Tax Questions Before a Business Sale

Settle four things before you sign: whether you are selling assets or the entity itself, how the price is allocated among the assets, how and when you will be paid, and what tax history the buyer will find. In an asset sale, IRC 1060 requires the price to be allocated among the assets, and a written allocation binds both sides. Installment payments can spread the gain, but some income is taxed in the year of sale regardless.

Once a deal closes, most of these choices are locked in. Planning before a transaction is a core part of Kathryn Meyer's strategic tax counsel work, alongside your accountant and deal counsel.

How to prepare the tax side of a sale, step by step

Decide what is being sold. The business's assets, the stock of a corporation, or interests in a partnership or LLC taxed as one. Each produces a different tax result for you and a different set of risks for the buyer.
Value the assets by class. For an asset sale, the price is allocated under the residual method: cash first, then the other classes in order, with whatever is left assigned to goodwill and going concern value.
Agree on the allocation in writing. Under IRC 1060(a), a written agreement on the allocation, or on any asset's value, binds buyer and seller unless the IRS finds it not appropriate.
Choose the payment terms. Cash at closing, an installment note, an earnout or a mix; each changes when you are taxed.
Review your own tax history first. Payroll deposits, worker classification, open audit years and unfiled returns will surface in the buyer's diligence.
Plan the filings. Both sides generally file Form 8594 with their returns for the year of sale, and a new Form 8594 for any later year in which the price changes.

Asset sale or entity sale

Question	Sale of assets	Sale of corporate stock	Sale of a partnership interest
How the seller's gain is taxed	Each asset separately: capital, section 1231 or ordinary, with depreciation recapture (Pub. 544)	Usually capital gain or loss (Pub. 544)	Capital, except the part from unrealized receivables or inventory, which is ordinary (Pub. 544)
Price allocation	Required under the residual method (IRC 1060)	Not required for the stock itself	Residual method applies when the buyer's share of partnership assets is adjusted under a section 754 election (Pub. 544)
Form 8594	Generally filed by both buyer and seller	Not for a stock purchase alone	Not for a transferred partnership interest, unless the purchase is treated as a purchase of partnership assets
Buyer's basis	The price allocated to each asset; goodwill and other section 197 intangibles amortized over 15 years	Basis in the stock; the company keeps its own asset basis	Basis in the interest; its share of partnership assets is adjusted under section 743(b) when a section 754 election is in effect
Who keeps the entity's tax history	The seller's entity	The company, now owned by the buyer	The partnership, which pays a BBA imputed underpayment in the adjustment year

That last row is often the deciding one for a buyer. A company that is sold keeps its own unpaid taxes and audit exposure, so buyers of stock or partnership interests ask for representations, indemnities and holdbacks. Under the centralized partnership audit regime, IRC 6225 generally has the partnership pay an imputed underpayment in the year the audit is finished, not the year audited, so an incoming partner can bear the cost of a return filed before joining. The details are in how partnership audits work under the centralized audit regime.

Allocating the price

Publication 544 says a business sold for a lump sum is treated as a sale of each asset, and both buyer and seller must use the residual method. The Form 8594 instructions list seven classes, from cash (Class I) through receivables (Class III), equipment and other tangible property (Class V), section 197 intangibles such as customer lists and covenants not to compete (Class VI), and goodwill and going concern value (Class VII). The amount allocated to any asset other than goodwill cannot exceed its fair market value.

The two sides often want different numbers. A seller generally prefers price on assets that produce capital gain; a buyer prefers price on assets it can depreciate or deduct faster. Once both sign an allocation, IRC 1060(a) holds each of them to it. A practice sale adds ethics rules to the same tax rules, as explained in how the sale of a law practice is taxed. If you are a 10 percent or greater owner selling an interest in an entity and you also sign an employment contract, covenant not to compete, royalty or lease agreement with the buyer, IRC 1060(e) requires both of you to report information about it.

Getting paid over time

A sale with at least one payment after the end of the year of sale is an installment sale under IRC 453, and gain is generally reported as payments arrive, in the proportion that gross profit bears to the contract price. Several rules limit that deferral:

Recapture comes first. Depreciation recapture under sections 1245 and 1250 is taxed in the year of sale, even if little cash arrives that year (IRC 453(i)).
Inventory is excluded. Dispositions of inventory and dealer sales do not qualify (IRC 453(b)(2)).
Large notes carry an interest charge. For property sold for more than $150,000, an interest charge can apply when the face amount of such notes from the year that are still outstanding at year end exceeds $5,000,000 (IRC 453A).
Borrowing against the note counts as payment. For those same notes, loan proceeds secured by the note are treated as a payment received (IRC 453A(d)).
Related buyers who resell. If a related buyer resells within two years, the seller can be treated as paid at that time (IRC 453(e)).
Electing out. A seller can elect to report all the gain in the year of sale, by the return due date including extensions; revoking it requires IRS consent (IRC 453(d)).

