Takeaways

• Complex Tax Considerations: Exiting a business can involve multiple tax rules, filings, and reporting requirements.
• Different Tax Results by Asset Type: A “business sale” is often treated as the sale of individual business assets, and different assets may produce different tax outcomes.
• Final Tax Returns and Filings: Ensure all required final returns and related forms are filed, including specific IRS forms for closing a business.

When the time comes to sell or close your business, understanding the tax implications is crucial to support a smooth transition and help you stay aligned with IRS reporting requirements. Whether you’re selling an ongoing operation or winding down, the tax responsibilities associated with exiting a business can be complex.

This guide walks through key considerations, including how gains and losses may be determined, how depreciation can affect the character of income, and what final filings are commonly required.

Capital Gains and Losses

Calculating Capital Gains or Losses on the Sale

When people say they are “selling a business,” the transaction is often treated for tax purposes as the sale of a group of assets (for example, equipment, inventory, furniture, customer lists, and sometimes goodwill). Gain or loss is generally determined by comparing what you receive for each asset to that asset’s adjusted basis (often original cost plus certain improvements, minus depreciation for depreciable property).

In many business sales, the buyer and seller may need to allocate the purchase price among the assets being transferred. When a sale involves a group of trade or business assets and certain requirements apply, the IRS may require reporting that allocation on Form 8594.

Example: Tom decides to sell his coffee shop for $200,000. He originally purchased the shop for $150,000 and made $30,000 worth of improvements over the years. He also claimed $20,000 in depreciation. Tom’s adjusted basis in the business is calculated as follows: $150,000 (original purchase price) + $30,000 (improvements) – $20,000 (depreciation) = $160,000. Therefore, Tom realizes a capital gain of $40,000 ($200,000 selling price – $160,000 adjusted basis), which he will report on his tax return.Note: In many real-world business sales, the purchase price is allocated across multiple assets, and the gain/loss and tax treatment may be determined asset-by-asset rather than as one combined number.

Tax Rates and Reporting for Capital Gains

Capital gains tax rates can vary based on how long an asset was held and the taxpayer’s income level. Generally, long-term gains (assets held for more than one year) may qualify for preferential rates compared with short-term gains.

However, in a business sale, not all gain is automatically treated as “capital gain.” Some business property is reported on Form 4797, and certain items may be treated as ordinary income, while other items may be treated as capital gain or as §1231 gain/loss depending on the type of asset and other rules. In addition, certain real estate-related gains (often referred to as unrecaptured §1250 gain) may be subject to a maximum 25% rate rather than the standard long-term capital gain rates.

Form 8949 and Schedule D are commonly used for capital asset transactions, but business dispositions frequently involve Form 4797 as well, with only certain amounts (if any) flowing through to Form 8949/Schedule D depending on the situation.

Example: Sarah sells her bakery, which she has owned for five years, and the sale includes multiple assets. Some parts of the sale may be reported on Form 4797 (for business property), and any capital asset portions may flow through Form 8949 and Schedule D. Because she held the business for more than one year, any qualifying long-term components may receive preferential rates, while other components could be treated differently based on the asset type and applicable rules.

Depreciation Recapture

Understanding Depreciation Recapture Taxes

Depreciation recapture can apply when you sell certain depreciable business property at a gain after claiming depreciation deductions. In general, recapture rules may cause some or all of the gain—up to the amount of depreciation previously claimed—to be treated as ordinary income rather than as a preferentially taxed gain. The exact result can depend on the type of property (for example, different rules apply to §1245 and §1250 property), and some gains associated with real property may be treated under special rules (such as unrecaptured §1250 gain).

Example: James sells a piece of equipment used in his manufacturing business for $18,000. He originally purchased the equipment for $25,000 and claimed $10,000 in depreciation. That means his adjusted basis is $15,000 ($25,000 cost − $10,000 depreciation). His total gain is $3,000 ($18,000 sale price − $15,000 adjusted basis). Depending on the applicable recapture rules, some or all of that $3,000 gain may be treated as ordinary income due to depreciation recapture (up to the amount of depreciation previously claimed).

How the Sale of Assets Affects Recapture

The sale of depreciable business assets can trigger depreciation recapture and may also require determining how much of the result is ordinary income versus other types of gain or loss. Form 4797, Sales of Business Property, is commonly used to report dispositions of business property and to determine the character of the resulting gain or loss (including any recapture, when applicable).

Example: Mary sells several pieces of office equipment from her business. She reports these dispositions on Form 4797, which helps her determine whether any portion of the results is treated as ordinary income due to depreciation recapture and whether any remaining amount is treated as a different category of gain or loss, depending on the property and the outcome.

Final Tax Responsibilities

Filing Final Tax Returns for the Business

When closing your business, you generally must file a final return for the business and check the “final return” box on the applicable form. The type of return depends on your business structure—for example, Form 1120 for many C corporations or Schedule C for many sole proprietors.

In addition to filing the final return itself, the IRS generally expects you to file any required “final return and related forms” associated with the business’s operations (which can vary depending on whether you had employees, paid contractors, collected certain taxes, or had other filing obligations).

Example: John decides to close his sole proprietorship. To comply with IRS requirements, he files his final tax return, marking the “final return” box on his Schedule C. This indicates to the IRS that the business operations have ceased, and no further Schedule C filings are expected for that business activity. John also makes sure he completes any related final filings that applied to his business during the year.

IRS Requirements for Closing a Business

The IRS closing checklist often includes steps such as paying any outstanding taxes, filing final employment tax returns (when you have employees) using Form 940 and Form 941, and issuing final wage and withholding information to employees with Form W-2. If you paid independent contractors, you may also need to complete the IRS step to report certain payments made to contract workers.

You may also see the IRS described step to “Cancel your EIN and close your IRS business account.” In practice, this generally means you notify the IRS that the business is closing and request that the IRS close the associated business account, rather than “deactivating” an EIN for future reuse.

Example: When closing her boutique, Emily follows the IRS steps for properly closing her business. She files her final employment tax returns using Form 940 and Form 941, issues final W-2s to her employees, and ensures all outstanding taxes are paid. Because she also used freelance help during the year, she makes sure required contractor payment reporting is handled as part of the wrap-up process. Emily also notifies the IRS to close her business account tied to the EIN as part of the formal closure steps.

Consult with a Tax Professional

As you turn the page on your business journey, it’s essential to navigate the tax landscape with precision and care. Whether you’re selling your business or closing it down, the tax implications can significantly impact your financial outcome.

With over two decades of expertise, Mike Davidov, CPA can guide you through these complexities, ensuring that you meet all IRS requirements and optimize your tax position.

To discuss the specifics of your business sale or closure and how to best manage the associated tax responsibilities, schedule a free consultation with Mike Davidov, CPA today. Your next chapter awaits, and we’re here to help you start it on the right financial footing.