The Basics of the Tax Consequences of a Business Asset Sale

The sale of a business by a seller to a purchaser generally can take two forms: A sale of the business’s assets or a sale of equity interests in the business. As a general rule, the seller will favor a sale of equity and the purchaser will favor an asset sale. This is because with an equity sale, the seller will have capital gain whereas with an asset sale, the seller generally has some ordinary income. An asset purchase is more appealing to the purchaser because the tax basis of the assets will be equal to their purchase price and can be depreciated on that basis. The sale of a business via an asset sale is treated as if each of the assets of the business were sold separately for purposes of determining gain or loss.

All assets sold in an asset sale must be classified as capital assets, depreciable property used in the business, real property used in the business, or property held for sale to customers, such as inventory or stock in trade. The gain or loss on each asset is figured separately. The sale of capital assets results in capital gain or loss whereas the sale of real property or depreciable property used in the business and held longer than one year results in gain or loss under IRC § 1231. The sale of inventory results in ordinary income or loss to the seller.

In general, both the purchaser and seller of a business must use the “residual method” to allocate the consideration to each business asset transferred. The purchaser’s consideration is the cost of the assets acquired. The seller’s consideration is the amount realized (money plus the fair market value of property received) from the sale of assets. The residual method determines gain or loss from the transfer of each asset and how much of the consideration is for goodwill and certain other intangible property. It also determines the purchaser’s basis in the business assets.

The residual method requires the consideration to be reduced first by the cash and general deposit accounts (including checking and savings accounts but excluding certificates of deposits) and allocated among the various business assets in the following order:

Class I: Cash, demand deposits, and similar cash items.
Class II: Readily marketable stock and securities and certificates of deposit.
Class III: All other tangible and intangible assets not in any other class.
Class IV: IRC § 197 intangibles other than goodwill and going concern value.
Class V: Goodwill and going concern value.

In this way, gain and/or loss is allocated among all the assets of the business.

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