The tax treatment of a sale of a disregarded entity turns on a single question: does one buyer walk away owning the whole thing? If yes, the IRS ignores the membership interest you transferred on paper and treats the deal as if you sold each underlying business asset one by one. If no — because you sold a slice, or split the sale between two or more buyers — the entity stops being disregarded before the deal closes, becomes a partnership, and the sale is taxed as a sale of a partnership interest. That fork changes which assets throw off ordinary income, which qualify for capital gain rates, and how much tax you actually owe.
Why the Structure of the Sale Controls the Tax
A single-member LLC that hasn’t elected corporate status is disregarded for federal income tax purposes.1Internal Revenue Service. Single Member Limited Liability Companies The IRS doesn’t see the entity, so it can’t see a transfer of the entity’s ownership interest either. What it sees is whatever is left when you look through the LLC: the assets. That look-through is why the identity and number of buyers, not the language of the purchase agreement, decides how the sale is taxed.
Selling 100% to a Single Buyer
Sell your entire interest to one buyer and the transaction is a deemed asset sale. The membership interest is invisible for tax purposes; the only thing the IRS can recognize changing hands is the underlying property. You and the buyer must allocate the purchase price across every asset in the business and both report the allocation on Form 8594, Asset Acquisition Statement Under Section 1060.2Internal Revenue Service. About Form 8594, Asset Acquisition Statement Under Section 1060 Both sides attach the form to the return for the year of the sale, and both must report consistent numbers. Mismatched allocations attract IRS attention.
Because each asset generates its own gain or loss with its own character, one closing can produce four different tax rates on the same 1040. Equipment throws off ordinary income from depreciation recapture. Real property carries a 25% rate on unrecaptured depreciation. Goodwill generally lands at long-term capital gain rates. Inventory is always ordinary income. There is no single “sale of the business” line.
How the Price Gets Allocated
Section 1060 requires the residual method.3Office of the Law Revision Counsel. 26 USC 1060 – Special Allocation Rules for Certain Asset Acquisitions Seven asset classes fill in a fixed order, each up to fair market value, and whatever price remains lands in Class VII (goodwill).4Internal Revenue Service. Instructions for Form 8594
- Class I: cash and bank deposits
- Class II: actively traded securities and certificates of deposit
- Class III: accounts receivable and debt instruments
- Class IV: inventory
- Class V: all other tangible and intangible assets not covered by the other classes (equipment, furniture, vehicles)
- Class VI: Section 197 intangibles other than goodwill, such as customer lists, trademarks, and noncompete agreements
- Class VII: goodwill and going concern value
The allocation is where sellers and buyers pull in opposite directions. More value in inventory and depreciated equipment means more ordinary income for you. More value in goodwill usually means long-term capital gain. Buyers prefer weight in the classes they can depreciate or amortize soonest. Negotiating the allocation is one of the highest-leverage tax moves in the whole transaction.
Character of Your Gain
Depreciation recapture is usually the largest ordinary-income item. Under Section 1245, gain on tangible personal property is ordinary income up to the total depreciation you previously claimed; only gain above that amount can qualify for capital treatment.5Office of the Law Revision Counsel. 26 USC 1245 – Gain From Dispositions of Certain Depreciable Property Real property runs on Section 1250: gain attributable to prior depreciation (unrecaptured Section 1250 gain) is taxed at a maximum rate of 25%, and any gain above that amount is long-term capital gain at 0%, 15%, or 20%.6Office of the Law Revision Counsel. 26 USC 1250 – Gain From Dispositions of Certain Depreciable Realty
Depreciable and real property used in the business and held more than a year is Section 1231 property.7Office of the Law Revision Counsel. 26 USC 1231 – Property Used in the Trade or Business and Involuntary Conversions Net Section 1231 gains for the year are treated as long-term capital gains; net losses are treated as ordinary losses, which escape the $3,000 capital-loss limit. Watch the five-year lookback: if you claimed ordinary loss treatment on net Section 1231 losses in any of the five preceding years, an equal amount of this year’s Section 1231 gain is recharacterized back to ordinary income.
Goodwill and going concern value in Class VII typically qualify for long-term capital gain treatment when the business has been held more than a year. For most established service businesses, that residual is where most of the price ends up, which is why the sale can still come out reasonably well even after recapture. Inventory (Class IV) and accounts receivable (Class III) always produce ordinary income no matter how long you’ve held them.
