gain is capital versus ordinary, and it controls the buyer’s ability to depreciate or amortize what they purchased.
The instructions to Form 8594 and Publication 544 explain the mechanics and how different classes affect gain recognition and basis reporting under the Internal Revenue Code. When both sides file the same allocation, you avoid mismatch notices and keep the audit trail clean.
Here is a practical workflow that keeps both parties aligned:
Model after-tax proceeds early: Build a seller after-tax worksheet side-by-side with a buyer amortization and EBITDA view so everyone sees the trade-offs before numbers “set.”
This modeling step prevents late surprises.
Lock a principled framework in the LOI: Set bands and priorities for the big buckets, such as inventory at book, accounts receivable at face less reserves, fixed assets at fair market value, and remainder to section 197 intangibles.
Clarity in the LOI reduces renegotiation risk during the purchase agreement.
Mirror the Form 8594s: Draft one schedule that both sides will file, then attach it to the purchase agreement.
Matching filings reduces the risk of IRS mismatch letters.
Keep a light evidence file: Maintain comps that support intangible value, fixed-asset listings, basis schedules, and a short note on any covenant amount.
Documentation keeps diligence moving and supports your position if asked.
Taken together, these steps align incentives early, shorten negotiation cycles, and protect after-tax proceeds. You trade guesswork for a shared model, set clear guardrails before numbers harden, and leave a clean paper trail that keeps diligence and post-close filings straightforward.
What Is Capital Gain vs Ordinary Income in an Asset Sale
Allocation is not a neutral exercise.
The class you push dollars into determines your tax rate and character:
Goodwill and going-concern value, along with many intangible assets under section 197, typically produce capital gain to the seller.
For the buyer, these items amortize over fifteen years.
Inventory and unrealized receivables are ordinary income to the seller.
Buyers prefer value here because the cost of goods and receivable collections flow through faster.
Depreciable tangible personal property that is section 1245 property can trigger depreciation recapture up to the amount of prior depreciation, which is ordinary income.
Avoid overvaluing equipment above credible fair market value.
Real property can involve unrecaptured section 1250 gain, taxed at a special maximum rate separate from standard capital gains rates.
Separating land from building and grounding values with assessor data or a broker's opinion helps.
When a business owns real estate, a carve-out can make sense. Often, the operating assets are sold in one agreement, while the property is sold or leased under a separate agreement. That separation keeps the operating business allocation cleaner and allows a potential like-kind exchange under Section 1031 on the property only.
Depreciation Recapture Basics
Depreciation recapture is the portion of gain on depreciable property equal to prior depreciation deductions. The key point for sellers is that recapture is generally taxed as ordinary income, not at capital gains rates.
This is why overstating equipment value can backfire. Keep values anchored to fair market evidence. If you can reasonably migrate value into section 197 intangibles supported by customer relationships, brand, or software, you usually convert potential recapture into capital gain while still giving the buyer amortizable basis.
How Tax Works in a Stock Sale
When you sell corporate stock, your tax character typically follows the holding period. For many sellers, the federal capital gains tax applies when shares are held for more than one year, generally resulting in a long-term capital gain. Stock held one year or less is a short-term capital gain and is taxed at ordinary rates.
The buyer does not automatically receive a basis step-up inside the company, which is why some buyers request special elections in S-corp deals to simulate an asset sale while letting the seller achieve stock-sale-like results. Because those elections change both parties’ outcomes, model them alongside price and terms so you can trade value fairly.
Special Rules That Often Change the Bill
Even after structure and allocation are settled, several rules can increase or decrease taxes. The goal is to use the levers that improve after-tax proceeds without derailing bank approval or buyer confidence.
Installment Sale Reporting
An installment sale spreads the recognition of gains over the years you receive payments. Many seller notes qualify, and some earnouts can qualify when they are contingent on a purchase price. Remember, depreciation recapture is often taxed in year one regardless of timing.
Use installment payments to manage cash flow and taxable income, but do not rely on them to fix recapture. Clear payment mechanics, reasonable interest, and default remedies help the bank and counsel approve the structure without delay. The IRS covers the basics in Topic No. 705.
Net Investment Income Tax
High-income taxpayers can owe the 3.8 percent Net Investment Income Tax on certain capital gains. This surcharge sits on top of other taxes and can affect your final tax liability even when you do not expect it.
Including NIIT in your projections early prevents shortfalls in estimated tax planning. See the IRS overview of the Net Investment Income Tax for thresholds and exceptions.
Real Estate Carve-Out With Section 1031
If part of your transaction includes business or investment real property, a like-kind exchange may defer gain on the property when strict rules are met. A clean way to execute is to split the deal, one agreement for operating assets and one for the property, then run the property through a qualified intermediary on a separate timeline. Early separation keeps lender diligence straightforward and avoids closing crunches.
Qualified Small Business Stock: When a Stock Sale May Be Partially Tax Free
If your company is a C-corporation and the shares qualify as Qualified Small Business Stock held more than five years, a section 1202 exclusion may eliminate some capital gains tax. In most main-street deals, this is rare because eligibility depends on original issuance, active business requirements, and the holding period.
When the facts are there, they can be powerful, but they are not a last-minute fix. Start with the IRS’s Section 1202 discussion in Publication 550 and consult a tax advisor on eligibility.
Coordinate Charitable Giving
Charitable contributions can be timed to the sales year to help manage taxable income, but the details matter. Confirm deduction limits, the type of property donated, and whether a contribution before closing affects your ability to offset capital gains. Align the plan with your estimated liability rather than treating giving as an afterthought.
