Navigating the Sale of Your Business: Essential Tax Considerations

Key takeaways:

• Evaluate asset sale versus stock sale to understand tax consequences and business valuation impacts.
• You should consider installment sales, equity rollovers, ESOPs, and earn-outs to optimize tax outcomes.
• Negotiate purchase price allocation aggressively to minimize depreciation recapture and reduce ordinary income exposure.
• You must assess organizational structure and potential F reorganization or Section 338(h)(10) election consequences.
• Engage tax advisors and M&A experts early to align business valuation with estate and wealth transfer strategies.

Selling your business is a major milestone—exciting but also complex, bringing with it a host of important questions: What type of sale is the right fit for you and your business? What are some ways to maximize your net proceeds? How can you avoid unexpected tax liabilities?

For business owners, achieving the most tax-efficient transaction requires careful consideration of how to structure the sale, manage capital gains, minimize the tax burden, and allocate the purchase price. You must decide which type of sale suits your business best and which tax strategy will create the optimal outcome.

What Type of Sale Is Right for You?

Different sale structures—installment sales, equity rollovers, ESOPs, and earn-outs—have distinct tax timing, liability allocation, and risk profiles that materially affect after-tax proceeds.

In choosing the optimal type of sale for your business, you need to determine how the business should be structured post-transaction. By planning strategically, you can enhance your after-tax proceeds and ensure a smoother transition. Your options for selling the business depend on the type of buyer and may include the following:

• Seller financing/installment sale. Receiving payments over time instead of as a lump sum can have beneficial tax implications. An installment sale allows you to spread out capital gains tax liability over several years, potentially lowering your overall tax burden.
• Equity rollover. An equity rollover involves retaining an equity stake in the new company formed by the buyer and deferring some tax liabilities, such as capital gains taxes on the portion of the business rolled over (until the equity is eventually sold). Retaining equity means you continue to share in the business’s rewards—but also its risks. (For more information, see our article Key Considerations in an Equity Rollover.)
• ESOP. Selling to employees through an employee stock ownership plan (ESOP) guarantees a stock sale, which already offers you an advantage as the seller. It also potentially allows you to defer or avoid all taxes on the sale of your business, an option that is unique to ESOPs. This strategy comes with some complexity, but the potential tax savings can be significant. (For more information on ESOPs, check out our website and our article ESOP Tax Incentives for Selling Shareholders.)
• Earn-outs and contingent payments. While earn-outs or contingent payments can increase your total sale proceeds, they also introduce risk, as future payments depend on the business meeting specific financial targets. If those targets aren’t met, you may receive less than anticipated. Additionally, if an earnout is tied to the owner’s continued employment post-transaction, it may be taxed as ordinary income rates rather than capital gains.                  

Other factors can impact your tax burden too, such as:

• Employment and consulting agreements. Entering into an employment or consulting agreement with the buyer post-sale can offer tax deferral and continued income streams, but beware: payments from such arrangements are treated as ordinary income, subject to higher tax rates than capital gains (see discussion below).
• Estate planning and wealth transfer. Consider how the sale fits into your broader estate and wealth transfer plans. Proper planning can help minimize taxes and ensure your financial legacy. Gifting shares to family members or trusts before the sale can reduce the taxable estate. Using trusts can help manage the tax implications and provide for future generations. (For more information, check our guide on wealth transfer and estate planning.)

PCE's advisory practice has structured a range of seller-favorable transactions using installment sales, equity rollovers, ESOPs, and earn-outs to achieve tax-efficient outcomes.

Which Tax Strategy Suits Your Needs?

When selling your business, the tax considerations are multifaceted and complex. Having an idea of the different tax-impacting elements of the agreement prior to closing the sale can help you plan appropriately and avoid headaches down the road.

Capital gains tax vs. ordinary income taxes

Long-term capital gains treatment generally results in lower tax rates for held assets or stock sales, while ordinary income rates apply to compensation and certain recaptured amounts, producing different after-tax results.

Capital gains tax is a critical consideration when selling your business, as it applies to the profit made from the overall sale of assets or stock. If you’ve owned the business for more than a year, you qualify for the long-term capital gains tax rate—0%, 15%, or 20%, depending on your taxable income—which is typically lower than the short-term rate. The structure of the sale, however, determines whether some portion of the proceeds may be taxed at ordinary income tax rates, which are based on your business income, the organizational structure of your business (i.e., S corporation, C corporation, partnership, sole proprietorship, limited liability corporation), and, as mentioned, the terms of any employment and consulting agreements.

PCE professionals regularly analyze capital gains versus ordinary income scenarios to align transaction structures with client tax objectives.

Structuring the sale: Asset sale vs. stock sale

As stated above, the structure of your business sale significantly impacts your tax implications. The tax treatment of an asset sale, in which you sell individual assets and liabilities of your business while remaining the legal owner of the entity, can be complicated, as different assets are taxed at different rates. Tangible assets (such as equipment and inventory) may be subject to ordinary income tax rates due to depreciation recapture, which occurs when the sale price exceeds the asset’s depreciated value, thus increasing your tax liability. Intangible assets like goodwill, on the other hand, are generally taxed at capital gains rates.

Buyers usually prefer an asset sale because they can step up the basis of the assets to their fair market value, which provides better depreciation and amortization benefits. As a seller, however, you’re more likely to face higher tax rates due to the combination of ordinary income and capital gains taxes, although it’s worth remembering that the buyer’s advantage can be a lever in negotiating the overall purchase price.

