Do Capital Gains Apply to Sales of Franchise Ownership? (w/Examples) + FAQs

Yes, the profit from selling your franchise can be taxed at lower capital gains rates, but it is never that simple. A huge portion of your profit is almost guaranteed to be taxed as regular, high-rate income. The primary conflict arises from a specific Internal Revenue Service (IRS) rule called Depreciation Recapture, found in Internal Revenue Code (IRC) §1245. This rule forces you to “pay back” the tax benefits you received from depreciating assets like equipment, converting what you hoped would be a capital gain into ordinary income, which is taxed at a much higher rate.

The difference is staggering; federal tax rates on ordinary income can be as high as 37%, while long-term capital gains top out at 20%.¹ This means a single decision in how the sale is structured can cost you nearly half of your profit in extra taxes. Understanding this conflict is the key to keeping more of your hard-earned money.

Here is what you will learn to protect your profits:

💰 The Two Tax Worlds: You’ll master the critical difference between low-tax capital gains and high-tax ordinary income, and why this distinction is the most important concept in any business sale.
⚔️ The Buyer vs. Seller War: Discover why buyers and sellers are financially programmed to want opposite deal structures (asset sale vs. stock sale) and how this core conflict will define your negotiation.
🔪 The Asset Sale Autopsy: Learn exactly how an asset sale is dissected by the IRS, asset by asset, and pinpoint the specific rules that turn your profits from capital gains into ordinary income.
🏛️ Your Business’s Tax DNA: Understand how your choice of business entity (like an LLC, S-Corp, or C-Corp) permanently impacts your tax bill when you sell, for better or for worse.
🗺️ State Tax Minefields: Get a clear guide to the unique and often-overlooked state-level taxes in key states like California, New York, Texas, and Florida that can ambush you at closing.

The Two Tax Worlds: Capital Gains vs. Ordinary Income

The entire U.S. tax system is split into two parallel worlds: ordinary income and capital gains. Your goal when selling your franchise is to have as much of your profit as possible land in the capital gains world. This is because the tax rates in that world are significantly lower.

A capital asset, according to the IRS, is almost everything you own for investment, including your ownership interest in a business (like stock).² When you sell a capital asset, you have a capital gain or loss. The profit you make is your “capital gain,” and the government taxes this gain.

The formula to figure out your gain is simple, but the details are what matter. You take the total amount you received in the sale and subtract your investment in the asset. This investment is called your “adjusted basis”.⁴

Your adjusted basis starts with your original cost. Over time, it goes down with deductions like depreciation and goes up with improvements.² A lower basis means a bigger taxable gain when you sell, which is a shock for many owners who have been taking depreciation deductions for years to lower their taxes.⁵

The most important factor for your tax rate is the holding period. If you own a capital asset for more than one year, your profit is a long-term capital gain, which gets the special low tax rates.² If you own it for one year or less, it’s a short-term capital gain, which is taxed at the same high rates as your ordinary income, like wages.²

The Great Divide: Why Buyers and Sellers Are at War Over the Deal Structure

Every franchise sale negotiation boils down to one fundamental conflict: the buyer wants an asset sale, and the seller wants a stock sale. These two structures have opposite tax and legal consequences, creating a natural tug-of-war where one side’s victory is the other’s financial loss.⁷

A stock sale is simple and clean for the seller. You sell your ownership shares (your stock in a corporation or membership interest in an LLC) directly to the buyer.⁸ The business entity itself doesn’t change; it just has a new owner. For you, the seller, this is ideal because the entire profit is generally treated as a single long-term capital gain, taxed at those favorable low rates.⁷

Buyers, however, hate stock sales. They inherit the business exactly as it is, including its entire history of potential liabilities—like old tax problems or lawsuits.⁸ More importantly, they inherit your old, low basis in the assets. This means they get minimal future depreciation deductions, which costs them real money in higher taxes for years to come.⁷

An asset sale is the opposite. The business entity itself sells its individual assets—equipment, inventory, customer lists, and goodwill—to the buyer.¹² The buyer loves this because they get a “step-up in basis,” meaning their new basis for the assets is the price they just paid.⁷ This allows them to take huge depreciation deductions, saving them a fortune in taxes. They also get to leave your company’s old liabilities behind with you.⁸

