What Should I Do to Find and Fix Tax Problems Before Selling My Business?

Selling a business can be one of the most significant financial events of your life. But if tax issues are not identified and resolved before you consider a sale, they can substantially reduce the net proceeds from the sale.

Before entering into negotiations to sell your business it’s critical to involve a qualified M&A tax specialist. They can identify hidden tax liabilities, outdated structures, or reporting errors that might weaken your negotiating position—or worse, reduce your after-tax proceeds.

Proactively addressing these issues not only helps you avoid unpleasant surprises during due diligence but also gives you time to implement strategies that can significantly strengthen your position with buyers.

What Tax Documents Should You Review Before a Sale?

Thorough documentation is essential for identifying potential tax issues. The first step is reviewing the following:

Tax Returns (Federal and State): An M&A tax advisor will scrutinize the company’s tax returns for positions that are either technically flawed or too aggressive. Examples include overstated deductions, incorrect tax accounting methods, improper capitalization versus expensing of costs, or questionable eligibility for tax credits.

These positions may not have triggered scrutiny in the past, but they can raise red flags for a buyer conducting a thorough quality of earnings or tax diligence review.

If discovered late in the process, these issues can lead to last-minute purchase price reductions, increased escrow holdbacks, or even kill the deal. Identifying and correcting them early—before going to market—puts the seller in a much stronger negotiating position and helps ensure a smoother, more profitable transaction.

Depreciation Schedules: An M&A tax advisor will look for assets that have been fully depreciated, misclassified, or inconsistently reported across years, which could create unexpected depreciation recapture or distort the tax basis used in gain calculations.
Entity Structure Documentation: The tax implications of the sale depend significantly on whether your business is structured as a C corporation, S corporation, partnership, or sole proprietorship.

It’s surprisingly common for S elections to be flawed—often due to missing consents, ineligible shareholders, or overlooked second classes of stock. These issues can usually be corrected before a transaction, but they must be identified early to preserve the tax benefits of S corporation status. In some cases, a buyer may even require an F Reorganization to mitigate the risk of a defective S election and preserve the intended tax treatment of the deal.

State Income Tax Exposure – An M&A tax specialist will review for unfiled or improperly filed state income tax returns, especially in states where the business has sales, payroll, or property. They’ll also evaluate whether state apportionment was calculated correctly and whether federal-to-state adjustments were properly handled. These issues can create material state tax liabilities that buyers may uncover in due diligence—potentially leading to price reductions or escrow requirements if not addressed in advance.

Unpaid Sales and Services Taxes – Many business owners are surprised to learn during due diligence that they owe back sales tax or have unfiled returns, often due to evolving nexus rules after the Wayfair Supreme Court case and the expansion of sales tax to digital goods and services in some states. These liabilities can reduce purchase price or delay closing if not identified and addressed early.

How Does Sale Structure Impact Tax Liabilities?

The structure of the sale—whether it’s an asset sale or a stock sale—has major tax consequences:

Asset Sale: The business sells individual assets (equipment, inventory, goodwill). Each asset is treated individually for tax purposes. Depreciated assets are subject to depreciation recapture, taxed as ordinary income. Gains on capital assets may be taxed at favorable long-term capital gains rates.
Stock Sale or Equity Sale: The buyer acquires stock or, in certain cases, LLC units in the business entity. Typically, this results in capital gains treatment for the seller.

Sellers often prefer stock sales due to lower capital gains tax, while buyers favor asset sales for better tax basis and depreciation opportunities. Negotiations should reflect these conflicting interests and include appropriate tax indemnities.

Why Is Purchase Price Allocation So Important?

In an asset sale the IRS requires that the total purchase price be allocated among the assets being sold based on their relative fair market values.

It’s best for Buyer and Seller to agree, in writing, on purchase price allocation to avoid unnecessary IRS challenge.

Purchase price allocation affects both the seller’s tax liability and the buyer’s future depreciation tax benefits. Key categories include:

Tangible assets (e.g., inventory, equipment)
Intangible assets (e.g., goodwill, customer lists)
Non-compete agreements
Consulting contracts

Allocating more of the purchase price to goodwill benefits the seller by reducing ordinary income tax exposure.

Allocating more of the purchase price to tangible assets like inventory and equipment benefits the buyer by generating larger and faster tax deductions through cost of goods sold and depreciation. However, allocating more purchase price to tangible assets is generally unfavorable for the seller because it often results in higher ordinary income (rather than capital gain), increasing the seller’s tax liability.

What Is Depreciation Recapture and Why Does It Matter?

Depreciation recapture is the portion of gain on the sale of a depreciated asset that is taxed as ordinary income, rather than at the more favorable capital gains rate. When a business sells an asset, such as equipment or real estate, the IRS “recaptures” the depreciation deductions previously taken by taxing that portion of the gain at higher rates. The goal is to prevent taxpayers from benefiting from both accelerated depreciation and long-term capital gain treatment on the same asset.

