Seller's Federal Income Tax Issues from Sale of a Business

Why does the structure of the sale matter so much to me as the seller?

Because it usually decides whether you pay one layer of tax or two, and how much of your gain is taxed at capital gain rates instead of ordinary rates. Every business sale is either an asset sale or an entity sale. In an asset sale, the buyer purchases the assets of the business — equipment, inventory, accounts receivable, contracts, customer lists, trade names, goodwill — and you keep the legal entity. In an entity sale, the buyer purchases your stock or membership interests and takes the entity as it is, with all of its assets and liabilities.

As a seller you generally prefer to sell the entity. Selling stock or membership interests usually produces a single layer of tax on a single category of income: long-term capital gain, taxed at a maximum federal rate of 20% plus the 3.8% net investment income tax. You report one number and the analysis is nearly over. An asset sale is messier — you divide the price among dozens of assets and recognize a different character of income on each one, and if your entity is a C corporation an asset sale triggers two levels of tax instead of one.

Buyers generally want the opposite, because buying assets gives them a stepped-up basis to depreciate and amortize and leaves your liabilities behind. That conflict is resolved with money: a well-advised seller quantifies the extra tax an asset sale would cost and prices it into the deal. Model the after-tax result before you sign a letter of intent, not after.

How the Purchase Price Allocation Affects Your Tax

What is Internal Revenue Code Section 1060 and why does it control my tax bill?

Section 1060 applies to any "applicable asset acquisition" — essentially any sale of a group of assets that make up a trade or business. It requires you and the buyer to allocate the total price among the assets using the residual method and to report that allocation to the IRS on IRS Form 8594, Asset Acquisition Statement, filed with each party's return for the year of sale. The allocation controls how much of your gain is ordinary income and how much is capital gain, which is why it deserves as much attention as the price itself.

What are the asset classes used in the allocation?

The residual method assigns the price to seven classes in order. Each class absorbs value up to its fair market value before anything spills into the next class:

• Class I — cash and demand deposits.
• Class II — actively traded personal property, certificates of deposit, foreign currency, and marketable securities.
• Class III — accounts receivable, mortgages, and credit card receivables.
• Class IV — inventory and property held primarily for sale to customers.
• Class V — everything not in another class, which is where furniture, fixtures, equipment, vehicles, buildings, and land land.
• Class VI — Section 197 intangibles other than goodwill and going concern value, including customer lists, trade names, licenses, and covenants not to compete.
• Class VII — goodwill and going concern value, which absorbs whatever is left over.

Why should I care how the allocation is written?

Because it determines how much of your price is taxed at 37% and how much is taxed at 20%. Dollars allocated to inventory produce ordinary income. Dollars allocated to fully depreciated equipment produce ordinary depreciation recapture. Dollars allocated to a covenant not to compete produce ordinary income. Dollars allocated to goodwill produce long-term capital gain. A seller who lets the buyer write the allocation is often signing up for a materially larger tax bill.

The buyer has the opposite incentive on some assets — buyers like allocations to equipment and inventory they can deduct quickly, while you usually prefer goodwill. The lesson: negotiate the allocation and put it in the purchase agreement. A written allocation both parties agree to generally binds them and the IRS under Section 1060(a), as long as it is not unreasonable in light of actual fair market values. An allocation left to be worked out after closing is a dispute waiting to happen, and the two Forms 8594 must match or you invite an audit.

The Character of Your Gain

Is my gain capital gain or ordinary income?

In an asset sale, it is both, asset by asset. The general pattern:

• Inventory — ordinary income, no exceptions.
• Accounts receivable of a cash-basis business — ordinary income when collected or sold.
• Equipment, vehicles, and other personal property — ordinary income to the extent of prior depreciation, then Section 1231 gain (generally treated as long-term capital gain) above original cost.
• Real estate — Section 1231 gain, with prior straight-line depreciation on buildings taxed as "unrecaptured Section 1250 gain" at a maximum 25% rate.
• Goodwill, going concern value, customer lists, trade names — long-term capital gain if held more than one year.
• Covenant not to compete — ordinary income.
• Consulting or employment payments — ordinary income, plus employment taxes.