For you, the seller, an asset sale is a tax disaster. The IRS doesn’t see it as one sale; it sees it as dozens of separate sales of individual assets.¹ As we’ll see next, many of these individual sales do not qualify for capital gains treatment, forcing large chunks of your profit to be taxed as high-rate ordinary income.¹²

| Seller’s Viewpoint | Stock Sale | Asset Sale |

|—|—|

| Tax Treatment | Excellent. Mostly one layer of tax at low capital gains rates. | Poor. A mix of capital gains and high-rate ordinary income. |

| Legal Liability | Excellent. Buyer takes on all past business liabilities. | Poor. You are left with the old company and its historical liabilities. |

| Simplicity | Simple. A straightforward transfer of ownership stock. | Complex. Requires transferring every asset, lease, and contract individually. |

| Overall Preference | Strongly Preferred | Strongly Resisted |

The Asset Sale Autopsy: Where Your Capital Gains Dream Dies

When a buyer forces you into an asset sale, the IRS requires you and the buyer to perform a financial autopsy on the deal. You must agree on how to slice up the total purchase price and assign a value to every single asset being sold, from the delivery van to the brand’s reputation. This process is called the purchase price allocation, and it is reported to the IRS on Form 8594.¹²

This allocation is a critical negotiation because it directly determines how much of your profit is taxed as ordinary income versus capital gain.¹⁵ The buyer wants to allocate as much money as possible to things like equipment, which they can depreciate quickly. You want to allocate as much as possible to “goodwill,” which is taxed as a capital gain.¹⁴

The Tax Man’s Clawback: Depreciation Recapture

The biggest tax shock for sellers in an asset sale is depreciation recapture. For years, you took depreciation deductions on your equipment and property to lower your taxable income. The IRS views this as a benefit they gave you. Under IRC §1245 and §1250, the recapture rule allows the IRS to “claw back” that benefit at the time of sale.¹⁶

For tangible personal property like equipment, vehicles, and furniture (Section 1245 Property), the rule is brutal. Any gain you realize on the sale of these assets is taxed as ordinary income up to the total amount of depreciation you’ve ever taken.¹⁶ Since equipment rarely sells for more than its original cost, this effectively means the entire gain on your depreciated assets gets hit with the highest tax rates.¹²

For real estate like a building (Section 1250 Property), the rules are slightly different. The portion of your gain that equals the straight-line depreciation you took is “unrecaptured” and taxed at a special, higher rate of 25%.¹⁶ This is still worse than the 15% or 20% long-term capital gains rates.

The Tax Character of Your Intangible Assets

A huge part of your franchise’s value is in things you can’t touch. The tax treatment for these intangible assets varies dramatically, making their valuation a key battleground in the negotiation.

Goodwill: This is the value of your brand’s reputation, customer loyalty, and earning power. For tax purposes, goodwill is a capital asset under IRC §197. The profit from selling goodwill is taxed at the favorable long-term capital gains rate, making it the most tax-friendly asset for you as the seller.¹⁹
Covenant Not to Compete: The buyer will pay you to promise not to open a competing business nearby. Any money specifically allocated to this covenant is always taxed as ordinary income to you.²¹ The buyer can amortize this cost over 15 years, so they have an incentive to allocate a reasonable amount here.²¹
Franchise Agreement: The legal right to operate the franchise is itself an intangible asset under IRC §197. The initial franchise fee you paid is capitalized and amortized over 15 years.²⁵ When you sell, the gain on the franchise right itself generally qualifies for capital gains treatment.²⁹ Any transfer fee you pay to the franchisor reduces your total taxable gain.³¹

Your Business Structure is Your Tax Destiny

The legal structure you chose when you started your business—C-Corp, S-Corp, or LLC—has massive consequences that come due the day you sell. This choice, combined with the sale structure, dictates your final tax bill.

C-Corporations: The Double Taxation Nightmare

A C-Corporation is a separate legal entity that pays its own taxes. This creates a painful problem in an asset sale known as double taxation.⁷ First, the corporation sells its assets and pays corporate income tax on the profit. Then, when the remaining cash is distributed to you, the shareholder, you pay a second tax at your personal capital gains rate.¹¹ This two-layer tax can devour over 50% of your profit.³²

Because of this, C-Corp owners will fight desperately for a stock sale. In a stock sale, only the shareholders are taxed on their personal gain from selling the stock, resulting in a single, much lower tax bill.⁷ This puts C-Corp sellers in a tough spot, as buyers almost always prefer an asset sale.

