Selling a Manufacturing Business: Where the Ordinary Income Hides

Four layers of tax in one manufacturing deal

A machine shop, fabricator or processor rarely sells as one asset. The buyer pays for equipment, inventory, real estate and the earnings stream, and each piece has its own character. Ordinary income reaches 37% above $768,700 of joint taxable income while long-term capital gain tops out at 20% above $613,700 (Rev. Proc. 2025-32, 2026), so which layer a dollar lands in decides how much of it you keep. The capital gains hub covers the base rates; this page covers the layers that are specific to manufacturers.

1. Inventory and the LIFO reserve: ordinary, year of sale.
2. Machinery and tooling: ordinary up to prior depreciation (IRC 1245).
3. The plant: 25% on prior straight-line depreciation, more if cost segregation or the new production property deduction was used.
4. Goodwill, customer approvals, know-how: mostly capital gain.

The LIFO reserve: ordinary income most owners forget

Many manufacturers carry raw materials and work in process on LIFO (IRC 472), which keeps old, lower costs on the books. The gap between LIFO cost and current cost is the LIFO reserve. In an asset sale the buyer pays current value for the inventory, so the whole reserve is realized as ordinary income. Inventory is not a capital asset (IRC 1221(a)(1)) and cannot be reported on the installment method (IRC 453(b)(2)(B)), so it is taxed in the closing year even if part of the price is deferred. Example 1 carries a $700,000 reserve; the table also charges the 3.8% net investment income tax on it ($26,600), which an owner who materially participates usually does not owe (IRC 1411), so treat that line as conservative.

In a stock sale the reserve stays inside the company and the buyer inherits the deferred tax, which buyers price. A C corporation that converts to S status must include its LIFO recapture amount in income for its last C year, with the added tax payable in four equal installments (IRC 1363(d)). Converting also starts a five-year built-in gains period (IRC 1374(d)(7)), so the timing of a conversion relative to a sale needs a model, not a guess.

Machinery, tooling and the cost segregation boomerang

CNC machines, presses, molds and dies are Section 1245 property. Most have been expensed through Section 179 or bonus depreciation, which P.L. 119-21 made permanent at 100% for property acquired after January 19, 2025 (IRC 168(k)), so the price allocated to them is mostly recapture and, under Section 453(i), it is taxed in the year of sale even on a note. See the depreciation recapture analysis.

Cost segregation works the same way in reverse. A study that moved electrical, process piping, crane rails or land improvements into 5, 7 or 15-year lives created faster deductions, but those components are Section 1245 or ordinary recapture property when the plant is sold. Example 2 uses the same $9,000,000 gain as Example 1; the only change is $600,000 of plant depreciation that was taken on segregated components. Tax rises from $2,518,261 to $2,590,261. The cost segregation before a sale analysis shows the math, and how the plant price is split between building and components decides how much comes back.

The plant and the new production property deduction

Straight-line depreciation on a factory is unrecaptured Section 1250 gain taxed at up to 25% (IRC 1(h)(1)(E)); appreciation above original cost is Section 1231 gain. The plant can be exchanged into other real estate (see the 1031 exchange analysis) or kept and leased to the buyer.

P.L. 119-21 added a 100% write-off for qualified production property: the production portion of a new factory whose construction begins after January 19, 2025 and before 2029, placed in service before 2031, excluding offices, research, engineering and sales space (IRC 168(n)). That write-off is depreciation like any other and comes back as ordinary income when the plant is sold, and changing the use within 10 years triggers recapture under Section 1245 (IRC 168(n)(5)). Buyers should know that an existing plant qualifies in their hands only if nobody used it for qualified production from January 1, 2021 through May 12, 2025 (IRC 168(n)(2)(B)), so a running factory sold to another manufacturer usually does not.

Research costs after the 2025 law change

From 2022 through 2024, research and experimental costs, including much engineering and tooling design work, had to be capitalized and amortized. New Section 174A restores a current deduction for domestic research costs paid in tax years beginning after December 31, 2024, while foreign research stays on a 15-year schedule under Section 174 (P.L. 119-21, Section 70302). Rev. Proc. 2025-28 lets taxpayers deduct the unamortized 2022 to 2024 domestic balance in one or two years, and lets small businesses (average gross receipts of $31,000,000 or less for 2025) apply the new rule retroactively.

For a seller this is an ordinary deduction that can offset recapture if it lands in the right year. Unamortized foreign research costs do not become deductible just because the business is sold (IRC 174(d)), and in a stock sale any remaining balance goes with the company unless it is priced.

Patents, processes and who owns them

Since 2018, a patent, invention or secret process created by your own efforts is not a capital asset in your hands (IRC 1221(a)(3)) and is excluded from Section 1231 (IRC 1231(b)(1)(C)). An individual inventor who transfers all substantial rights to a patent can still receive long-term capital gain under Section 1235, even when payments are royalties tied to the buyer's production. If you personally hold key patents outside the company, that ownership deserves a separate line in the deal and a separate model.

C corporations: ESOP and QSBS exits

Manufacturing is not on the list of excluded service fields, so stock in a qualifying C corporation can be qualified small business stock: up to $15,000,000 of gain excluded for stock issued after July 4, 2025, with a $75,000,000 gross asset test, or $10,000,000 for older stock (IRC 1202, as amended by P.L. 119-21). See the QSBS analysis.

A sale to an employee stock ownership plan lets C corporation owners defer gain under Section 1042 if the plan owns at least 30% of the stock after the sale, the seller has held the shares at least 3 years, and the proceeds are reinvested in qualified replacement property within 3 months before to 12 months after the sale (IRC 1042(b), (c)). S corporation stock does not qualify. The ESOP 1042 analysis and the C corporation double tax page cover the trade-offs.

The Ohio layer and next steps

Ohio treats gain from selling a business, including goodwill and an ownership interest sold by an owner who materially participated, as business income (ORC 5747.01(B)); the first $250,000 is deducted and the rest is taxed at 3% for 2026 (ORC 5747.02). In Example 1 that state layer is $260,750. More detail is on the Ohio page. Seller financing can spread the goodwill and plant gain but not the recapture or inventory; the installment sale of a business analysis shows how much that is worth. To see your own layers modeled, get the Big Sale Tax Analysis.

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