Business Sale Tax Attorney

The Four Ways to Sell a Business — and What Each One Does to Your After-Tax Number

Every closely-held business sale to a private-equity or strategic buyer reduces to one of four federal-tax structures. The structures look superficially similar — a buyer pays cash, the seller transfers ownership — but they produce very different tax outcomes for both sides. Here is each one in plain English.

Structure 1 — Plain Stock Sale

The seller transfers shares directly to the buyer and recognizes long-term capital gain. The buyer steps into the company at its existing tax basis — no step-up, no §197 amortization of goodwill, no fresh depreciation on equipment.

For the seller, the math is straightforward: sale price minus stock basis equals capital gain, taxed at the federal long-term capital gain rate (20%) plus the §1411 Net Investment Income Tax (3.8%) plus state. For a California-resident seller, the combined federal-plus-state long-term capital gain rate is approximately 37.1% — federal 23.8% plus California 13.3% (California has no preferential rate for capital gain).

Plain stock sales are clean legally. They preserve contracts, licenses, and the company's EIN. But because the buyer is taking the entity "as-is" from a tax perspective, the buyer's effective cost of capital under this structure is higher. Sophisticated buyers compensate by discounting the offered price. In practice, plain stock sales produce the lowest net to the seller of the four structures — usually 65–67% of gross sale price for a California-resident seller.

Structure 2 — Stock Sale With a §338(h)(10) Election

IRC §338(h)(10) lets the buyer and seller jointly elect to treat a stock sale as an asset sale for federal tax purposes. Legal form stays stock; federal tax form becomes asset.

The election is available only when the target is an S corporation or a member of a consolidated group. It is made on Form 8023 by all of the S-corp's shareholders and the buyer. Once elected, the deemed sequence under §338(h)(10) is: the S-corp sells all its assets to a new corporation owned by the buyer, then immediately liquidates and distributes the proceeds to the old shareholders.

The benefit to the buyer: basis step-up under §197 on goodwill and other intangibles (amortizable over 15 years), §168 on fixed assets (depreciable on the regular schedule), and basis step-up on inventory. That step-up has a present value the buyer is willing to pay for — typically 30–50% of the present value of the buyer's future tax savings, paid as an increase in purchase price. This is the "buyer gross-up."

The cost to the seller: gain character is no longer pure capital. Under §1060, the consideration is allocated across seven asset classes — cash, securities, mark-to-market debt, inventory, tangible property, §197 intangibles, and goodwill. Depreciation recapture on equipment (§1245) becomes ordinary income. Goodwill remains capital. For a service business with negligible §1245 property, the character mix is overwhelmingly still capital — but for a manufacturer or any business with material depreciated equipment, the recapture cost matters.

One critical warning: §338(h)(10) carries a §1374 Built-In Gain trap. If the S-corp has any C-corp history within the five-year recognition period (either through direct conversion or carried-over basis), the deemed asset sale triggers an additional 21% federal corporate-level tax on the built-in gain at conversion. For a thirty-year-old S-corp that was never a C-corp, this is a non-issue. For any S-corp that converted from C within the last five years, it is the controlling fact.

Verifying the S-election effective date is the first thing we do on any §338(h)(10) matter. We pull Form 2553 from the corporate records or the earliest 1120-S filed. If the company has a recent conversion history, we discuss whether to wait out the five-year window before electing.

Structure 3 — F-Reorganization Plus Sale of LLC Interest (Recommended for Most Closely-Held Sales)

An F-reorganization under IRC §368(a)(1)(F) combined with a Qualified Subchapter S Subsidiary (QSub) election and conversion to a single-member LLC produces asset treatment for the buyer without requiring a §338(h)(10) joint election. It is the firm's workhorse pre-sale structure for closely-held S-corps.

The sequence is subtle and the order matters. Get it wrong and you have a taxable transaction at the contribution step.

Step one: form a new S corporation. Call it NewSCo. NewSCo files Form 2553 to elect S-corp status. The shareholders of NewSCo at formation are the same shareholders as the existing OpCo, in the same proportions.

