How taxes affect the net proceeds when you sell a small business

Selling a small business is more than negotiating a price. Taxes often determine how much of that price you actually keep. Key federal issues include whether the sale is treated as a stock sale or an asset sale, how much of the proceeds are taxed as capital gain versus ordinary income (including depreciation recapture), eligibility for exclusions such as Section 1202 (QSBS), the potential reach of the 3.8% Net Investment Income Tax (NIIT), and state income taxes that vary widely by jurisdiction. The IRS provides a practical overview in its Selling a Business guidance (IRS.gov) and the U.S. Small Business Administration offers a useful synopsis for sellers (sba.gov).

In my work advising owners of closely held firms, I’ve repeatedly seen the sale structure chosen largely determine the tax outcome. Buyers typically prefer asset purchases for step‑up opportunities; sellers often prefer stock sales for full capital gains treatment. Early coordination between tax, legal, and transaction advisors produces the best results.

Asset sale vs. stock sale: why structure matters

  • Asset sale: The buyer purchases individual business assets—equipment, inventory, IP, and often goodwill. Buyers can allocate purchase price to depreciable assets, creating future tax deductions. For sellers, allocations can increase the portion of the deal taxed as ordinary income (for example, payments allocated to inventory or receivables) and trigger depreciation recapture taxed at ordinary rates or the 25% unrecaptured Section 1250 rate for certain real property.
  • Stock sale: The buyer buys equity (shares or membership interests). Sellers typically receive capital gains treatment on the difference between sale price and tax basis, often at lower long‑term capital gains rates. However, buyers inherit the seller’s tax basis in assets (no step‑up), potentially reducing buyer interest.

Buyers and sellers negotiate allocations and price adjustments. Section 1060 rules (asset allocation in an intangible asset sale) and related tax rules control how allocations are reported for tax purposes.

Calculating gain, basis, and depreciation recapture

  • Gain = Amount realized (selling price + liabilities transferred) − Adjusted basis (original cost plus improvements − accumulated depreciation).
  • Depreciation recapture: When depreciable assets are sold for more than their adjusted basis, a portion of the gain attributable to prior depreciation can be taxed as ordinary income (or up to 25% for unrecaptured Section 1250). That recaptured amount can materially raise your tax bill compared with pure capital gain treatment.

Common trap: owners treat the headline sale price as taxable gain without subtracting selling expenses (broker fees, legal fees, transfer taxes), which are generally deductible from the amount realized and reduce gain.

Special provisions that may reduce tax

  • Section 1202 (Qualified Small Business Stock, QSBS): If you sold qualifying C‑corporation stock that meets QSBS rules (original issuance, active business test, holding period, and gross asset limits), you may exclude up to 100% of gain on qualified stock issued after September 27, 2010. Limits apply (greater of $10 million or 10× the taxpayer’s basis) and specific requirements must be met — confirm eligibility with tax counsel and review IRS guidance (see IRS and SBA resources).
  • Installment sale (Section 453): Spreading payments across years can spread recognition of gain and may keep you in a lower marginal bracket. Note: depreciation recapture and certain types of gains may be recognized up front and not eligible for installment treatment, so examine the rules before choosing this route.
  • Charitable strategies: Gifts to charitable remainder trusts (CRTs) or structured charitable transfers can provide income streams, eliminate immediate capital gains on donated assets, and deliver tax deductions. These are complex and require early planning.
  • Opportunity Zone reinvestments: If you realize a capital gain, investing in a qualified Opportunity Fund may defer part of the gain and provide potential step‑ups later. Rules and timelines are strict.

Important correction to a common misconception: like‑kind exchanges (Section 1031) are no longer available for general business assets after the Tax Cuts and Jobs Act of 2017; they are limited to real property held for business or investment. Do not assume a 1031 exchange will defer taxes on the sale of a business unless the transaction involves qualified real estate (see IRS 1031 guidance).

Entity‑specific considerations

  • S corporations: Sellers must consider built‑in gains (BIG) tax if the S corporation was previously a C corporation, and specific rules apply for how gain is treated on asset sales. If you sell S‑corp stock, some adjustments (e.g., basis in stock and corporate tax attributes) affect individual tax outcomes.
  • Partnerships and LLCs taxed as partnerships: Gains and ordinary income items pass through to partners/members according to the partnership agreement and tax allocations. The character of the item (ordinary vs. capital) remains critical.
  • C corporations: Selling C‑corp assets may generate a double tax — the corporation pays tax on the gain, and shareholders may pay tax on distributions of proceeds. A stock sale avoids that corporate level tax in most cases.

State and local taxes

State income tax rates and treatment of capital gains differ—some states tax capital gains as ordinary income while others have preferential rates. Additionally, states may impose franchise taxes, sales taxes on certain asset transfers, or transfer taxes. Evaluate state exposures early, especially for multi‑state businesses.

Practical planning checklist (timeline and priorities)

  1. Start 12–24 months before planned sale: get current valuations, update books and tax records, and identify potential QSBS or basis issues.
  2. Gather documents to support basis: purchase agreements, capital improvements, asset dispositions, and depreciation schedules.
  3. Model after‑tax proceeds for both asset and stock sale scenarios. Include estimated federal, state, NIIT, and possible built‑in gain taxes.
  4. Discuss allocation and buyer preferences; understand Section 1060 allocation requirements for asset purchases and how they affect tax reporting.
  5. Evaluate liquidity options: cash at closing versus installment payments, escrow holdbacks, earnouts and their tax treatment.
  6. Consider tax‑sensitive payout vehicles: installment sale, CRTs, opportunity zone investments, or qualified small business stock reinvestments when applicable.
  7. Engage a CPA/tax attorney early and coordinate with your transactional attorney to include tax protections in the purchase agreement (tax covenants, indemnities, representations).

Real‑world examples (illustrative)

  • Bakery sale (asset sale): Seller allocated significant proceeds to equipment and goodwill. Because equipment had depreciation taken in prior years, the seller faced depreciation recapture taxed partly as ordinary income; legal and broker fees reduced the amount realized. Pre‑sale planning maximized allocations to long‑term capital categories and used an installment treatment for part of the purchase to spread tax liability.
  • Tech founder (QSBS): A founder of a qualifying C‑corporation met Section 1202 requirements and excluded most of the sale gain after confirming the company’s qualified status and holding period. Proper documentation of original issuance and active trade or business certification was crucial.

Common mistakes to avoid

  • Waiting until after the business is sold to consult a tax advisor.
  • Assuming every seller will get capital gains treatment — some portions may be ordinary income.
  • Ignoring state tax and transfer tax exposures.
  • Failing to document basis and capital improvements that reduce taxable gain.
  • Misapplying Section 1031 to non‑real estate transactions.

Interlinked resources on FinHelp

When to get professional help

If the deal value is material to your retirement plans or includes complex elements (IP, ESOPs, international operations, or deferred compensation), retain a CPA experienced in transaction tax, a tax attorney for entity and contract treatment, and your transactional attorney to embed tax protections within the purchase agreement. In my practice, deals planned with tax advisors 12–24 months in advance consistently produce better after‑tax outcomes and fewer post‑closing disputes.

Sources and authoritative guidance

Professional disclaimer: This article is educational and not a substitute for personalized tax, legal, or financial advice. Tax law changes, and outcomes depend on your facts and circumstances; consult a qualified CPA or tax attorney before taking action.