Tax Implications of Selling a Small Business

Selling a small business means income, and income means taxes. But the terms of the deal impact how much of the sale price goes to taxes and how much stays with you. This includes the structure of the sale, in what arrangement the small business currently exists, whether the sale is all-cash or payment-based, and more. If you have questions about this complex financial situation, consider speaking with a financial advisor.

The Basics of Selling a Small Business

The tax side of selling a small business has many moving parts, and as the seller, you’ll have a lot of decisions to make. However, some of those choices are restricted by the Internal Revenue Service. Other decisions will be negotiated by the buyer, since their interests can ran counter to the seller’s.

There are four main tax-related issues to keep in mind when selling a business:

Whether proceeds of the sale are taxed as ordinary income or capital gains
If the sale is an all-cash deal or requires payment installments
Whether the sale is one of assets or one of stocks
Whether the sale can be treated as a tax-free merger in the case of a deal between two corporations

Keep in mind these issues are relevant for federal income taxes. Different states have different rules and may collect more or less taxes than the IRS on the same deal.

How Business Sales Are Taxed

To the IRS, selling a business is generally not viewed as the sale of a single asset. Instead, most individual assets within the business are treated as though they’re being sold separately.

This approach affects how the sale will be taxed, either as long-term capital gains or as ordinary income, which can significantly impact the seller’s tax obligations.

For assets held longer than 12 months, proceeds are considered long-term capital gains, taxed at a maximum rate of 20% for most taxpayers.

Proceeds classified as ordinary income, however, are taxed at the taxpayer’s individual rate, which can be as high as 37%, more than twice as high as the long-term capital gains tax rate.

The Asset Allocation of the Business

A business owner discussing the sale of a business.

Sellers will often want the sale of as many business assets as possible to be treated as capital gains to save on taxes. However, the asset allocation decision is not entirely up to the seller.

The IRS says, for instance, that selling inventory produces ordinary income. But selling capital assets held for more than a year creates a long-term capital gain.

Within these boundaries, there is some flexibility. For example, the buyer often wants as much of the price as possible allocated to costs that can be deducted or assets that depreciate. This, in turn, can reduce the new owner’s tax bill.

It’s this potential conflict between buyer and seller that makes allocation of assets an important part of negotiations. A seller may offer concessions on price or terms of the deal to get a more favorable allocation.

How the Deal Structure Affects Taxes

In addition to asset allocation, the deal’s structure can affect the tax bill. If the seller agrees to take the price in installments, for instance, they can defer paying taxes until the payments are received.

Buyers may end up paying more when they don’t have to pay everything upfront. And the seller may also be able to charge interest, in addition to saving on taxes. Installment sales do add more risk, though, because the new owner must run the business well enough to produce profits to make payments.

Explaining Corporate Stock Sales

Sales of sole proprietorships, partnerships and LLCs have to be treated as sales of separate assets. When a corporation is sold, however, the deal can be presented as a stock sale rather than a sale of assets.

This is important because if the corporation sells its assets, the proceeds will be taxed twice — once when the corporation pays taxes and again when its shareholders file individual returns. In contrast, a stock sale gets taxed once, saving on taxes for the seller.

The buyer, however, often wants an asset sale because it presents more opportunities for depreciation deductions. This is another area that can lead to more negotiations between the buyer and the seller.

What Is a “Tax-Free” Corporate Merger?

If one corporation is buying another corporation, the deal can be done by exchanging stock. Under the right circumstances, this can mean no taxes at all.

The IRS has specific rules about tax-free stock exchanges. For example, there can’t be any cash involved — it has to be strictly an exchange of stock.

Planning Ahead Before the Sale

Selling a business can take months or even years to finalize, and early tax planning may reduce the overall tax burden. Business owners should consider strategies such as converting ordinary income assets into capital assets, reviewing their depreciation schedules, or making retirement plan contributions in the final year of ownership to offset income. Consulting a tax professional or financial advisor in advance may allow time to reorganize the business structure or adjust the timing of the sale for more favorable tax treatment.

Estate planning may also factor into the strategy. For example, owners looking to transfer business proceeds to heirs may explore gifting interests in the business before the sale or using trusts to limit estate taxes. Owners close to retirement may coordinate the timing of the sale with Social Security or Medicare considerations to manage taxable income.

By taking steps ahead of the transaction, sellers can enter negotiations better prepared, with clarity on how different deal structures will affect after-tax proceeds. This can help them make informed decisions that align with both their financial goals and timeline.

Bottom Line

A business owner reaching an agreement with a buyer for the sale of her business.

The way taxes are handled during the sale of a business depends on the type of business entity being sold. This namely applies to whether it’s a sole proprietorship, partnership, LLC or corporation. It also matters what type of entity is buying the business, which assets are included and how the deal is structured. All this is governed by a complex set of IRS rules.

Tips for Selling a Small Business

A financial advisor can offer you guidance on tax strategies for your business, as well as overall financial planning, investment opportunities and long-term growth. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Selling a business has significant tax implications, and the best way of minimizing your taxes may not be obvious. No matter the size of your business, consider enlisting the help of professional tax, accounting and financial advisors.