Taxes When You Sell a Business: 20% or 37%?

Marcus owns a profitable HVAC and mechanical-services company in Phoenix, Arizona. He files single. A strategic buyer offers $2,400,000; his basis in the business is $400,000, so his gain is $2,000,000. His broker tells him “it’s capital gains, you’ll pay about 20%.” His CPA tells him the bill could be closer to 37% on a big chunk of it. They are both right — and which one wins depends on three decisions Marcus makes before he signs.

At 23.8% (the long-term capital-gains top rate of 20% plus the 3.8% net investment income tax), Marcus owes roughly $476,000 in federal tax. At 37% ordinary rates, the same $2,000,000 gain costs $740,000. That $264,000 spread is the whole game. This is the decision-stage map for which rate you actually pay — and where to go deeper on each lever.

The two numbers: 23.8% vs 37%

Every dollar of business-sale gain lands in one of two buckets, and the buckets are taxed very differently.

• Long-term capital gain — up to 23.8%. Gain on capital assets you held more than one year (most importantly goodwill) is taxed at the long-term capital-gains rate: 0%, 15%, or 20% depending on taxable income (IRC §1(h)). For a 2026 single filer, the 20% rate kicks in above $533,400 of taxable income; MFJ above $600,050. On top of that, the 3.8% net investment income tax (IRC §1411) applies once your modified AGI exceeds $200,000 single / $250,000 MFJ. Combined top rate: 23.8%.
• Ordinary income — up to 37%. Some slices of the price are never capital gain no matter how long you held the business: inventory, accounts receivable, and depreciation recapture on equipment and real estate (IRC §§1245, 1250, 751). These are taxed at your ordinary-income rate, which tops out at 37% for 2026 income over $626,350 (single) / $751,600 (MFJ).

Your effective rate is just the weighted average of how much of the price falls into each bucket. So the planning question is never “capital or ordinary?” in the abstract — it is “how do I shift as many dollars as possible into the 23.8% bucket?” Three levers do that.

Plain English first: basis, recapture, ordinary vs capital

Three terms drive the whole calculation. If these are fuzzy, the rest of the math is fuzzy.

• Basis. What the asset cost you for tax purposes, reduced by depreciation you already claimed. Gain = sale price − basis. Marcus’s $400,000 basis means only $2,000,000 of his $2,400,000 price is taxable gain.
• Depreciation recapture. When you sold equipment or buildings, you wrote off their cost over the years (depreciation), which lowered your taxable income at ordinary rates. The IRS “recaptures” that benefit at sale: the portion of gain equal to prior depreciation is taxed as ordinary income (§1245 equipment) or at up to 25% (§1250 real estate). You don’t get capital-gain treatment on deductions you already took.
• Ordinary vs capital. Capital assets (goodwill, going-concern value, the franchise itself) get the favorable 23.8% ceiling. Ordinary-income assets (inventory, receivables, recaptured depreciation) get no break and are taxed up to 37%.

Lever 1: Asset sale vs stock sale

This is the single biggest fork in the road, and it is usually the most contested term in the deal.

In a stock sale, you sell your ownership interest (corporate stock or LLC membership units). The buyer steps into your shoes. For you, it is one clean capital gain on the difference between the sale price and your stock basis — almost entirely at the 23.8% ceiling, with no recapture because you are not selling the underlying assets.

In an asset sale, the company sells its assets and you keep the (now cash-rich) entity. The total price is allocated across the assets under IRC §1060 using Form 8594. That allocation determines your tax: inventory and receivables are ordinary, equipment carries §1245 recapture, real estate carries §1250 recapture, and only goodwill and going-concern value stay capital.

Buyers almost always prefer asset sales because they get a stepped-up basis in the assets they buy and can depreciate them again going forward — and under the OBBBA legislation enacted in July 2025, 100% bonus depreciation was restored for qualifying property placed in service after January 19, 2025, which makes a buyer’s step-up even more valuable than it was during the 2023–2024 phase-down years. That deduction is worth real money to the buyer, which is exactly why you can often negotiate a higher price or a better allocation in exchange for giving them the asset structure. The deal-structure trade-off is lever #1; we run the full negotiation at a $10M exit in the linked guide below.

Lever 2: How much of the price is ordinary vs capital

Even inside an asset sale, the §1060 allocation across the seven asset classes decides your blended rate. You and the buyer both report the same allocation on Form 8594 — it must match, and the IRS compares them. Within reason, you push value toward goodwill (capital, 23.8%) and the buyer pushes value toward equipment and inventory (which they get to re-depreciate). Here is how the same $2,000,000 gain swings depending on allocation.