S-Corporations and Pass-Throughs: A Safer Harbor

S-Corporations, LLCs, and Partnerships are “pass-through” entities, meaning they don’t pay tax at the business level. Instead, all profits and their tax character (ordinary or capital) flow directly to the owners’ personal tax returns.¹ This structure completely avoids the double taxation nightmare of a C-Corp in an asset sale.⁷

Even so, the seller still faces the problem of depreciation recapture and other rules that convert a portion of the gain to ordinary income.¹² Selling your stock in an S-Corp or your membership interest in an LLC is still preferable, as it is generally treated as a clean capital gain.¹² However, partnerships and LLCs have a special rule for “hot assets” (IRC §751), which recharacterizes the portion of gain from inventory and receivables as ordinary income.¹²

The Hybrid Solution: A Tax Loophole You Can Both Agree On

There is a special tax election that can solve the buyer-seller standoff: the Section 338(h)(10) election. This is available for sales of S-Corporations and certain C-Corporations.⁷ It allows a deal that is legally a stock sale to be treated as an asset sale purely for tax purposes.

This is the best of both worlds. The buyer gets what they want most—a stepped-up basis in the assets for future depreciation deductions.⁷ The seller gets the legal simplicity and liability protection of a stock sale while avoiding the C-Corp double taxation problem.⁷ It’s a powerful compromise that can save a deal from falling apart.

Real-World Scenarios: Seeing the Tax Bill in Action

Let’s see how these rules impact the sale of “BurgerBarn,” a franchise sold for $2 million. The owner’s total adjusted basis in the business is $500,000, meaning the total profit is $1.5 million.

Scenario 1: The S-Corp Asset Sale Trap

BurgerBarn is an S-Corp, and the buyer demands an asset sale. The parties agree to allocate the $2 million price as follows: $200,000 to equipment and $1.8 million to goodwill. The equipment originally cost $400,000 and has been fully depreciated, so its adjusted basis is $0.

Transaction	Tax Calculation
Equipment Sale	The gain is $200,000 ($200k price – $0 basis). Because this gain is less than the $400,000 in depreciation taken, the entire $200,000 is recaptured as ordinary income under IRC §1245.
Goodwill Sale	The gain is $1.3 million ($1.8M price – $500k basis). This is treated as a long-term capital gain.
The Painful Result	The seller has $200,000 taxed at high ordinary income rates (up to 37%) and $1.3 million taxed at lower capital gains rates (up to 20%). A significant portion of the profit gets a tax haircut.

Scenario 2: The LLC Equity Sale Dream

Now, assume BurgerBarn is an LLC, and the owner sells their membership interest (equity) for $2 million. The owner’s basis in their interest is $500,000. The LLC has no “hot assets.”

Transaction	Tax Calculation
Equity Sale	The total gain is simply $1.5 million ($2M price – $500k basis).
The Beautiful Result	The entire $1.5 million profit is treated as a long-term capital gain. The seller pays tax at the lower 20% rate on the whole amount, saving a massive amount compared to the asset sale.

Scenario 3: The C-Corp Double Taxation Nightmare

Finally, imagine BurgerBarn is a C-Corp that undergoes an asset sale. The gain breakdown is the same as the S-Corp scenario: $200,000 ordinary income and $1.3 million capital gain, for a total corporate profit of $1.5 million.

Transaction	Tax Calculation
Tax #1: Corporate Level	The corporation pays tax on its profit. Assuming a 21% corporate rate, the tax is $315,000 (21% of $1.5M). This leaves $1,685,000 in cash ($2M – $315k tax).
Tax #2: Shareholder Level	The remaining $1,685,000 is distributed to the owner. This distribution is taxed again as a capital gain. At a 20% rate, the second tax is $337,000.
The Devastating Result	The total tax paid is $652,000 ($315k + $337k). This is an effective tax rate of over 43% on the $1.5 million profit, demonstrating the catastrophic cost of double taxation.

The Paperwork Deep Dive: Conquering IRS Form 8594

In an asset sale, you and the buyer must jointly file IRS Form 8594, Asset Acquisition Statement. This form is not a suggestion; it’s a legally binding report to the IRS detailing how you’ve allocated the purchase price across seven specific asset classes.¹² The IRS compares the forms from both sides to ensure you’ve reported the same numbers.

Part I: General Information

This section is straightforward. It asks for the name and ID number of the buyer and seller, the date of the sale, and the total sales price.

Part II: The Seven Asset Classes

This is the heart of the form and the negotiation. The IRS requires you to allocate the price using the “residual method,” filling up each class in order before moving to the next.13

Class I: Cash and bank deposits. The value is exactly what it is.
Class II: Actively traded personal property, like marketable securities.
Class III: Accounts receivable.
Class IV: Inventory held for sale to customers.
Class V: All other assets not in other classes. This is a huge category that includes your equipment, machinery, vehicles, and furniture—the very assets subject to painful depreciation recapture.
Class VI: Section 197 intangibles, except for goodwill. This includes things like your franchise agreement and non-compete agreements.
Class VII: Goodwill and going concern value. This is the “residual” class. Whatever is left of the purchase price after you’ve valued everything else gets dumped here.¹⁴

The consequence of this waterfall is clear. The seller wants to assign the lowest justifiable fair market value to Class V assets to minimize ordinary income from depreciation recapture. They want to maximize the amount that “spills over” into Class VII, which is taxed as a capital gain.¹⁴ The buyer wants the exact opposite, creating the central tension of the negotiation.