You report the Section 1231 and recapture items on IRS Form 4797 and the capital items on Schedule D.

What is depreciation recapture and why did it wreck my tax projection?

Depreciation recapture is Congress collecting back the benefit of deductions you already took. Under Section 1245, when you sell equipment, machinery, vehicles, software, or other tangible and intangible personal property, gain is taxed as ordinary income up to the amount of depreciation you previously deducted. Only gain above your original cost gets capital gain treatment.

This surprises sellers constantly, and it has gotten worse. Because 100% bonus depreciation is now permanent for qualifying property acquired and placed in service after January 19, 2025, many businesses have written their equipment down to zero basis. Every dollar of the price allocated to that equipment is ordinary income on the way out. The deduction you loved in year one is the tax bill you hate in year six.

How is goodwill taxed when I sell my business?

Goodwill held for more than one year is a capital asset in your hands, and gain on its sale is long-term capital gain — the most favorable result available to a seller. This is why you should push to allocate as much of the price as possible to goodwill. Buyers, who must amortize goodwill over 15 years, push the other way, so the goodwill allocation is almost always negotiated.

What is "personal goodwill" and can I really sell it separately?

Sometimes, and when you can, it is extremely valuable. If your business is a C corporation, an asset sale normally produces corporate-level tax on the goodwill plus a second tax when the proceeds are distributed to you. But if the goodwill belongs to you personally — your reputation, relationships, and skill, not the corporation's — you may be able to sell that personal goodwill directly to the buyer and report a single level of long-term capital gain, sidestepping the corporate-level tax on those dollars.

Courts have allowed this where the facts supported it, most famously in Martin Ice Cream Co. v. Commissioner and Norwalk v. Commissioner. But the IRS attacks personal goodwill aggressively, and the claim fails where you had signed an employment agreement or a non-compete with your own corporation, because the goodwill then belonged to the corporation. Personal goodwill is a fact-driven position that must be built long before the sale, documented in the transaction, and supported by an appraisal. Do not attempt it without a tax lawyer and a CPA.

How are covenant not to compete payments taxed to me?

Badly. Amounts allocated to a covenant not to compete are ordinary income to you, taxed at rates up to 37%. The buyer amortizes the covenant over 15 years under Section 197 regardless of its actual term, so the buyer usually has no strong reason to demand a large allocation to it. If the buyer does insist, understand that you are paying ordinary rates on those dollars, and price accordingly.

How are consulting and employment payments after closing taxed to me?

Consulting fees and post-closing salary are ordinary compensation income to you, subject to self-employment tax or payroll tax rather than capital gain rates. Buyers often prefer to route dollars this way because compensation is immediately deductible to them. Where you will genuinely work after closing, the compensation should be reasonable for the services actually rendered; where the payment is really disguised purchase price dressed up as salary, you are exposed on audit. Watch how much of your deal is characterized as post-closing compensation.

Do I owe the 3.8% net investment income tax on the sale?

Often, yes. The net investment income tax under Section 1411 applies at 3.8% to net investment income of individuals whose modified adjusted gross income exceeds $250,000 for joint filers or $200,000 for single filers. Gain from selling a passive business interest is investment income and is subject to the tax. Gain allocable to assets used in a trade or business in which you materially participated is generally excluded, but the rules for pass-through entities are technical and the year-of-sale income spike often pushes you over the threshold anyway.

How Your Entity Type Changes the Result

What happens if my business is a C corporation?

You face the double tax problem, and it is severe. In an asset sale, the corporation pays 21% federal corporate tax on the gain. Then, when the after-tax proceeds are distributed to you in liquidation, you pay capital gain tax on the difference between what you receive and your stock basis. The combined effective federal rate can approach 40% or more.

This is the single strongest reason a C corporation owner resists an asset sale and prefers to sell stock, and it is where a personal goodwill component or a Section 1202 exclusion, discussed below, can save real money.

What happens if my business is an S corporation?

Much better. An S corporation's gain on an asset sale generally passes through to you and is taxed once at your level, with the character of the gain preserved. Your stock basis increases by the pass-through gain, so the liquidating distribution usually produces little or no additional tax.

