Sole Proprietorship Sale: Asset-by-Asset Tax Treatment and Recapture

Selling a sole proprietorship means selling individual assets, each with different tax treatment. Learn about depreciation recapture and Form 8594 allocation rules.

It is always an asset sale. Because a sole proprietorship has no separate legal entity, the buyer purchases each asset individually: equipment, inventory, customer lists, goodwill, and real property. Each asset category receives its own tax treatment.

Depreciation recapture hits first. Equipment and other depreciable assets you previously wrote off are subject to Section 1245 recapture, taxed at ordinary income rates up to the amount of depreciation you claimed. This often surprises sellers who expect capital gains treatment on the full amount.

Self-employment tax applies to some proceeds. The portion allocated to inventory and accounts receivable can be subject to self-employment tax under IRC 1402, adding 15.3% on top of income tax. Goodwill and capital assets are generally exempt from SE tax.

Form 8594 locks in the allocation. Both buyer and seller must file this form with matching asset class allocations. Disagreements trigger IRS attention.

The pitfall: Sole proprietors cannot structure a stock sale to get uniform capital gains treatment. The asset-by-asset allocation means some proceeds will inevitably be taxed at ordinary rates, and your CPA must negotiate that allocation carefully.