Step two: the shareholders contribute all of their OpCo stock to NewSCo in exchange for NewSCo stock. NewSCo now owns 100% of OpCo, and the shareholders own 100% of NewSCo in the same ratios. The exchange is non-taxable under §354 because it qualifies as a "mere change in identity, form, or place of organization" under §368(a)(1)(F).

Step three: NewSCo immediately files Form 8869 making a Qualified Subchapter S Subsidiary election for OpCo under §1361(b)(3). OpCo ceases to exist as a separate corporation for federal tax. All of OpCo's assets and liabilities are deemed owned directly by NewSCo. The combined contribution + QSub election is treated as the F-reorganization, provided the six requirements of Treas. Reg. §1.368-2(m) are satisfied: same shareholders, same proportional ownership, business continuity, no change in tax attributes, ends with one S-corp, qualifies as a mere change in form.

Step four: NewSCo converts the former OpCo (now a QSub) into a single-member LLC owned by NewSCo. Two paths to do this — state-law conversion under the applicable corporations code, or state-law merger into a newly formed single-member LLC. Either way, the result is the same: NewSCo owns 100% of a single-member LLC that holds all the operating assets. The LLC is disregarded for federal tax.

Step five: at closing, the buyer purchases 100% of the LLC interest from NewSCo. Under Rev. Rul. 99-5, the purchase of 100% of a disregarded LLC is treated as a deemed asset sale at the federal level. The seller (NewSCo) recognizes gain on the underlying assets per §1060. The shareholders pick up their share of that gain on their K-1s.

Three structural reasons this beats §338(h)(10) for most closely-held sales — same tax outcome at the shareholder level, very different execution.

First, no buyer joint election is required. The buyer simply purchases an LLC interest. Asset treatment happens by default under Rev. Rul. 99-5. No Form 8023, no risk that buyer's counsel refuses to make the election, no negotiation over election mechanics.

Second, no §1374 BIG exposure regardless of S-election history. The F-reorganization is treated as a non-taxable "mere change" under Reg. §1.368-2(m). The sale by NewSCo of an LLC interest is not a "deemed liquidation of an old S-corp" — so the BIG recognition window is not re-opened. Even where the S-corp has a complicated conversion history, this structure avoids the BIG trap that §338(h)(10) faces.

Third, cleaner negotiation. Buyer counsel sees an LLC interest sale, prices it, papers the membership interest purchase agreement, and moves on. No tax-election tail wagging the deal.

The shareholder-level federal and state outcome is essentially identical to a §338(h)(10) — same character mix, same gross-up dynamic, same net to the seller. The advantage is execution, not tax. For more on the mechanical sequencing, see F-reorganization attorney. The treatise authority is Bloomberg Tax Portfolio 774-4th, Single Entity Reorganizations: Recapitalizations and F Reorganizations.

Structure 4 — F-Reorganization Plus Charitable Remainder Trust Hybrid

The F-reorganization plus CRT structure adds one move before closing: the seller contributes a portion of the LLC interest to a Charitable Remainder Trust under IRC §664, and the CRT sells its share to the same buyer at the same closing.

The doctrinal threading-of-the-needle here matters. A CRT cannot hold S-corporation stock — CRTs are not on the §1361 list of permitted S-corp shareholders, and contributing S-corp stock to a CRT terminates the S-election. The CRT contribution has to happen after the F-reorganization-to-LLC has converted the equity into LLC interest, not at the S-corp-stock level. The order is non-negotiable.

Once the LLC interest is contributed to the CRT, four economic effects compound:

Effect 1 — Immediate charitable deduction. The donor receives a federal income-tax deduction equal to the actuarial present value of the remainder interest passing to the named charitable beneficiary at trust termination. The remainder factor depends on the donors' ages, the §7520 rate at contribution, the payout rate, and the type of CRT. For a joint-life CRUT at 5% payout with donors in their late 60s, the remainder factor is typically around 20%. On a $2.975M contribution, that produces approximately a $595,000 deduction, usable against ordinary income up to 30% of AGI with a five-year carryforward.

