What is A Capital Gains Tax?
A capital gains tax applies to the sale of capital assets (such as stocks, bonds, real estate, and business assets) whereas an ordinary income tax applies to regular earned income. The capital gains tax rate is significantly lower than the ordinary income tax rate because of the general feeling that the formation of capital benefits society and thus should not be taxed (when sold or realized) as much as ordinary earned income. As we shall see, business sales are generally subject to capital gains tax, but there are exceptions which business sellers must take into account.
Calculating Capital Gains Tax
- The first step before figuring out how much capital gains tax one may owe is determining the capital basis of the asset being sold.
- As an example, let us suppose that one is selling a capital asset – such as a commercial investment property – for $500,000.
- Then let us suppose that the seller originally paid $250,000 for the property a few years ago, and the current depreciated value of the property is $200,000 (meaning the seller has taken $50,000 in depreciation deductions since the original purchase).
- The current capital basis is the depreciated value of $200,000.
- The capital gain (if any) is the seller’s net proceeds of the sale minus the capital basis.
- This means that the seller would be realizing a capital gain of $300,000 for the sale of the property ($500,000 – $200,000).
- The long term capital gains tax rate in this instance is 15%.
- For single people, the 2021 long term (for assets held for more than a year) capital gains tax rate is 0% for capital gains up to $40,400, 15% for capital gains up to $445,850, and 20% for capital gains over $445,850.
- Taxpayers filing as a married couple similarly face no tax up to $80,800, 15% rates for capital gains up to $501,600, and 20% rates for capital gains over $501,600.
- In our example, the seller of the investment property would thus face a capital gains tax liability of $45,000 (15% of the $300,000 capital gain).
- The same calculation method of the commercial investment property in this example may be applied to the sale of any capital asset (including businesses).
Business Sales: Stock Purchase Deal or Asset Purchase Deal?
The buyer may purchase a business via a stock purchase deal or an asset purchase deal. In a stock purchase deal, the buyer actually buys the shares or membership interests of the corporate entity that owns the asset of the business. In an asset purchase deal, the buyer creates their own corporate entity and purchases the assets of the seller’s corporate entity (typically made defunct after the closing). Stock purchase deals are rare because buyers generally do not want to take on the liability of the seller’s corporate entity.
In Asset Purchase Deals, the Business Assets Are Taxed Separately
In a stock purchase deal, the Internal Revenue Service (IRS) simply treats the sale of stock as subject to capital gains tax. In an asset purchase deal, the Internal Revenue Service (IRS) taxes the sale of each individual asset that collectively comprise the total assets of the business being sold. Buyer and seller must agree to allocate the purchase price according to which classification (such as inventory, goodwill, equipment, or leasehold rights) the assets of the business comprise. The individual asset categories are usually subject to capital gains tax with exceptions.
Allocating the Purchase Price of A Business
The seller and buyer of the business must negotiate how the purchase price of the business is allocated for tax purposes. The seller will of course want to avoid the higher ordinary income tax rate whereas the purchaser will want to lower their future tax liability while increasing their future allowable deductions. The negotiations regarding allocating the purchase price should theoretically be tied to the true and correct asset valuations of each particular asset in relation to the purchase price. In reality, however, many buyers and sellers simply agree to assign values to the purchased assets that will correspond with their own interests.
Sale of Inventory May Be Treated As Ordinary Income
- Generally, the sale of physical assets that are used in the ordinary course of business operations are taxed at ordinary income rates.
- The sale of inventory (raw materials, work in progress, or finished goods) is thus treated by the IRS as ordinary income.
- The cost of the inventory is deducted from the sale when determining the tax liability.
- This can pose a problem for many business sellers (especially those sellers in retail-related industries) who carry a large amount of inventory.
- Any allocation of the purchase price from the sale of the business that falls under the ‘inventory’ category requires the seller to pay the much higher ordinary income tax rate.
- If a buyer has a valid tax certificate at the time of closing, then the IRS may not consider the income derived from the sale of inventory to be ordinary or regular.
- The seller should consult with their attorney when handling this critical matter.
Sale of ‘Non-Compete’ Asset May Be Treated As Ordinary Income
Oftentimes, the seller gives the buyer a ‘non-compete agreement’ as a part of a business transaction. The seller will agree to not compete against the business (which now belongs to the buyer) after the sale for a certain period of time and within a certain geographic region. As with inventory, the non-compete agreement may comprise a significant part of the value of the business, and hence part of the purchase price must be allocated toward the non-compete agreement. The money received for a non-compete agreement is (unfortunately for the seller) taxed at the higher ordinary income tax rates. Business sellers should therefore use every legal means to minimize this potential tax liability.
The good news for business sellers is that they generally face a far lower tax rate for selling their business as opposed to deriving ordinary income from their business. Be sure to consult with your attorney and accountant prior to the business sale in order to minimize your tax burden.
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