Selling Less Than 100% — or to More Than One Buyer
The deemed asset sale framework breaks the moment the entity ends up with more than one owner. Two or more owners means partnership classification by default.8eCFR. 26 CFR 301.7701-3 – Classification of Certain Business Entities Revenue Ruling 99-5 recharacterizes the transaction as a two-step event: first, the buyer is treated as purchasing a proportionate share of each underlying asset directly from you; second, you and the buyer are treated as contributing your respective shares to a newly formed partnership in exchange for partnership interests.9Internal Revenue Service. IRS Chief Counsel Advice 0825008 Your side of the deal is then taxed as the sale of a partnership interest.
A partnership interest sale generally produces capital gain under Section 741.10Office of the Law Revision Counsel. 26 USC 741 – Recognition and Character of Gain or Loss on Sale or Exchange The catch is Section 751: any portion of the gain attributable to “hot assets” — unrealized receivables and inventory — is recharacterized as ordinary income regardless of the character of the partnership interest itself.11Office of the Law Revision Counsel. 26 USC 751 – Unrealized Receivables and Inventory Items So the partnership route is cleaner on paper but not a blanket capital-gains conversion.
Net Investment Income Tax
An additional 3.8% Net Investment Income Tax applies to individuals with modified AGI above $200,000 (single) or $250,000 (joint). These thresholds are not indexed for inflation.12Internal Revenue Service. Questions and Answers on the Net Investment Income Tax Capital gains from a business sale count as net investment income, but if you materially participated in the business, gain from the sale of property used in that active trade or business may be excluded. The active-versus-passive line matters here: a hands-on owner is in a very different position from someone who held the LLC as an investment.
The QBI Deduction Won’t Help
The 20% qualified business income deduction under Section 199A does not apply to your sale gain. The IRS excludes capital gains and losses from qualified business income; the deduction covers operating income from a qualified trade or business, not the proceeds from selling it.13Internal Revenue Service. Qualified Business Income Deduction Build your projected tax bill without it.
Installment Sales
If the buyer pays over multiple years, the installment method under Section 453 spreads gain into the years payments arrive.14Office of the Law Revision Counsel. 26 USC 453 – Installment Method But in a deemed asset sale, the rules apply asset by asset. Two categories can’t be deferred:
- Inventory. All inventory gain is reported in the year of sale, regardless of when payment comes in.15Internal Revenue Service. Publication 537, Installment Sales
- Depreciation recapture. Any gain classified as ordinary income under Section 1245 or Section 1250 is reported in full up front.16Internal Revenue Service. Topic No. 705, Installment Sales
That last one catches sellers regularly. You owe the recapture tax at closing, but the cash to pay it may not arrive until year two or three of the note. Model the cash flow before you agree to the payment terms.
Estimated Taxes After Closing
Sale gain flows straight onto your individual return with no employer withholding behind it, so a large deal can blow past every safe harbor. Waiting until you file to pay the balance will typically trigger an underpayment penalty. Run the numbers with a tax professional shortly after closing and make a quarterly estimated payment by the next deadline.17Taxpayer Advocate Service. Making Estimated Tax Payments
What the Buyer Gets
A buyer of 100% receives the cleanest outcome available in a business acquisition: a full stepped-up basis in every asset equal to the Form 8594 allocation.4Internal Revenue Service. Instructions for Form 8594 Tangible assets get depreciated on the actual purchase price rather than your old (often fully depreciated) basis. Class VI and Class VII intangibles — goodwill, customer lists, trademarks, noncompete agreements — are amortized over 15 years under Section 197.18Office of the Law Revision Counsel. 26 USC 197 – Amortization of Goodwill and Certain Other Intangibles
A buyer of a partial interest instead ends up with a partnership interest whose outside basis reflects the purchase price, while the partnership’s inside basis in its assets still reflects your historical cost. The partnership can fix the mismatch with a Section 754 election, which adjusts inside basis for the incoming partner.19Office of the Law Revision Counsel. 26 USC 754 – Manner of Electing Optional Adjustment to Basis of Partnership Property Without it, the buyer effectively pays for basis that produces no deductions until the partnership sells or distributes the assets.20Internal Revenue Service. FAQs for IRC Sec. 754 Election and Revocation Once made, the election applies to all future transfers and distributions, not just the current one, so buyers should negotiate for it in the purchase agreement and both sides should understand the ongoing consequences before filing.
State Taxes
Many states follow the federal classification, so a deemed federal asset sale is also a state asset sale. Some states impose transfer taxes or require bulk sale notifications with tax clearance before closing; failing to comply can leave the buyer personally liable for your unpaid state tax obligations. Check with the tax authority in every state where the business operates well before the closing date.