Effect 2 — Tax-deferred compounding of the sale gain. The CRT sells its share of the LLC interest at closing. Gain is recognized inside the CRT, but the CRT is itself tax-exempt under §664(c). The gain accumulates and is taxed to the donors only as it is distributed under §664(b)'s four-tier ordering: ordinary income first, capital gain second, tax-exempt third, return of corpus fourth. The blended tax rate on actual annuity distributions is typically lower than the donor's individual rate on the same dollars taken in a lump sum.

Effect 3 — Lifetime annuity income. The CRT pays the donors a fixed payout for their joint lifetimes (or a term up to 20 years). On a $2.975M contribution at a 5% CRUT payout, year-one distributions are $148,750 per year, growing if the trust's net return exceeds 5%. Across a 24-year joint life expectancy, total nominal distributions exceed $4.5 million on a corpus that grows at 8% net while paying out 5%.

Effect 4 — Estate tax reduction. Assets contributed to a CRT are no longer in the donors' taxable estate. At a 40% federal estate-tax marginal rate above the unified credit, every dollar in the CRT is approximately 40 cents of estate-tax savings, on top of the charitable legacy at trust termination.

Modeled together at a 7% personal discount rate, an F-reorg + CRT with 35% to the trust on an $8.5M sale produces approximately $5.27M in total economic value to the donors — about $760,000 less in nominal NPV than the F-reorg + Asset Sale path, but with guaranteed lifetime income, reduced estate, and charitable legacy in exchange. Whether to choose the CRT hybrid is a values question, not a tax-optimization question. We run both numbers; the seller chooses.

How Buyers Pay You for the Step-Up: The Gross-Up Math

Sophisticated PE buyers will pay 30–50% of the present value of their future tax savings back to the seller as an increase in purchase price. This is the "buyer gross-up" — the mechanism that makes §338(h)(10) and F-reorg structures more lucrative than plain stock sales for both sides.

The math: a buyer who acquires $7.3M of goodwill in a deemed asset sale gets to amortize it over 15 years under §197. At the 21% federal C-corp rate, that produces a tax shield of about $1.53M of tax savings over 15 years, present-valued at the buyer's discount rate (commonly 7–9%) to about $930,000 in today's dollars.

A buyer who is paying for the right to that tax shield can rationally pay up to 100% of the PV — though they will not. In an arm's-length negotiation, buyers concede 30–50% of the PV step-up benefit back to the seller. On the $930K PV in this example, a 40% gross-up is about $372,000 of incremental purchase price.

That extra $372K is itself taxed to the seller at the seller's combined capital-gain rate (about 37.1% combined federal + California for a CA-resident). Net incremental cash to the seller, after tax, is approximately $234,000. Compared to the do-nothing plain stock sale, the §338(h)(10) or F-reorg structure produces about $234K more net to the seller — for which the seller has to do the structural work.

In practice, the gross-up negotiation gets simpler if the seller's counsel comes to the table with the analysis pre-modeled. Buyer counsel usually does this math too; doing it ourselves means the buyer is not the only party in the room who knows what the right number is.

§1060 Residual Method: How the Purchase Price Gets Allocated

Under §1060 and Treas. Reg. §1.1060-1, the buyer and seller must use the residual method to allocate consideration across seven asset classes. The allocation drives the seller's character mix and the buyer's basis step-up. It is filed on Form 8594 by both parties.

