Tax Talk Thursday: Asset Sale Tax Planning: Capital Gains vs. Ordinary Income When You Sell Your Business

When a business owner sells, the headline number is the purchase price. The number that actually matters is what’s left after tax, and that depends less on the price than on how the price is characterized. Two sellers can close identical $2 million deals and walk away with after-tax proceeds that differ by tens of thousands of dollars, simply because one negotiated the allocation and the other signed whatever the buyer’s attorney drafted.

In an asset sale, the IRS doesn’t see one transaction. It sees the sale of every individual asset in the business: equipment, inventory, receivables, real estate, customer lists, goodwill, and any side agreements. Each piece carries its own tax character. Some pieces are taxed at favorable long-term capital gain rates; others are taxed as ordinary income at rates up to 37%. This post walks through where the lines fall, where the traps are, and what you can still control before the deal closes.

Why the Character of the Gain Matters

For 2026, the federal rate gap between ordinary income and long-term capital gain is substantial:

Type of Gain	Top Federal Rate	Common Sources in a Business Sale
Ordinary income	37%	Depreciation recapture on equipment, inventory, cash-basis receivables, noncompete payments
Unrecaptured §1250 gain	25%	Prior straight-line depreciation on buildings
Long-term capital / §1231 gain	20%	Goodwill, appreciation on land and buildings, other long-held business assets
Net Investment Income Tax	+3.8%	May apply on top — but generally not to gain on assets used in a business in which you materially participate

The 0%, 15%, and 20% brackets for long-term gain are set by taxable income. For 2026, married couples filing jointly stay in the 15% bracket up to $613,700 of taxable income ($545,500 for single filers); the 20% rate applies above that. Most business sales push the seller into the 20% bracket, which makes the character question even more important: every dollar shifted from ordinary to capital saves up to 17 cents in federal tax.

A California Note

California does not give capital gains a preferential rate. Both ordinary income and capital gain are taxed at the same state rates (up to 13.3%, plus the 1% Mental Health Services Tax above $1 million). For California sellers, allocation planning is primarily a federal exercise — but the federal savings alone are often significant.

Asset Sale vs. Stock Sale: The Starting Point

Sellers generally prefer to sell stock or membership interests. A stock sale is typically one asset, one holding period, and one long-term capital gain. Buyers, on the other hand, generally prefer to buy assets, because an asset purchase gives them a fresh, stepped-up basis they can depreciate and amortize, and it helps them avoid inheriting the seller’s unknown liabilities.

For most small and mid-sized businesses, the buyer wins that argument, and the deal is structured as an asset sale. Deals that are legally structured as a stock sale can also be treated as asset sales for tax purposes through a Section 338(h)(10) or Section 336(e) election, or through an F reorganization before closing. If your deal involves any of these, the allocation analysis below applies to you as well.

How the Purchase Price Gets Divided: Section 1060

When a going business is sold as assets, IRC §1060 requires both parties to allocate the price using the residual method across seven asset classes. Each class is filled up to its fair market value in order, and whatever is left over lands in Class VII: goodwill and going concern value.

Class	What It Includes	Typical Character to the Seller
I	Cash and bank deposits	No gain
II	Marketable securities, CDs, foreign currency	Usually capital
III	Accounts receivable	Ordinary (if cash-basis, full amount)
IV	Inventory	Ordinary
V	Equipment, vehicles, furniture, real estate	Ordinary to the extent of depreciation recapture; balance §1231
VI	Section 197 intangibles other than goodwill (customer lists, noncompetes, licenses)	Varies; noncompetes are ordinary
VII	Goodwill and going concern value	Generally long-term capital / §1231

Both buyer and seller report the allocation on Form 8594, attached to their returns for the year of sale. If the purchase agreement includes a written allocation, §1060(a) generally binds both parties to it. That is why the negotiation over the allocation schedule, not the tax return, is where the tax outcome gets decided.