Mistakes to Avoid: Common Tax Traps for Franchise Sellers

Selling a franchise is a once-in-a-lifetime event, and it’s easy to make a costly mistake. Being aware of these common traps is the first step to avoiding them.

Ignoring State and Local Taxes (SALT): Many sellers focus entirely on the IRS and get blindsided by state taxes. States like California and New York have high income taxes that apply to your gain, and many have procedural traps like “bulk sale” notification rules that can make you liable for the buyer’s future tax bills if ignored.³⁶
Accepting the Buyer’s First Allocation: The buyer’s initial proposal for the purchase price allocation on Form 8594 will be structured to give them the maximum tax benefit, which means maximum tax pain for you. Never accept this without a fight; it is a negotiation, not a fixed-in-stone document.¹⁴
Not Having Clean Financials: Buyers will perform intense due diligence. If your financial records are messy, incomplete, or disorganized, it creates suspicion and gives the buyer leverage to demand a lower price or walk away.²⁶
Misunderstanding Your Franchise Agreement: Your franchise agreement contains strict rules about who you can sell to, what fees you have to pay (transfer fees), and whether the franchisor has the “right of first refusal” to buy the business themselves.⁴¹ Ignoring these rules can kill a deal at the last minute.
Failing to Plan for Post-Sale Restrictions: The non-compete clause in your agreement doesn’t disappear after you sell. You may be legally barred from working in the same industry in your area for several years, which can be a major financial and professional shock if you haven’t planned for it.⁴²

Do’s and Don’ts of Selling Your Franchise

Navigating a franchise sale requires careful planning and execution. Following these simple rules can help you protect your interests and maximize your final payout.

Do’s	Don’ts
DO get a professional business valuation early.	DON’T guess what your business is worth or rely on industry rumors.
DO assemble a team of experts (CPA, attorney, broker) before you start.	DON’T try to handle the legal and tax complexities on your own to save money.
DO meticulously clean up and organize at least three years of financial records.	DON’T show a potential buyer messy books; it screams disorganization and risk.
DO read and understand every word of the transfer provisions in your franchise agreement.	DON’T get surprised by a transfer fee or a franchisor’s right of first refusal.
DO negotiate the purchase price allocation as if it were part of the price itself.	DON’T treat Form 8594 as a simple administrative task; it has huge financial consequences.

Beyond the IRS: The Treacherous World of State and Local Taxes (SALT)

Just when you think you have the federal tax rules figured out, you have to face an entirely separate and often more confusing web of state and local taxes, collectively known as SALT.⁴⁴ These taxes are not an afterthought; they can represent a huge cost and a procedural nightmare if you’re not prepared.³⁶ Every state is different, but here’s a look at what to expect in some key states.

California: The Golden State’s Pricey Toll

California is known for its high taxes, and selling a business is no exception. Unlike the federal government, California taxes capital gains at the same high rates as ordinary income, which can go up to 13.3%.³² This eliminates the main federal tax advantage of structuring for capital gains.

Franchise Tax: Nearly every business entity (LLCs, S-Corps, C-Corps) must pay an annual minimum Franchise Tax of $800, even if the business is inactive or unprofitable.⁴⁶ LLCs earning over $250,000 also pay an additional LLC fee based on their total California income, which can be as high as $11,790.⁴⁶ You must file a final tax return and formally dissolve your entity to stop this tax from accruing.⁵⁰
Sales Tax: Sales tax applies to the sale of tangible assets like equipment and furniture. While an “occasional sale” exemption might apply if you sell your entire business, the rules are complex and must be carefully reviewed.⁵²
Property Tax: The sale of real estate owned by the business can trigger a reassessment, potentially leading to higher property taxes for the buyer, which can be a point of negotiation.⁸

New York: The Empire State’s Complex Rules

New York also offers no tax break for capital gains at the state level; they are taxed as ordinary income at rates up to 10.9%.⁵³ Combined with New York City taxes, the total rate can be one of the highest in the nation.⁵³

Franchise Tax: New York imposes a complex franchise tax on corporations. A business must calculate its tax liability in three different ways (based on business income, business capital, and a fixed-dollar minimum) and pay whichever amount is highest.⁵⁶ This means even an unprofitable business with significant assets can face a large state tax bill.
Bulk Sale Notification: This is a critical procedural trap. When selling business assets, the buyer is required to notify the NYS Department of Taxation and Finance at least 10 days before closing by filing Form AU-196.10.³⁷ If the buyer fails to do this, they can be held personally liable for any of the seller’s unpaid sales tax. This “successor liability” makes buyers extremely cautious and will halt a deal if not handled correctly.