The seven asset classes, in order of allocation priority:

• Class I — Cash and cash-equivalents. Allocated at face value. No gain consequence.
• Class II — Actively-traded securities. Allocated at fair market value. Rare in closely-held sales.
• Class III — Mark-to-market debt and CDs. Allocated at FMV.
• Class IV — Inventory. Allocated at FMV. Gain on inventory is ordinary income — important for businesses with significant inventory.
• Class V — Tangible property other than inventory. Real property, equipment, fixtures. Allocated at FMV. §1245 recapture on equipment converts up to accumulated depreciation into ordinary income.
• Class VI — §197 intangibles other than goodwill. Customer lists, non-compete agreements, licenses, trademarks. Allocated at FMV. Gain is long-term capital because §197 intangibles held more than one year are §1221 capital assets in the seller's hands.
• Class VII — Goodwill. Allocated as the residual — whatever consideration remains after Classes I–VI. Gain is long-term capital.

For a service business with limited tangible property and high enterprise value, the residual allocation is overwhelmingly Class VII goodwill. The character mix is therefore almost entirely capital. For a manufacturer with significant Class V equipment carrying depreciation recapture, the ordinary-income portion can be meaningful.

Buyer and seller must agree on the allocation and report consistently. Buyer-driven incentives push toward higher allocations to Classes V and VI (faster depreciation/amortization). Seller-driven incentives push toward higher Class VII (pure capital). The negotiation typically lands by reference to a defensible FMV appraisal of each asset class. We coordinate the appraisal scope with M&A counsel and the buyer's tax counsel before the §1060 allocation is finalized.

The §1374 Built-In Gain Trap (Five-Year Window)

IRC §1374 imposes a 21% federal corporate-level tax on the built-in gain of an S-corporation that recognizes that gain within five years of converting from C-corp status. Sales structured as §338(h)(10) deemed-asset sales trigger §1374 if the recognition window is still open.

The five-year window runs from the effective date of the S-election. The built-in gain is the difference between the fair market value of the assets at the conversion date and the corporate-level tax basis at conversion — appraised contemporaneously and documented. If the S-corp sells assets (or is deemed to sell assets under §338(h)(10)) within five years, the built-in gain recognized is taxed at the corporate level in addition to the shareholder-level capital gain.

The arithmetic: on a $7M built-in gain triggered inside the five-year window, the §1374 tax is approximately $1.47M of federal corporate tax, layered on top of the shareholder-level $2.6M of combined federal-state capital gain. The total federal-plus-state tax exceeds 47% of the gain — substantially worse than the 37.1% non-§1374 outcome.

The diagnostic step on every business sale matter: pull Form 2553 and the earliest 1120-S. If the S-election effective date is more than five years before the contemplated sale date, §1374 is closed. If it is within five years, we model the §1374 exposure before recommending any structure that triggers asset treatment.

The F-reorganization + LLC sale structure (Structure 3 above) sidesteps §1374 entirely because the F-reorg is a non-recognition event under §368(a)(1)(F) and Reg. §1.368-2(m). The LLC interest sale is by NewSCo, not the original S-corp, so there is no deemed liquidation event to re-open the §1374 window. This is one of the structural advantages of Structure 3 over Structure 2 when conversion history is an issue.

Personal Goodwill — Sometimes You Can Sell It Separately

Where a business's goodwill is genuinely personal to a shareholder rather than institutional, the shareholder can sell the personal goodwill directly to the buyer outside the corporate sale — generating capital gain to the shareholder personally without §1374 exposure or corporate-level tax.

The leading authority is Martin Ice Cream Co. v. Commissioner, 110 T.C. 189 (1998), refined by Norwalk v. Commissioner, T.C. Memo. 1998-279, and Howard v. United States, 448 F. App'x 752 (9th Cir. 2011). The cases require, at minimum: (1) no enforceable corporate-level non-compete agreement preventing the shareholder from competing with the company, (2) customer relationships that follow the individual personally, (3) reputation, skill, and contacts that the corporation cannot replicate without the individual, and (4) factual evidence that the buyer is paying for the individual's relationships and not the institutional brand.

The personal-goodwill carve-out works best for professional-services firms — solo practitioners, small consultancies, expert-witness practices — where the individual's reputation drives the revenue. It fails most often for institutional businesses with established brand, multi-employee customer relationships, and corporate-level non-compete provisions in the employment contracts. A 26-year-old institutional services business with a state-issued operating license, a multi-employee delivery model, and a corporate brand is unlikely to support the carve-out. A 35-year-old structural engineering firm where the owner is the named expert witness on every engagement is more likely to.