Entity-Specific Notes for Sellers
Different legal forms change where and when taxes show up.
Use these notes as framing, then work with a tax advisor to apply the rules to your facts:
Sole proprietorship: An asset sale by default. Proceeds are split by asset class, ordinary income on inventory and recapture, capital gain on goodwill, and going-concern value.
Careful record-keeping on the basis makes a material difference in a business sale.
LLC taxed as a partnership or disregarded entity: Asset sale treatment generally flows through to members.
Members often adjust estimated taxes to reflect large capital gains and any ordinary income items.
S corporation: An asset sale flows through and then is taxed at the shareholder level, while a stock sale is often a capital gain to shareholders. Buyers tend to prefer asset deals for basis step-up, but elections can bridge the gap in some cases.
Model both sides, then use price and terms to neutralize tax differences.
C-corporation: An asset sale can produce a corporate-level tax, then a shareholder-level tax upon distribution. Stock sales avoid the corporate-level tax.
Where corporate asset sales are necessary, explore whether personal goodwill is supportable to mitigate double tax.
The right entity lens turns a complex tax picture into a manageable plan. Align your structure choice and allocation strategy with how your entity is actually taxed, then run the numbers before the LOI so you can trade price and terms with clarity. A brief session with your tax advisor to pressure test assumptions now will save time, reduce surprises, and keep more of the check when you close.
A Mini Case Example, Showing Why Allocation Matters
Consider a $4,000,000 asset sale of a profitable services company. The parties begin with a rough allocation but agree to refine it before signing the purchase agreement.
Here’s an overview of the case example:
Inventory
Initial: $300,000
Tax character (initial mix): Ordinary income
Final: $220,000
Why: Set near book to avoid pushing value into ordinary-income buckets
Accounts receivable
Initial: $300,000
Tax character (initial mix): Ordinary income to the extent collected
Final: $240,000
Why: Kept at face less reserves to limit ordinary-income exposure
Equipment (§1245)
Initial: $400,000
Tax character (initial mix): Depreciation recapture up to prior depreciation (ordinary income)
Final: $280,000
Why: Anchored to fair-market value with dealer quotes to avoid overstating recapture
Goodwill & §197 intangibles
Initial: $3,000,000
Tax character (initial mix): Generally capital gain
Final: $3,260,000
Why: Remainder shifted here to favor capital gain; still amortizable to the buyer over 15 years
Total
Initial: $4,000,000
Final: $4,000,000
What Changed & Why It Mattered (Change → Impact)
Reduced inventory & equipment to credible FMV → Lower ordinary income and depreciation recapture for the seller
Increased remainder to §197 intangibles & goodwill → More capital gain to the seller; buyer still gets amortizable basis
Agreed to file matching Form 8594 schedules → Reduced IRS mismatch risk; smoother post-close filings
Small shifts like these often move six figures between ordinary income and capital gain without harming buyer economics. The key is to use credible support and to set the framework in the LOI rather than during final drafting. Stating results in terms of sale proceeds makes it easier for both sides to compare options.
FAQs
Before you dive into the details, here are quick answers to the questions sellers ask most often. Use these to sanity check your plan, then bring the ones that hit your situation into a conversation with your advisor. If a term is unfamiliar, skim back to the relevant section and apply the guidance to your facts.
Is Capital Gain Always Better Than Ordinary Income?
For most sellers, the answer is yes, because capital gains tax often produces a lower rate than ordinary income. However, the right answer depends on your mix of items, other taxable income, and state income tax exposure. Manage allocation so ordinary buckets like inventory and recapture are not oversized, then use a buyer-friendly trade to keep the deal balanced.
How Do Goodwill and Non-Compete Payments Get Taxed?
Goodwill and other section 197 intangibles generally produce capital gain to the seller and fifteen-year amortization to the buyer. Payments for a covenant not to compete or for consulting are ordinary income to the seller. Keep the covenant scoped to actual competitive risk and document why the amount is modest and defensible.
What Is Depreciation Recapture in Simple Terms?
Recapture is the portion of gain on depreciable property equal to your prior depreciation deductions. That slice is taxed as ordinary income. The practical takeaway is to keep equipment values anchored to fair market evidence rather than inflated numbers that increase recapture.
Do I Owe Tax If I Do Not Receive All the Cash at Closing?
Often, you can use installment reporting so that the gain is recognized as you receive payments. Depreciation recapture is typically taxed in the first year, so installments do not change that component. Set clear payment terms and interest so the bank and counsel approve the structure.
Do State Taxes and Local Taxes Apply?
Yes. Many states tax business sale proceeds, and some localities add their own rules. Add state income tax into your projections, especially if you are moving or if the business has operations in multiple jurisdictions. State rules can also affect whether you can offset capital gains with other items.
What Records Do I Need for Basis and Allocation?
Keep basis schedules for fixed assets, a current fixed-asset list, equipment dealer quotes or prior appraisals for fair market value, and short notes that explain your covenant amount, if any; file matching Form 8594s with the buyer. Good records lower your audit risk and streamline closing.
Work With Baton
Sellers who prepare early make better decisions and close with fewer surprises. Baton pairs market-ready valuation, buyer matching, LOI support, diligence organization, and close coordination, while you work with your tax advisor on the details.
If you are comparing a lump sum to installment payments or weighing a structured installment sale, we will help you model after-tax outcomes and negotiate a sale structure that fits your goals.
Start by exploring our resources on taxes on selling a business, planning for small business taxes, and trying our capital gain tax calculator.