The trap is the built-in gains tax of Section 1374. If your corporation was formerly a C corporation and converted to S status within the last five years, appreciation that existed at the date of conversion is taxed at the corporate level at 21% when recognized, and then taxed again at your level. If your S election is recent, calculate this before you sign anything.

What happens if my business is a multi-member LLC taxed as a partnership?

If the buyer purchases the LLC's assets, the LLC recognizes gain that passes through to the members, character intact.

If the buyer purchases your membership interest, Section 741 treats the sale as the sale of a capital asset — but Section 751 overrides that result for your share of "hot assets," meaning unrealized receivables (including depreciation recapture) and inventory. That share is ordinary income no matter how the deal is papered. You also must include your share of LLC liabilities in your amount realized, which frequently produces more taxable gain than you expected from the cash you actually receive.

What if I am the only owner of my LLC?

A single-member LLC that has not elected corporate taxation is disregarded for federal income tax purposes. Selling 100% of the membership interests is therefore treated as a sale of the underlying assets, with all the asset-by-asset character consequences described above. There is no capital gain shortcut. Revenue Ruling 99-6 governs, and it also addresses the mirror situation where a multi-member LLC drops to one member.

Could my gain be tax free under the qualified small business stock rules?

Possibly, if you own C corporation stock — and the rules recently got much more generous. Section 1202 lets a non-corporate shareholder exclude gain on qualified small business stock. The One Big Beautiful Bill Act, signed July 4, 2025, raised the per-issuer exclusion cap from $10 million to $15 million and raised the issuing corporation's aggregate gross asset ceiling from $50 million to $75 million, for stock acquired after July 4, 2025. It also created a tiered exclusion for stock acquired after that date: 50% after a three-year holding period, 75% after four years, and 100% after five years. The pre-existing five-year, 100% rule continues to apply to stock acquired on or before July 4, 2025.

Section 1202 requires an original issuance of stock, an active qualified trade or business, and satisfaction of a list of disqualifying business categories that excludes most professional services firms. It applies only to stock, which means it is unavailable to LLC members and it is one of the few reasons a closely held Arizona business might deliberately choose C corporation status. If there is any chance your company qualifies, raise it with your CPA years before you sell, not weeks before.

The buyer wants me to make a Section 338(h)(10) election. What does that cost me?

A Section 338(h)(10) election, made jointly by you and the buyer, treats what is legally a stock purchase of your S corporation as a deemed asset sale. The buyer gets the stepped-up basis it wants; you get taxed as though you sold assets, which usually means more ordinary income from recapture and hot assets and less pure capital gain than a clean stock sale would have produced. A Section 336(e) election can reach a similar result without a corporate buyer.

Because the election moves tax cost onto you, agree to it only if the buyer pays for the privilege — typically a gross-up that makes you whole on an after-tax basis. Have your CPA calculate the difference between your tax with and without the election before you consent, and put the gross-up in the purchase agreement.

Payment Terms and Timing

Can I spread my tax over several years using an installment sale?

Often, partially. Section 453 lets you report gain proportionally as payments are received when you receive at least one payment after the year of sale, which defers your tax and may keep you in lower brackets. It is reported on IRS Form 6252.

The important limits: installment reporting is not available for inventory, for depreciation recapture under Sections 1245 and 1250 (which is fully taxed in the year of sale regardless of when you are paid), for publicly traded securities, or for the accounts receivable of a cash-basis seller. A seller with heavily depreciated equipment can therefore owe substantial tax in year one on money it will not receive for years. There is also an interest charge under Section 453A on large deferred balances. Model the cash flow, not just the tax.

How are earnouts and contingent purchase price taxed to me?

Contingent payments are generally handled under the installment sale rules, with basis recovered under regulations that depend on whether the earnout has a stated maximum price, a fixed period, or neither. Part of each earnout payment is usually recharacterized as interest income under the imputed interest rules of Sections 483 and 1274, which is ordinary income to you.