What changes the answer

Deal structure. Stock, partnership interest and asset sales are taxed differently (Pub. 544), and the buyer's appetite for the entity's history often decides which one is possible.
The asset mix. Equipment with prior depreciation produces ordinary recapture (IRC 1245), while goodwill is amortized by the buyer over 15 years (IRC 197).
Payroll and worker classification. A buyer's diligence will test whether workers were properly classified and payroll taxes deposited. Unpaid trust fund taxes can follow responsible individuals personally under IRC 6672, as explained in whether the IRS can make you personally pay your company's payroll taxes.
Open years. Representations and indemnities should take account of the assessment periods in IRC 6501, explained in how far back the IRS can audit.
Later price changes. Earnouts and price adjustments require a supplemental Form 8594 for the year the change is taken into account (Form 8594 instructions).
Who owns the business. If the business is marital property in a divorce, the transfer and the later sale raise separate questions, covered in what tax issues you should settle in a divorce.

For example: a $1,000,000 sale paid over three years

For example, imagine a sole proprietor selling a consulting business's assets for $1,000,000 in 2026. The parties agree in writing to allocate $100,000 to equipment and $900,000 to goodwill. The equipment cost $100,000 and has been depreciated to a basis of $20,000, so the $80,000 gain on it is depreciation recapture. The owner built the goodwill and, we assume, has no basis in it. The buyer pays $250,000 at closing and gives a note for $750,000, with interest, over three years. Under IRC 453(i) the $80,000 of recapture is taxed in 2026 even though most of the price arrives later; the goodwill gain is reported as payments come in. Because the price is over $150,000, if the seller borrows against the note, the loan proceeds are treated as a payment. Both sides file Form 8594 showing the same allocation. If the buyer later pays an extra $50,000 under an earnout, each side files a supplemental Form 8594 for that year. This is a hypothetical, not a real case.

Common mistakes before a sale

Signing a letter of intent with no allocation. The allocation is negotiated, and leaving it for later gives up leverage.
Inconsistent Forms 8594. Buyer and seller reporting different allocations invites questions about both returns.
Assuming an installment note defers everything. Recapture is taxed in the year of sale, and pledging the note can accelerate the rest.
Leaving payroll problems for diligence to find. Contractor arrangements are easier to review before a sale than to defend in one; what happens in an IRS worker classification audit shows what the IRS examines.
Forgetting the covenant and consulting agreements. Side agreements with an owner, such as a covenant not to compete or a consulting contract, are separate from the price allocation and may need to be reported under IRC 1060(e).
Poor records of basis. Without records of what assets cost and how they were depreciated, gain cannot be computed or defended; what records the IRS requires explains the general standard.

What to do this week

Make a list of the business's assets by class, with cost, depreciation taken and estimated value.
Pull IRS account transcripts for the business's income and payroll returns for the last several years.
List every worker paid as a contractor, with the basis for that treatment.
Confirm that payroll deposits are current; a small firm's rules are in when a small law firm has to deposit payroll taxes.
Write down the payment terms you would accept and model the tax for each year.
Get tax advice on the letter of intent before you sign it.

Frequently asked questions

Do buyer and seller have to report the same allocation?

Each files its own Form 8594, and a written allocation agreement binds both under IRC 1060(a) unless the IRS finds it not appropriate. Reporting different numbers on the two forms undercuts that protection.

Can I use the installment method for all of the gain?

Not for depreciation recapture, which is taxed in the year of sale, and not for inventory. The rest of the gain on a qualifying sale is generally reported as payments are received unless you elect out.

Is a covenant not to compete deductible by the buyer?

A covenant entered into in connection with acquiring a business is a section 197 intangible, amortized over 15 years. Publication 544 adds that it cannot be treated as disposed of or worthless before the buyer disposes of its entire interest in the business.

Does a stock sale avoid Form 8594?

Form 8594 is for transfers of a group of assets that make up a trade or business, where the buyer's basis is set by what it paid. A buyer of stock acquires shares rather than the business's assets, so the form generally does not come into play; confirm how the buyer intends to treat the purchase before you sign.

What if the buyer finds a tax problem during diligence?

It is usually better to address it before closing, by correcting the return, negotiating a holdback or indemnity, or resolving it with the IRS. An open examination is handled through IRS audits and examinations counsel.

Planning a sale with the tax questions answered

A sale is the moment when years of tax decisions are tested at once. Kathryn Meyer spent more than two decades in the IRS Office of Chief Counsel and can help you structure the sale, review the allocation and payment terms, and address problems before a buyer finds them. To discuss a planned sale, contact the firm or call (571) 560-8674.

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