Overview
Selling a family business is both an emotional and financial milestone. Taxes often represent the single largest drag on net proceeds, so understanding how the Internal Revenue Service and your state will tax the sale is essential. This article explains the common federal tax categories you’ll face, how the sale structure affects liability, practical planning steps, and common pitfalls I see working with multigenerational business owners.
(IRS guidance and asset‑basis rules are authoritative; see IRS “Sale of a Business” and Publication 551 for details.)
Sources: IRS — Sale of a Business (https://www.irs.gov/businesses/small-businesses-self-employed/sale-of-a-business), IRS Publication 551: Basis of Assets (https://www.irs.gov/publications/p551).
Key tax categories you may encounter
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Capital gains: When you sell an ownership interest or business assets for more than your adjusted basis, the difference is generally a capital gain. Long‑term capital gains (for assets held more than one year) typically receive preferential rates (0/15/20%), although your effective rate depends on total taxable income and filing status. High‑income taxpayers may also owe the 3.8% Net Investment Income Tax (NIIT). See IRS Topic No. 409 and related guidance.
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Ordinary income and depreciation recapture: Assets that have been depreciated (machinery, equipment, some improvements) may trigger depreciation recapture on sale. Recapture on Section 1245 property is taxed as ordinary income to the extent of prior depreciation. For certain real property, “unrecaptured Section 1250” gains can be taxed at a special 25% maximum rate. These rules can materially increase tax liability compared with straight capital gains.
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Ordinary income on inventory and receivables: Assets sold that represent inventory, accounts receivable, or previously deducted expenses are usually taxed at ordinary income rates.
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Payroll and employment taxes: Typically, the sale of ownership interest or assets is not subject to payroll taxes; however, structuring compensation or retirement payouts improperly (e.g., recharacterizing sale proceeds as wages) can create withholding and payroll tax exposure.
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State and local taxes: Many states tax capital gains as ordinary income or have their own rates; plan with state tax rules in mind, especially if buyer and seller are in different states.
Sale structure matters: asset sale vs. stock/ownership sale
How you sell the business often dictates who pays what tax and how much:
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Asset sale (buyer purchases individual assets): Buyers often prefer asset sales to get a stepped‑up tax basis in assets. Sellers may face mixed tax results: some gains taxed as capital gains, some as ordinary income (inventory/receivables), plus depreciation recapture on depreciable tangible and intangible assets. Allocation of the purchase price among asset classes is critical because it determines the mix of ordinary vs. capital tax.
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Stock or membership interest sale (buyer buys the entity): Sellers of stock in C corporations or membership interests in pass‑through entities generally recognize capital gain or loss on the sale of their ownership interest. Buyers may be reluctant because they don’t get a stepped‑up basis in underlying assets, which affects price and negotiation.
Negotiation tip: Buyers and sellers negotiate purchase price allocation in the purchase agreement, and the IRS expects consistent reporting. Allocation affects immediate taxes for the seller and future deductions for the buyer—get tax advisers involved early.
Important forms and reporting
- Form 4797: Used to report the sale of business property where depreciation recapture is required.
- Schedule D (Form 1040) and Form 8949: Report capital gains and losses from sales of ownership interests.
- Form 6252: For installment sales when you report gain as payments are received (Section 453).
(See related FinHelp guides: “Schedule D (Form 1040) — Capital Gains and Losses” and our process article “Tax Steps When Selling a Business: From Valuation to Reporting” for walkthroughs.)
Internal resources:
- Qualified Small Business Stock (QSBS): https://finhelp.io/glossary/qualified-small-business-stock-qsbs/
- Tax Steps When Selling a Business: From Valuation to Reporting: https://finhelp.io/glossary/tax-steps-when-selling-a-business-from-valuation-to-reporting/
- Schedule D (Form 1040) — Capital Gains and Losses: https://finhelp.io/glossary/schedule-d-form-1040-capital-gains-and-losses/
Special tax breaks to consider
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Qualified Small Business Stock (Section 1202, QSBS): If the sold stock qualifies and you meet the 5‑year holding period and other requirements, Section 1202 can exclude up to 100% of gain on the sale of QSBS for eligible taxpayers (subject to limits and alternative rules). Many family businesses aren’t eligible, but early‑stage C corporations that meet active business tests and size limitations might qualify. See our QSBS guide for details and eligibility checks.