In a stock sale, you sell your ownership shares in the company, transferring all assets and liabilities to the buyer. Stock sales are usually more favorable for the seller due to lower capital gains taxes (if the shares have been held for more than a year, as mentioned earlier) and because you can avoid depreciation recapture of individual assets. But buyers may hesitate over the need to assume all existing liabilities and to forgo the opportunity for higher tangible asset depreciation benefits. (For a detailed comparison of asset sales versus stock sales, refer to our guide on structuring the sale of your business.)

Organizational structure: F reorganization and Section 338(h)(10) election (tax-treatment options)

Based on your organizational structure, certain options offer greater influence over the outcome of your tax position in a sale. These options may allow you to treat the sale as a stock sale for legal purposes, while treating it as an asset sale for tax purposes – specifically, the F reorganization and Section 338 (h)(10) elections.

If applicable to your circumstances, choosing an F reorganization or a Section 338(h)(10) election can optimize tax outcomes for both buyer and seller. An F reorganization involves a tax-free restructuring of the seller’s S corporation or other business, which allows you to perform a tax-deferred equity rollover (explained above) while the buyer treats the transaction as an asset purchase for tax purposes. A Section 338(h)(10) election also treats the sale of stock as a sale of assets for tax purposes, providing potential tax benefits for both buyer and seller, but typically does not allow for a deferral of an equity rollover investment by the seller. (For more details, read our article on choosing an F Reorganization or a Section 338(h)(10) election.)

Specialized tax counsel is typically engaged for F reorganizations and Section 338(h)(10) elections due to their technical complexity and cross-party tax consequences.

Allocation of purchase price

Allocation of the purchase price across IRS asset classes determines whether proceeds are taxed as ordinary income or capital gains and is formalized on Form 8594, which both parties must file.

Buyers and sellers have different viewpoints on how to allocate the purchase price. The purchase price allocation dictates the tax treatment of the proceeds from the sale of your business and is reported on federal tax form 8594, which both parties must file with their tax returns for the year in which the sale occurred. A robust valuation of intangible assets supports defensible purchase price allocation on Form 8594.

On this form, the assets fall into different classes as determined by the IRS: Class 1, 2, and 3 assets are valued at face value. Class 4 assets (inventory) are valued at cost. Class 5 (fixed assets and tangible property) is where negotiation between buyer and seller will most likely occur, as these reflect fair market value and are subject to depreciation recapture. Class 6 assets are intangibles aside from goodwill, such as permits or a trained workforce. And class 7 is where goodwill is recorded along with whatever is left of the purchase price after all other asset classes are accounted for.

Differentiating business and personal goodwill informs valuation approaches and the proper tax treatment on sale.

Often the largest of intangible assets, goodwill is typically taxed at the capital gains rate: buyers in an asset sale can amortize this amount over 15 years, delivering a potentially significant tax benefit from their perspective. Buyers will seek a higher value assigned to tangible assets such as property and equipment, as these provide them with a step-up in basis and depreciation benefits. Meanwhile, sellers like you prefer that a low value is assigned to tangible property because it is taxed at ordinary income rates and depreciation recapture applies.

Documented purchase price allocations supported by independent valuations promote defensible positions on Form 8594 and help reduce audit risk.

Frequently Asked Questions

Q: Which types of sale structures can help defer or spread tax liability when selling a business?
A: Installment sales spread recognition of capital gains over multiple tax years, reducing immediate tax burden. Equity rollovers defer gain by reinvesting proceeds into new equity, and ESOP transactions can permit deferral or exclusion of tax under specific ESOP rules, each with different risk and documentation requirements.

Q: How does an installment sale affect capital gains tax timing?
A: An installment sale recognizes gain as payments are received, allowing the seller to defer tax liability into future years and potentially smooth taxable income. Interest and the allocation of principal versus gain on the note affect the taxable amounts and should be documented clearly.

Q: What are the main tax differences between an asset sale and a stock sale?
A: An asset sale allocates proceeds across asset classes, which can trigger depreciation recapture taxed as ordinary income for certain tangible assets while intangibles like goodwill are generally taxed as capital gains. A stock sale typically results in capital gains treatment for the seller but transfers entity-level liabilities to the buyer, creating different negotiating dynamics.

Q: How can ESOPs impact the tax treatment of a business sale?
A: Selling to an ESOP generally constitutes a stock sale and can allow sellers to defer or potentially avoid tax on the sale under certain ESOP provisions, making it a uniquely tax-advantaged option for some owners. The strategy requires specific structure, trustee involvement, and professional advice due to legal and tax complexities.

Q: Why does allocation of the purchase price matter for taxes?
A: Purchase price allocation determines which portions of proceeds are taxed as ordinary income versus capital gains and is reported on Form 8594 by both buyer and seller. Buyers often seek higher tangible asset values for depreciation benefits, while sellers prefer allocations that maximize capital gains treatment, so clear documentation and defensible valuations are important.

Consulting the Experts to Ensure Optimal Tax Outcomes

Coordinated M&A, ESOP, and tax advisory support aligns transaction structure, valuation, and documentation to minimize tax risk and defend allocations to authorities.

Start by reviewing the options described above but be sure to consult your tax advisor. Engaging with experienced M&A professionals is crucial to successfully navigating tax-related issues during the sale of your business. At PCE, we specialize in providing comprehensive M&A and ESOP advisory services, ensuring that you receive tailored advice for your unique situation. Our team of experts is here to guide you through every step of the process, from evaluating your options to executing the sale. Reach out to us to explore your alternatives and make informed decisions about your business sale.

PCE combines M&A, ESOP, and tax planning capabilities to deliver integrated advisory services for transaction execution and tax optimization.