The basic formula
Gain (or loss) = amount realized − adjusted basis
- Amount realized is the cash received, plus the fair market value of any other property received, plus any liabilities the buyer takes over, less selling costs such as broker fees.
- Adjusted basis is generally what the seller paid, plus capital improvements, minus depreciation allowed or allowable.
The whole gain or loss is recognised unless a specific rule defers it, such as a like-kind exchange or a tax-free reorganisation.
Mini example. A fund bought a building for $5 million, spent $1 million improving it and has taken $1.5 million of depreciation, so its adjusted basis is $4.5 million. It sells for $7 million and pays $200,000 of selling costs, so the amount realized is $6.8 million. The gain is $2.3 million: $1.5 million of it is unrecaptured section 1250 gain, taxed at up to 25% for individuals, and $0.8 million is section 1231 gain at long-term capital gains rates.
Asset sales
In an asset sale, the seller sells the business's assets one by one, even if they change hands in a single contract. Three things follow.
1. The price must be allocated. When a group of assets that makes up a trade or business is sold, buyer and seller must split the price using the residual method in section 1060, and both report the result on Form 8594. The price is allocated in this order, each class up to its fair market value:
| Class | Assets |
|---|---|
| I | Cash and bank deposits |
| II | Actively traded property, certificates of deposit, foreign currency |
| III | Accounts receivable and other assets marked to market |
| IV | Inventory |
| V | Everything else, such as buildings, land, equipment and furniture |
| VI | Section 197 intangibles other than goodwill, such as customer lists and trademarks |
| VII | Goodwill and going concern value, which takes whatever is left |
2. Each asset has its own character. Inventory and receivables produce ordinary income. Depreciation on equipment is recaptured as ordinary income. Buildings produce section 1231 gain, with the depreciation portion taxed at up to 25%. Goodwill is generally capital gain. So the seller cares how much of the price lands in each class, and so does the buyer.
3. The buyer gets a stepped-up basis. The buyer's basis in each asset is what it paid for it, so it can depreciate buildings and equipment and amortise goodwill and other section 197 intangibles over 15 years from the new, higher figure.
Share sales
When shareholders sell shares in a corporation, they sell one capital asset:
- the gain is the price less their basis in the shares, usually long-term capital gain if held for more than a year;
- the company itself sells nothing, so its asset basis stays where it was, and the buyer gets no step-up; and
- the company's history comes with it: its tax attributes, such as net operating losses (subject to limits after a change of ownership), and its liabilities, including any unpaid tax.
Elections under section 338(h)(10) or section 336(e) can treat a qualifying share sale, such as a sale of an S corporation or a subsidiary of a consolidated group, as an asset sale for tax purposes, giving the buyer a step-up.
Partnership interests sit in between
Selling an interest in a partnership or LLC is mostly treated as selling a capital asset under section 741, but with a look-through: the seller's share of the partnership's inventory and depreciation recapture, the "hot assets" under section 751, is ordinary income, and its share of unrecaptured section 1250 gain is taxed at up to 25%. The buyer can get a step-up in its share of the partnership's assets if the partnership has a section 754 election in place. Foreign sellers have extra rules, covered in our page on Schedule K-3, Part XIII.
Worked example: selling a C corporation
Individual shareholders own a C corporation. Its assets have a tax basis of $40 million and are worth $100 million. The shareholders' basis in their shares is $30 million. Assume a 21% corporate rate, a 23.8% rate on the shareholders' capital gains (20% plus the 3.8% net investment income tax), and no state tax.
Asset sale, then liquidation:
- The corporation's gain is $100m − $40m = $60 million, taxed at 21%: $12.6 million.
- It distributes the remaining $87.4 million to the shareholders in liquidation. Their gain is $87.4m − $30m = $57.4 million, taxed at 23.8%: about $13.66 million.
- Total tax: about $26.26 million. The shareholders keep about $73.74 million.
Share sale for the same $100 million:
- The shareholders' gain is $100m − $30m = $70 million, taxed at 23.8%: $16.66 million.
- They keep $83.34 million, about $9.6 million more than in the asset sale.
The buyer sees it the other way round. In the asset deal it gets a $100 million basis to depreciate and amortise; in the share deal it inherits the $40 million basis. That is why buyers often prefer assets, sellers of C corporations prefer shares, and the price is negotiated with both in mind.
What this means for funds
- Buyout exits of C corporation portfolio companies are usually share sales. Exits of LLC or partnership portfolio companies give the buyer a step-up more easily, which can support a higher price.
- Real estate funds can sell the building or the entity that owns it. Selling the entity can change state transfer taxes. For federal tax, selling a single-member LLC that is a disregarded entity is treated as selling the building itself, and selling an interest in a property partnership brings out similar character through the look-through rules above.
- Purchase agreements for asset deals should agree the section 1060 allocation, so buyer and seller file consistent Forms 8594.
This explainer is general information, not tax advice.
Sources
- 26 U.S. Code § 1001, Cornell LII
- 26 CFR § 1.1001-2, Cornell LII
- Instructions for Form 8594 (11/2021), IRS
- 26 U.S. Code § 751, Cornell LII
- 26 U.S. Code § 338, Cornell LII
Related reading
- Unrecaptured Section 1250 Gain, Explained
- Check-the-Box Elections and Form 8832, Explained
- Glossary: Capitalisation vs depreciation
This explainer is analysis and general information, not tax, legal or investment advice.