The Ordinary Income Traps

1. Depreciation Recapture on Equipment (Section 1245)

This is the biggest surprise for most sellers. If you took depreciation on equipment, vehicles, or furniture (including Section 179 expensing and bonus depreciation), any gain up to the amount of that prior depreciation is ordinary income, not capital gain. Equipment bought for $400,000 and fully expensed in year one has a basis of zero. Sell it for $300,000, and all $300,000 is ordinary income. The same rule applies to previously amortized purchased intangibles.

2. Real Estate and Unrecaptured Section 1250 Gain

For buildings held by individuals and flow-through entities, prior straight-line depreciation is generally taxed at a maximum 25% rate rather than 20%. Appreciation above the original cost is §1231 gain. Land is not depreciated and produces §1231 gain only. If the building is owned in a separate LLC and leased to the operating company, consider whether it belongs in the sale at all.

3. Inventory and Receivables

Inventory sold as part of the business produces ordinary income. For a cash-basis business, receivables have a zero basis, so every dollar allocated to them is ordinary income. These amounts are largely fixed by fair market value, so the planning opportunity here is limited, but they should be modeled so there are no surprises.

4. Noncompete Agreements and Consulting Contracts

Buyers almost always want the seller to agree not to compete. Payments allocated to a covenant not to compete are ordinary income to the seller. Payments under a post-closing consulting or employment agreement are ordinary income and, in the case of consulting fees, generally subject to self-employment tax as well. Many seller-side allocation problems start here.

5. The Section 1231 Five-Year Lookback

Net §1231 gains are normally taxed as long-term capital gain. But under §1231(c), if you deducted net §1231 losses as ordinary losses in any of the prior five years, an equal amount of this year’s §1231 gain is recharacterized as ordinary income. Prior-year equipment dispositions and property losses should be reviewed before closing.

6. Sales to Related Parties (Section 1239)

Selling depreciable property to a related party, such as an entity you control or a family member’s controlled entity, can convert what would have been capital gain into ordinary income. Family and insider succession deals need a specific review under §1239.

Illustrative Example: Same Price, Different Result

Assume Linda owns 100% of an S corporation and agrees to sell the business assets for $2,000,000. She is married, files jointly, materially participates in the business, and will be in the top federal brackets. The buyer’s first draft of the allocation looks like this:

Asset	Allocated Price	Ordinary Income	Capital / §1231 Gain
Accounts receivable (cash basis)	$100,000	$100,000	—
Inventory (basis $120,000)	$150,000	$30,000	—
Equipment (cost $400,000; basis $50,000)	$300,000	$250,000	—
Covenant not to compete	$250,000	$250,000	—
Goodwill (self-created)	$1,200,000	—	$1,200,000
Total	$2,000,000	$630,000	$1,200,000

Linda’s advisors push back on two items. An independent equipment appraisal supports a fair market value of $250,000, not $300,000. And the noncompete is reduced to $50,000, a figure consistent with Linda’s realistic ability to compete (she is retiring) and documented in the agreement. The difference moves to goodwill:

Asset	Allocated Price	Ordinary Income	Capital / §1231 Gain
Accounts receivable (cash basis)	$100,000	$100,000	—
Inventory (basis $120,000)	$150,000	$30,000	—
Equipment (appraised)	$250,000	$200,000	—
Covenant not to compete	$50,000	$50,000	—
Goodwill (self-created)	$1,450,000	—	$1,450,000
Total	$2,000,000	$380,000	$1,450,000

The total gain is identical ($1,830,000), but $250,000 moved from ordinary income to capital gain. At a 37% versus 20% federal rate, that is roughly $42,500 in federal tax savings, from a negotiation that took place before signing and cost the buyer very little.

Why the Buyer May Agree

A buyer amortizes both a noncompete and goodwill over the same 15 years under §197, so shifting value from the noncompete to goodwill usually costs the buyer nothing. Equipment is different: with 100% bonus depreciation available again for qualifying property, buyers want more price allocated to equipment. That is where the real negotiation happens, and why a supportable appraisal matters.

