Buying or selling a small business is a milestone that comes with both excitement and complexity. Alongside negotiations and valuation, the tax consequences of a sale can significantly affect what you actually take home when the deal closes.

For most owners, tax planning in a small business sale isn’t an afterthought; it’s one of the most important parts of the transaction. The structure of the deal, the types of assets involved, and the timing of payments can all change your final number and tax liability in very real ways.

Here’s what every small business owner should understand before heading into a sale process.

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1. Deal Structure Drives Tax Outcome

As I shared in a previous article on deal structure, small business sales fall into one of two categories: an asset sale or an equity sale (stock or membership interest). The distinction matters more than almost any other factor.

Asset Sale

In an asset sale, the buyer purchases specific assets of the business — equipment, inventory, customer lists, goodwill, and sometimes real estate. This is the most common structure for small business transactions.

For buyers, it’s usually preferred because they can “step up” the tax basis of the acquired assets and take new depreciation deductions. For sellers, it can be less favorable because different assets are taxed differently. The proceeds are often divided between capital gains and ordinary income depending on asset type.

For example:
- Goodwill and intangible assets → taxed as long-term capital gains.
- Inventory and receivables → taxed as ordinary income.
- Depreciation recapture on equipment → taxed as ordinary income to the extent of prior deductions.

This allocation of value between asset classes is documented on IRS Form 8594 (Asset Acquisition Statement) and negotiated between the parties. Even small differences in allocation can produce meaningful changes in after-tax proceeds.

Stock (or Membership Interest) Sale

In a stock sale, the buyer purchases ownership of the business entity itself. The company’s assets and liabilities remain intact; only the ownership changes hands.

For sellers, this is generally the cleaner, more tax-efficient route because gain on the sale of stock is typically taxed as a long-term capital gain. For buyers, it can be less appealing since they inherit all historical liabilities and don’t receive a stepped-up basis in the underlying assets.

In a Pennsylvania C corporation sale, the difference in effective tax rate between a stock sale and an asset sale can be significant — especially if depreciation recapture or double taxation applies at the corporate level.

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2. Bridging the Gap: Elections That Balance Buyer and Seller Interests

Buyers and sellers rarely want the same thing. Buyers prefer asset deals for the stepped-up basis and future deductions. Sellers usually favor stock deals for cleaner exits and capital gain treatment. Fortunately, the tax code provides several elections and structures designed to bridge that divide.

Section 338(h)(10) Election

This election can be useful in small business acquisitions where the buyer purchases the stock of an S corporation or a subsidiary within a consolidated group. The Section 338(h)(10) election allows both parties to treat the stock sale as if the company sold all its assets and immediately liquidated — even though only the stock technically changed hands. 

The buyer gains the benefit of a stepped-up asset basis, allowing for larger depreciation and amortization deductions in the future—similar to the benefits of an asset purchase. The seller may face depreciation recapture and income tax treatment, resulting in higher immediate tax liability. However, this approach can also justify a higher purchase price and make the overall sale more tax-efficient. It’s a valuable middle ground when the parties want the simplicity of a stock deal with the tax advantages of an asset purchase.

F-Reorganization

An F-reorganization is a tax-efficient way to restructure a business before a sale. It involves restructuring the selling operating entity (most often used when an S corporation is being sold) before closing, typically by moving the equity of the operating entity into a new holding company owned by the same shareholders. The buyer then acquires the equity of the operating entity, which are treated as assets for tax purposes. 

Why does this matter? It gives the buyer the tax benefits of an asset purchase—such as a step-up in asset basis and future depreciation deductions—without the logistical challenges of transferring every contract, license, and account individually. For sellers, an F-reorganization is generally tax-neutral at the time of restructuring, and it can make the business more attractive to buyers by reducing post-closing complications and risk. While this structure is more complex, it can simplify post-closing operations and accommodate partial acquisitions (good for family or multi-owner businesses).

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3. Special Rules for Pass-Through Entities

Many closely held businesses operate as LLCs or partnerships taxed as partnerships. In these cases, a buyer typically acquires a membership or partnership interest rather than the entity’s underlying assets. That difference creates unique tax dynamics.

An IRC Section 754 election allows the partnership to adjust (or “step up”) the inside basis of its assets for the new owner’s share, mirroring the benefits of an asset purchase without disrupting the partnership’s continuity. This adjustment can create meaningful tax savings by increasing depreciation and amortization deductions over time—particularly for businesses with equipment, real estate, or valuable intangible assets such as goodwill. For example:

• Equipment: The buyer can depreciate assets based on current fair market value rather than the partnership’s older, lower basis.
• Real Estate: A higher basis allows for larger depreciation deductions on buildings and improvements.
• Intangibles: Goodwill and customer relationships can be amortized over 15 years, reducing taxable income in future years.