Texas: No Income Tax, But Don’t Get Too Comfortable

Texas is famous for having no personal income tax, which is a massive advantage for a seller realizing a large gain from a business sale.⁶⁰ However, the state makes up for this with other business taxes.

Texas Franchise Tax: This is not a tax on “franchises” and it’s not an income tax. It’s a “privilege tax” for the right to do business in the state.⁶¹ The tax is calculated on the business’s “margin,” which can be determined in one of four ways (e.g., total revenue minus cost of goods sold, or total revenue minus compensation).⁶³
Thresholds and Rates: For 2024-2025, businesses with total revenue at or below $2.47 million owe no tax.⁶² Above that, the rate is 0.375% for retail/wholesale and 0.75% for other businesses.⁶² Upon selling, you must file a final franchise tax report.⁶²
Sales Tax: Texas imposes sales tax on the transfer of tangible personal property in an asset sale. The state rate is 6.25%, but local taxes can increase the total.⁶⁵

Florida: Another No-Income-Tax Haven with Its Own Quirks

Like Texas, Florida has no personal income tax, making it a very attractive state for sellers to realize capital gains.⁶⁶ The state also does not have a franchise tax for most pass-through entities like LLCs and S-Corps.⁶⁷

Corporate Income/Franchise Tax: If your business is a C-Corporation or an LLC taxed as one, it will be subject to Florida’s 5.5% corporate income tax.⁶⁷
Documentary Stamp Tax: This is a unique Florida tax levied on certain documents. When real estate is sold, a stamp tax of $.70 per $100 of value is due on the deed.⁶⁸ Written obligations to pay money, like a promissory note from the buyer, are also taxed at $.35 per $100, though this is capped at $2,450 for unsecured notes.⁶⁸
Sales Tax: Florida’s 6% state sales tax (plus any local surtax) applies to the sale of tangible business assets.⁶⁶ When you sell your business, you must notify the Florida Department of Revenue to close your account.⁷¹

Frequently Asked Questions (FAQs)

1. Is the initial franchise fee I paid deductible when I sell?

No. The unamortized portion of your initial franchise fee is part of your business’s basis. This higher basis reduces your total taxable gain on the sale, but it is not a separate, direct deduction.25

2. What is the difference between a franchise fee and a state franchise tax?

Yes. A franchise fee is paid to the franchisor for brand rights. A state franchise tax is a “privilege tax” paid to a state for the right to do business there; it has nothing to do with the franchise business model.61

3. How is my customer list taxed when I sell?

Yes. A customer list is generally considered part of your business’s goodwill. In an asset sale, the profit allocated to goodwill is typically taxed at lower long-term capital gains rates.12

4. Can I use an installment sale to spread out my tax payments?

Yes. An installment sale allows you to recognize gain as you receive payments over several years. However, any gain from depreciation recapture must be reported as ordinary income in the year of the sale, regardless of payment timing.14

5. Do I have to pay taxes if I sell my franchise at a loss?

No. If you sell for less than your adjusted basis, you have a capital loss. You can use this loss to offset other capital gains, and potentially deduct up to $3,000 against your ordinary income per year.2

6. What is the tax impact of the transfer fee I pay the franchisor?

Yes, it helps. The transfer fee is a selling expense. It reduces the total amount you “realize” from the sale, which in turn lowers your overall taxable gain.31

7. I’m a sole proprietor. How is my sale taxed?

Yes, it’s different. The sale of a sole proprietorship is always treated as an asset sale by the IRS. You cannot do a stock sale, so your gain will be a mix of ordinary income and capital gains.14

8. What is “depreciation recapture” in simple terms?

Yes. It’s the IRS “clawing back” the tax benefits you got from depreciation. The part of your profit that comes from prior depreciation deductions is taxed as high-rate ordinary income instead of low-rate capital gains.

9. Why does the buyer want a “stepped-up basis” so badly?

Yes, it’s a huge benefit for them. A “stepped-up basis” lets the buyer use the price they paid you as their new basis for depreciation. This gives them much larger tax deductions for years, saving them money.

10. Do I need to tell my state I’m selling my business?

Yes, absolutely. Most states require you to file final sales tax, franchise tax, and income tax returns. States like New York and California have specific “bulk sale” rules that must be followed to avoid major penalties.