Entity Type Changes the Math

S Corporations and Partnerships

In an S corporation or partnership asset sale, the gain flows through to the owners and keeps its character: ordinary stays ordinary, capital stays capital. Two points deserve attention. First, an S corporation that converted from a C corporation within the last five years may owe the §1374 built-in gains tax at the corporate level. Second, if a partner sells a partnership interest rather than the partnership selling assets, §751 still treats the partner’s share of receivables, inventory, and depreciation recapture (“hot assets”) as ordinary income, so a sale of the interest does not make the recapture disappear.

C Corporations and Personal Goodwill

A C corporation has no capital gain rate preference: gain is taxed at 21% at the corporate level, and the after-tax proceeds are taxed again when distributed to shareholders. One planning concept used in this setting is personal goodwill, which is goodwill that belongs to the owner personally (reputation, relationships, skills) rather than to the corporation. When supported, it can be sold directly by the owner at capital gain rates and avoid the corporate layer of tax.

Personal goodwill is a genuine gray area. Courts have respected it where the owner had no noncompete or employment agreement with the corporation and the value truly followed the individual (Martin Ice Cream Co. v. Commissioner). Courts have rejected it where the owner had already transferred those relationships to the corporation through a noncompete (Howard v. United States). The position works when the facts support it and it is documented with a separate purchase agreement and a qualified valuation. It is not a label that can be added at closing.

C corporation owners should also compare an asset sale to a stock sale. Stock held long enough in a qualifying C corporation may be eligible for the §1202 qualified small business stock exclusion, which is only available on a sale of stock.

Planning Strategies to Consider Before Signing

1.      Model the allocation before the letter of intent. Once a price and structure are agreed in principle, your leverage on allocation shrinks. Run the after-tax numbers under at least two allocation scenarios early.

2.      Get independent valuations. An appraisal of equipment and a valuation of intangibles make your allocation defensible and give you a factual basis to resist inflated equipment or noncompete values.

3.      Negotiate the allocation schedule into the purchase agreement. A written, agreed allocation binds both parties and prevents a mismatched Form 8594 later.

4.      Separate compensation for your time from compensation for the business. If the buyer wants you to stay on, price the consulting or employment agreement at a reasonable market rate rather than letting it absorb purchase price.

5.      Review prior depreciation and §1231 history. Know your recapture exposure and whether the five-year lookback applies before you agree to anything.

6.      Decide what stays out of the deal. Real estate held separately can often be leased to the buyer instead of sold, spreading or deferring gain.

7.      Consider an installment sale for the capital portion. Installment reporting under §453 can spread capital gain across years, but depreciation recapture is recognized in full in the year of sale regardless of when cash is received, and large installment notes can trigger an interest charge. Plan for the tax on recapture from first-year cash.

8.      Coordinate with the rest of your tax year. Timing of closing, retirement plan contributions, charitable planning, and estimated payments all interact with a large one-time gain.

In an asset sale, the purchase price is only half of the deal. The allocation of that price determines how much of your gain is taxed at 20% and how much is taxed at 37%, and that allocation is almost always negotiated, written into the purchase agreement, and locked in before your tax preparer ever sees the numbers. The sellers who keep the most are not the ones with the most aggressive positions; they are the ones who modeled the outcome early and backed their allocation with valuations.

•     If you expect to sell in the next one to three years, gather depreciation schedules and fixed asset records now.

•     Bring your tax advisor in before the letter of intent, not after the purchase agreement is drafted.

•     Ask for the buyer’s proposed allocation schedule early and model the after-tax result.

•     Keep noncompete and consulting amounts tied to their real economic value.

•     For C corporations, evaluate asset vs. stock structure, personal goodwill, and §1202 eligibility before negotiations begin.

•     Confirm estimated tax payments for the year of sale so a large gain doesn’t also create underpayment penalties.

MKHS Tax Group helps business owners model asset sale allocations, compare deal structures, and plan for the tax year of a sale before terms are locked in. Email us at info@mkhstaxgroup.com to schedule a consultation.