A separate risk to watch: if your earnout is conditioned on your continued employment, the IRS may treat it as compensation rather than purchase price, converting your capital gain into ordinary income subject to employment taxes. Have the earnout drafted so it reads as purchase price, not disguised wages.

The buyer wants to pay me over time with a promissory note. What should I watch?

Make sure the note bears an adequate stated rate of interest. If it does not, Sections 483 and 1274 will impute interest at the applicable federal rate, recharacterizing part of what you both called principal. That converts some of your capital gain into ordinary interest income. Stating a market rate of interest in the note is simpler and keeps the characterization clean. You should also secure the note — a security interest in the assets or a stock pledge — so you are protected if the buyer defaults before paying you in full.

Can my sale be entirely tax free?

Only in narrow circumstances. A corporate reorganization under Section 368 — where you receive stock of the acquiring corporation rather than cash — can defer your gain, but it requires you to keep a continuing proprietary interest in the buyer, which is not what most retiring Arizona owners want. Section 1031 like-kind exchange treatment was limited by the Tax Cuts and Jobs Act to real property only, so it no longer shelters goodwill, equipment, or other business assets. For the typical closely held business sale, your realistic goal is favorable character and sensible timing, not elimination.

Arizona and Practical Considerations for Sellers

What about Arizona income tax on my sale?

Arizona imposes a flat 2.5% individual income tax under A.R.S. § 43-1011, and the Arizona return starts from federal adjusted gross income. That means most of the federal characterization decisions described above flow straight through to your Arizona return.

Arizona also allows a subtraction under A.R.S. § 43-1022 equal to 25% of net long-term capital gain included in federal adjusted gross income, which lowers your effective Arizona rate on long-term gain to roughly 1.875%. This provision recently improved for business sellers. For tax years beginning before 2026, the subtraction applied only to gain from assets acquired after December 31, 2011, which disqualified many owners of long-established companies. For tax years beginning on or after January 1, 2026, the Legislature removed the acquisition-date limitation, so the 25% subtraction now applies to all net long-term capital gain regardless of when the asset was acquired. An Arizona owner selling a business founded in the 1990s finally gets the benefit.

If you live outside Arizona, or your business operates in more than one state, you also face apportionment and nonresident filing questions that need a CPA's attention.

Are there other Arizona taxes I should worry about when I sell my assets?

Yes. Arizona transaction privilege tax under the retail classification of A.R.S. § 42-5061 may apply to the sale of tangible personal property in some circumstances, and your unpaid TPT and withholding liabilities can follow the business to the buyer, who will demand indemnification for them. County personal property tax and license transfers also need attention. These are not income taxes, but they belong on your closing checklist.

When should I bring in a lawyer and a CPA?

Before you sign the letter of intent. The letter of intent typically fixes the price and the structure, and once you have signed a nonbinding LOI calling for an asset sale, it is very difficult to renegotiate the structure without appearing to retrade the deal. The cheapest hour you will spend on the sale of your business is the first one.

What tax terms should be in my purchase agreement?

At a minimum the agreement should state the structure, contain a binding purchase price allocation, allocate responsibility for pre-closing and post-closing taxes, require cooperation on Form 8594, address any Section 338(h)(10) election and the gross-up that goes with it, and limit your indemnification exposure to a defined cap and survival period. A handshake sale generates litigation and IRS notices in roughly equal measure. Protect yourself in writing.

Get Help Selling Your Arizona Business

Arizona business attorneys Richard Keyt and his son, attorney and former CPA Richard C. Keyt, have represented Arizona business sellers for decades and have formed 10,000+ Arizona LLCs. We prepare and negotiate asset purchase agreements, stock and membership interest purchase agreements, purchase price allocations, promissory notes, security agreements, and non-competes — and we coordinate with your CPA so the structure you sign produces the after-tax result you actually want when you sell your business.

To learn more about buying or selling an Arizona business read our article called Buying / Selling an Arizona Business FAQs & Checklist.

To get started, complete our Business Purchase / Sale Questionnaire.

To hire us or ask a question, call Richard Keyt at 480-664-7478 or Richard C. Keyt at 480-664-7472, or email rk@keytlaw.com.