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Installment sale (Section 453): Spreading payments over years can smooth tax burden and may lower bracket pressure. Be careful: interest on deferred payments is taxable and certain exceptions (like inventory sales or sales of debt instruments) limit use. Use Form 6252 to report installment income.
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Charitable strategies: Donating a portion of business assets, using charitable remainder trusts (CRTs), or structured sales to charities can reduce taxable gain while supporting philanthropic goals. Each strategy has legal and tax complexity.
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Opportunity Zones and 1031 exchanges: 1031 like‑kind exchanges only apply to real property (not stock or most business assets). Opportunity Zone funds may offer deferral and exclusion possibilities for capital gains, but they require careful timing and compliance.
Practical examples (illustrative)
Example 1 — Simple ownership sale:
- Basis in shares: $100,000
- Sale price: $1,000,000
- Long‑term capital gain: $900,000
Tax outcome: The $900,000 is taxed at capital gains rates (0/15/20% based on income) plus possible NIIT (3.8%), assuming no special exclusions apply.
Example 2 — Asset sale with depreciation recapture:
- Equipment original basis: $200,000; accumulated depreciation: $150,000; adjusted basis: $50,000
- Equipment sale price: $150,000
Gain: $100,000 — depreciation recapture under Section 1245 means that $100,000 is taxed as ordinary income to the extent of prior depreciation, which can push combined tax higher than the capital gains rate.
These simplified examples show why allocation and basis matter. Work with a CPA to run pro forma tax models before finalizing terms.
Step‑by‑step planning checklist (practical)
- Engage a tax advisor and business valuation expert at least 6–12 months before a planned sale. I routinely see better outcomes when we model outcomes early.
- Decide target sale structure and negotiate price allocation language in the purchase agreement.
- Check eligibility for Section 1202 (QSBS) or other special relief.
- Consider an installment sale if cashflow, buyer creditworthiness, and tax timing make sense.
- Model federal and state taxes, including NIIT and AMT interactions where applicable.
- Coordinate with estate planning if the sale involves transfers to family members (gifts vs. sale vs. carryover basis effects).
- Document allocations, valuations, and representations to reduce audit risk.
Common mistakes and misconceptions
- Treating all gain as capital gain: Depreciation recapture and ordinary income items can significantly change tax figures.
- Waiting too late to plan: Timing, entity elections, and minor structuring choices can make or break opportunities like QSBS—plan early.
- Forgetting state taxes: A seller who relocates temporarily or closes a sale with multistate implications can face unexpected state liabilities.
- Assuming installment sales eliminate total tax: They only defer recognition and may increase interest and complexity.
Transfer to family members: sale vs. gift vs. estate
Transferring a business to family by sale, gift, or retention until death each has different tax consequences. Gifting may trigger gift tax use of lifetime exemption and creates carryover basis for the recipient. A sale at fair market value recognizes gain. Estate transfer can provide a stepped‑up basis at death (subject to estate tax rules). Coordinate with an estate attorney and CPA before choosing a path.
Final tips from practice
- Run pro forma tax models for both buyer and seller positions — the negotiation will hinge on tax consequences.
- Keep clean documentation of basis, depreciation schedules, and prior tax filings.
- Warn buyers and sellers that allocation schedules in the purchase agreement should match their tax returns to avoid IRS disputes.
Professional disclaimer: This article is educational and does not replace personalized tax, legal, or financial advice. For tailored guidance, consult a qualified CPA and an attorney familiar with business transactions and tax law.
Author note: In my 15+ years advising family business owners, the best outcomes come from early, collaborative planning between tax, legal, and valuation advisors. A well‑timed, well‑structured sale can preserve hundreds of thousands of dollars in after‑tax proceeds compared with a poorly structured transaction.