For partnership buyers, confirm during your M&A due diligence whether a 754 election is already in place — or plan to make one as part of the deal.

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4. When Mergers Get Creative: Triangular Structures

Larger or more complex small business acquisitions sometimes use triangular mergers to achieve specific legal or tax outcomes. Triangular mergers are most common when the buyer is a corporation with one or more subsidiaries. While not common for the sale of a single-location business or family-owned S corporation, they can come into play when:

• The buyer is a corporate group or private equity firm buying through an existing subsidiary.
• The business being sold has valuable licenses, contracts, or regulatory approvals that can’t easily be transferred.
• The deal involves continuity of operations (keeping the same name, contracts, or employees in place).

There are two triangular merger strategies:

• Forward Triangular Merger: The target merges into a subsidiary of the buyer, and the subsidiary survives. This structure is generally treated as an asset acquisition for tax purposes, giving the buyer a stepped-up basis in the assets.
  
  
• Reverse Triangular Merger: The buyer’s subsidiary merges into the target, and the target survives as a wholly owned subsidiary of the buyer. This preserves a parent subsidiary structure and is useful in regulated industries or professional services where new licenses or client consents would be time-consuming or costly. This is typically treated as a stock acquisition — preserving the target’s legal identity, contracts, and licenses.

These structures allow flexibility where regulatory, licensing, or continuity issues make direct asset or stock transfers difficult.

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5. Installment Sales and Timing of Payment

If you’re selling on terms — receiving payments over several years rather than all at once — you may qualify to report the sale as an installment sale. This allows you to recognize gain (and pay tax) only as payments are received, spreading the liability over time.

Benefits include:

• Reduction in the immediate tax hit for year one.
• May lower your effective tax rate by spreading income across multiple years.

Keep in mind that installment reporting generally applies only to capital gain income — not to ordinary income items like depreciation recapture or inventory. These details should be clearly outlined in your purchase agreement and reviewed carefully with your attorney and CPA in advance of closing. If the buyer defaults, the remaining gain may never be collected, though depreciation recapture is still taxed in full the year of sale.

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6. State and Local Tax Considerations

Federal tax planning often dominates discussions, but state and local taxes can meaningfully affect net proceeds.

For Pennsylvania small business owners:

• The state personal income tax rate is 3.07%, applied to both ordinary income and capital gains.
• For corporate sellers, Pennsylvania’s corporate net income tax is currently 7.99% and is scheduled to decrease gradually to 4.99% by 2031
• Local earned income taxes may also apply, depending on your municipality.

Business owners selling multi-state operations or real property should consider where nexus exists and where income will be sourced for apportionment purposes. Nexus simply means a connection that creates a tax obligation in a particular state. If your business has nexus in a state, that state has the legal right to tax part of your income.

Nexus can be created by things like:

• Having a physical presence — offices, employees, warehouses, or property in the state.
• Making sales or deliveries into the state (economic nexus).

Nexus not only determines which states can tax part of the gain from your sale but also how that income is divided between them. For Pennsylvania sellers, this can affect how much of the sale proceeds are taxed in-state versus elsewhere, making it a critical piece of M&A tax planning.

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7. 1031 Exchanges for Real Estate

If the sale includes real estate, a 1031 like-kind exchange may allow you to defer capital gains by reinvesting the proceeds into other qualifying property within prescribed timelines (generally 45 days to identify, 180 days to close). While personal goodwill and operating assets don’t qualify, this can be a useful tool when the business sale includes real estate attached to the transaction as either an investment or business-use real property.

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8. Planning Early Pays Off

The best time to start tax planning isn’t when you sign the LOI — it’s a year or more before you plan to sell. 

A proactive approach in preparing to sell your small business gives you time to:

• Clean up financials and confirm accurate basis tracking.
• Evaluate entity structure (C corp vs. S corp) and potential elections.
• Model multiple sale structures and allocations to see after-tax outcomes.
• Coordinate with your CPA and legal counsel to position for the most efficient result.

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Final Thought

Taxes may not be the most exciting part of selling a business, but they’re one of the few things you can meaningfully control with the right preparation.

Understanding how deal structure, timing, and allocation decisions interact with the tax code can make the difference between a good deal and a great one. If you’re thinking about selling in the next few years, now is the time to start planning — your future buyer, and your future self, will thank you.

If you’re weighing a possible sale or just want clarity on how taxes could affect your outcome, I’m happy to help you think it through. Contact me, and we can set up a time to discuss your business and the best way to plan ahead, setting you up for a successful M&A closing process.