We do not affirmatively raise personal goodwill if the facts do not clearly support it — overreaching invites the IRS to challenge the entire transaction. Where the facts are strong, the carve-out can shift meaningful gain from the corporate level (with §1374 exposure) to the shareholder level (no §1374). Buyer-side counsel may also push for the carve-out independently, since it improves the buyer's basis allocation. The analysis is fact-specific and we do it on a deal-by-deal basis.

California-Specific Issues: Resident, Nonresident, and the Safe Harbor

California taxes residents on all income from whatever source derived under R&TC §17041. For a California-resident seller, California captures 13.3% of the entire gain regardless of how the sale is structured. There is no California analog to §1202 QSBS. There is no preferential state capital-gain rate.

The question we get most often is whether moving out of California before the sale defeats California tax. The answer is more complicated than it looks.

For a plain stock sale (Structure 1), stock is an intangible. Under R&TC §17952 and Cal. Code Regs. 18 §17951-3, gain on the sale of an intangible by a nonresident is sourced to the seller's state of domicile — not to the state where the underlying business operates. A nonresident selling stock of a California business could escape California tax on the gain, subject to the business-situs doctrine.

For an asset sale or a §338(h)(10) or F-reorganization (Structures 2–3), the analysis is different. Under R&TC §17951 and §17041(b), gain on the sale of California-source business assets by a pass-through entity flows through to the owners as California-source business income — regardless of the owners' residency. Even a successful residency change does not defeat California tax on the asset-treatment portion of the transaction.

The residency safe harbor under R&TC §17014 requires either an 18-month continuous out-of-state presence with documented severance of California contacts, or a successful facts-and-circumstances showing of nonresidency outside the safe harbor. The safe harbor is not just physical absence — it requires driver's license change, voter registration change, primary-residence relocation, severance of California business engagement, and a documented days-in-California log. The Franchise Tax Board aggressively challenges residency changes that follow a tax-motivated pattern and that fall short of the safe harbor.

For a closely-held business owner contemplating an exit within twelve months, initiating a residency change to defeat sourcing on a single transaction is structurally infeasible — the 18-month safe harbor cannot be met, and a facts-and-circumstances move executed under the timing pressure of a sale negotiation is exactly what the FTB looks for. We have seen well-counseled clients attempt this and lose on audit.

For a business owner with a longer runway — three to five years — a real residency change can work. It requires lifestyle change, not just paperwork. If you have time to plan a real exit, we can help you decide whether the residency angle is worth the disruption.

Coordinating With Your M&A Counsel and CPA

Tax structuring is one workstream in a business sale. Corporate due diligence, definitive-agreement drafting, regulatory filings, and accounting all run in parallel. Each workstream has an owner.

Your M&A counsel runs the definitive agreement — purchase agreement, disclosure schedules, escrow, indemnity, and post-closing covenants. They negotiate the deal terms with buyer counsel and quarterback the closing.

Your CPA owns the financial diligence package, the quality-of-earnings analysis, and the post-closing tax filings (final S-corp return, K-1s reflecting the gain allocation, any short-period returns required by the structural transaction).

Brotman Law owns the tax structure decision, the entity-formation work for an F-reorganization, the §338(h)(10) election if relevant, the §1060 allocation methodology, the §1374 BIG diagnostic, the personal-goodwill analysis, and the California sourcing strategy. Where a CRT is in scope, we coordinate with the trust counsel on drafting and funding.

We start work three to twelve months before the contemplated closing. Three months is the tight end — workable on a clean S-corp with no conversion history. Twelve months is comfortable — gives time for an F-reorganization to age before closing, for any necessary entity cleanup, and for the gross-up math to be developed before purchase-price negotiation. If you have longer than twelve months, we can do meaningful pre-sale planning work that materially improves your position when the deal closes.