Section 1245 property includes machinery, equipment, and other tangible personal property.
Section 1250 property includes real estate. If straight-line depreciation was used, the unrecaptured portion is taxed at a maximum of 25%.

By allocating more of the purchase price to assets with little or no prior depreciation—such as newly acquired equipment or non-depreciable assets—the seller can minimize depreciation recapture, thereby reducing the portion of gain taxed at higher ordinary income rates and lowering overall tax liability in an asset sale.

Strategic purchase price allocation can reduce depreciation recapture for the seller by assigning more value to assets not subject to recapture, such as goodwill, which is taxed at favorable capital gain rates instead of higher ordinary income rates.

Can You Use Installment Sales to Spread Out Tax Liability?

In many cases the Buyer will agree to structure payments for the business over time, allowing the Seller to use the installment method.

An installment sale is a method of structuring the sale of a business or asset where the seller receives payments over time, rather than in a single lump sum. For federal tax purposes, the seller generally reports gain as payments are received, spreading the tax liability over multiple years.

This can be beneficial because:

It may allow the seller to stay in a lower tax bracket each year, reducing the overall tax burden.
It defers taxes, improving after-tax cash flow in the early years.
It creates the opportunity to time income strategically, for example, to align with lower-income years or the expiration of other tax attributes like NOLs.

However, it’s important to consider the credit risk of the buyer and whether the seller can afford to defer receipt of the full proceeds.

Installment sales must comply with strict IRS rules. Interest income must be accounted for separately, and sellers must file IRS Form 6252 annually to report the gain.

Are There Advanced Tax Strategies for Business Sales?

Advanced tax planning can significantly reduce tax liability:

Qualified Small Business Stock (QSBS) under Section 1202 allows up to 100% exclusion of capital gains for federal income tax purposes if stock of a C corporation is being sold and if certain conditions are met, such as holding the stock for at least five years and meeting gross asset thresholds.
Opportunity Zone Investments allow for the deferral or elimination of capital gains if proceeds are reinvested in a Qualified Opportunity Zone Fund within 180 days.
Employee Stock Ownership Plans (ESOPs) may allow business owners to sell to employees and defer capital gains under Section 1042, provided the proceeds are reinvested in qualifying replacement property.
Partnership Freeze or Preferred Equity Recapitalization in closely held partnerships or LLCs involves restructuring ownership into preferred and common units and can help shift future appreciation to heirs or reduce the value of what’s sold for tax purposes.
Charitable Remainder Trusts (CRT) involve contributing ownership interests to a CRT before a sale thereby providing an immediate charitable deduction for the seller(s) and spreading gain over time, often with lifetime income to the seller(s).
State Residency Planning can be beneficial for owners in high-tax states. Establishing residency in a low or no-tax state before the sale can yield significant tax savings- but timing and intent must be a carefully documented.

All of these strategies require advance planning and legal structuring.

How Do State-Level Taxes Affect Business Sale Planning?

While federal taxes get the most attention, state taxes can significantly impact your net proceeds:

State Income Tax on Gain – The state where the seller resides (and where the business operates) often taxes the gain on the sale. California and New York are examples of high tax states, while Florida, Texas, and Nevada have no state income tax.

Apportionment Rules – For multistate businesses, the portion of gain taxed in each state depends on factors like property, payroll, and sales apportionment. Misapplied rules or incorrect calculations can lead to overpayment or audit risk.

Entity Structure Implications – C corps and S corps are taxed differently at the state level. Some states don’t recognize S corporation status, which can lead to double taxation unless addressed in advance.

Pass-Through Entity (PTE) Tax Elections – Most states allow pass-through entities (S corps and partnerships) to pay income tax at the entity level to preserve the federal SALT deduction – elections that should be evaluated and maximized in the year of sale.
Nexus and Filing Obligations – A sale can create state filing requirements in new states if tangible or intangible assets are transferred there. Buyers will scrutinize state tax exposure closely during diligence.

Proactive state-level planning can avoid costly surprises and unlock meaningful tax savings. Long-term strategic planning might involve residency changes, using trusts, or reallocating where assets are located.

When Should You Start Tax Planning for a Sale?

Ideally, tax planning should begin 1–3 years before a potential sale. Many beneficial strategies, such as QSBS qualification or trust planning, require multi-year lead times. Early engagement with CPAs, tax attorneys, and financial advisors ensures that tax exposures are minimized and opportunities are fully captured.

Summary

Selling a business is not only a financial transaction—it is a highly complex tax event. To protect your investment:

Have past tax filings reviewed.
Identify exposure to depreciation recapture
Optimize purchase price allocation to favor capital gains
Consider installment sales or advanced planning tools
Assess state-level tax exposure and plan to mitigate state taxes on the sale.

Proactive tax strategy is key. Gilabert Hopkins LLP CPAs provides comprehensive tax planning services to help business owners identify problems early and execute transactions efficiently and legally. With proper planning, you can maximize your sale proceeds and minimize your tax burden.