Same business, same $2,000,000 gain, same buyer — and a $105,600 difference in federal tax driven purely by how the price is allocated. (Goodwill-heavy: $1.7M × 23.8% + $300K × 37% = $404,600 + $111,000 = $515,600. Equipment-heavy: $900K × 23.8% + $1.1M × 37% = $214,200 + $407,000 = $621,200.) The allocation is negotiable, it is binding once signed, and it is worth fighting for. Marcus, with mostly goodwill and little equipment, is naturally in the favorable column — but he still needs the contract to say so.

Lever 3: Installment timing

Even with the gain mostly capital, recognizing $2,000,000 in a single year is its own tax problem. It pushes your taxable income above $533,400 (single), so the entire gain hits the top 20% capital-gains rate, and it blows through the $200,000 NIIT threshold so all of it carries the extra 3.8%.

An installment sale (IRC §453) lets you report gain proportionally as you receive payments instead of all at once. Spread a $2,000,000 gain over five years and each year you recognize roughly $400,000 — potentially keeping more of it in the 15% capital-gains band and softening the NIIT hit. Three rules to know:

1. Recapture is not deferrable. §1245/§1250 depreciation recapture is taxed in full in the year of sale (IRC §453(i)), even if you receive no cash for it yet. Plan for that year-one ordinary hit.
2. Inventory and dealer property don’t qualify. Installment treatment is unavailable for inventory or property held for sale in the ordinary course (IRC §453(b)(2)).
3. You take buyer credit risk. Spreading the gain means waiting for the money. If the buyer defaults, you have a tax mess and a collection problem. Secure the note.

One trap most sellers miss: the interest charge under IRC §453A. If your outstanding installment obligations from a non-dealer sale exceed $5,000,000 at year-end, the IRS charges interest on the deferred tax for the slice above that threshold — effectively billing you for the privilege of deferral. On a $2,000,000 note Marcus stays under the $5M trigger, so it never bites him; but a founder spreading an $8,000,000 or $12,000,000 gain feels it, and it can quietly erase much of the bracket-management benefit. Run the §453A math before assuming an installment note is free deferral. Note too that an installment sale interacts with NIIT every year a payment lands: each year’s recognized gain is investment income, so if a $400,000 annual slice still pushes your MAGI over the $200,000 single / $250,000 MFJ threshold, that year’s gain carries the 3.8% surtax even though you spread it. The win from spreading is keeping more of each year’s gain in the 15% capital-gains band (taxable income below $533,400 single / $600,050 MFJ in 2026) rather than the 20% band — not always escaping NIIT entirely.

The routing table: which lever fits your situation

The biggest single lever, if you qualify, is QSBS. If Marcus had organized as a C-corp at least five years ago and the company met the $50,000,000 gross-asset test at issuance, IRC §1202 could exclude the greater of $10,000,000 or 10× his basis — wiping out his entire $476,000 federal bill. He didn’t (he runs an S-corp), so QSBS is off the table for him. But for a founder who structured early, it is the difference between a 23.8% bill and a 0% bill.

What most people miss

Three things sink more business-sale tax bills than any others, and none of them is the headline rate.

• State tax is the silent 5%–13%. Most states tax capital gains as ordinary income with no preferential rate. California adds up to 13.3%, New York up to 10.9%, New Jersey 10.75%. On a $2,000,000 gain in California, that is roughly $266,000 of state tax stacked on top of the federal 23.8% — pushing the all-in rate near 37% even on “capital” gain. Marcus in Arizona pays a flat 2.5% state rate; geography is worth six figures.
• QSBS doesn’t fully conform in ~7 states. California, New Jersey, Pennsylvania, Mississippi, Alabama and a couple of others don’t follow the federal §1202 exclusion. You can exclude $10M federally and still owe full state tax on it.
• The Form 8594 allocation must match the buyer’s. You and the buyer each file Form 8594 reporting the §1060 allocation. If your numbers disagree, you invite an audit and the IRS can impose its own allocation. Lock the allocation in the purchase agreement before closing — not after.

The deciding move

The lever you pull is set by your entity and timeline, not by your accountant’s skill after the fact. If you hold qualifying C-corp stock past the five-year mark, QSBS is the move and it can take the bill to zero — so confirm your §1202 eligibility before you sign, because the holding period and the gross-asset test are fixed history you can’t recreate. If you don’t qualify for QSBS, the decision collapses to two contract terms you negotiate at the table: push the deal toward a stock sale (or a goodwill-heavy §1060 allocation) to keep gain in the 23.8% bucket, and use an installment note to spread recognition across years and stay under the 20%-rate and NIIT thresholds. Those two clauses — structure and timing — are worth the $264,000 spread between 23.8% and 37%. Run the asset-vs-stock negotiation in detail using the linked exit guide before you let the buyer’s lawyer write the first draft.