Taxation on the Sale of Business Assets
A common concern among small business owners: “Will I have to pay taxes on the sale of my business?”
That’s a great question but there are a lot of details to consider when selling a business so the answer, while most likely is yes, contains many variables that will determine how much tax you’ll pay, whether it will be capital gain or ordinary income tax and when you’ll pay the tax.
But, let’s first begin with the different types of business assets there are and let me provide some information about them so you have a very basic understanding of the terminology.
There are tangible assets and intangible assets and they are typically taxed differently when sold. Tangible assets, at the most basic level, are assets you can touch while intangible assets you cannot. Examples of tangible assets would be equipment, vehicles and buildings and examples of intangible assets include goodwill, customer lists and trademarks, to name just a few.
Within the tangible asset category, you have both personal property and real property. In my prior examples, equipment and vehicles would be considered section 1245 personal property and the building would be considered section 1250 real property.
When I use the term personal property, I don’t mean property that you personally own; I’m referring to property other than a building which is referred to as real property in the tax world. So, to recap – equipment, vehicles and tools are considered personal property and building structures are considered real property.
Intangible property is referred to as section 197 property and it refers to assets such as the customer lists, trademarks, covenant not to compete and goodwill, just to name a few. These assets are typically amortized over 15 years, not depreciated, but the basic concept is the same – you’re writing these assets off over a period of time set forth by the Internal Revenue Service. Also, please keep in mind that I am oversimplifying the tax code here.
Hopefully, that gives you some basic information about the different types of business assets you might be selling. Now let’s talk sale structures.
Each business sale is negotiated differently which can affect the taxation on your deal; maybe you’re selling your business on contract over time while others might require payment up front. How you structure your sale can have a significant impact on the amount and type of tax you will pay as well as when you pay your tax. If you’re selling your business on an installment agreement over time– then you’ll likely recognize the taxation over that same period of time. However, if you have inventory that is part of the business sale, that has to be recognized as ordinary income in the year the sale takes place, even in the case of an installment sale.
So what do I mean when I say “how you structure your sale?” I’m referring to how the purchase price is allocated to the various assets being sold.
Let’s say Dave is selling his business for $100,000. He and his buyer agree that $4,000 is allocated to tools and the rest of the sale price is allocated to his customer list, an intangible asset created by Dave. Now let’s further assume Dave paid $3,000 for his tools originally and that he already wrote the full $3,000 off on his taxes. Dave would pay ordinary income tax on $3,000 since that is the amount he depreciated and he would pay capital gain tax on the remaining $1,000 of the tools plus the additional $96,000 allocated to the intangible asset of Dave’s client list. So, total sale price subject to capital gain is $97,000 and the remaining $3,000 will be subject to ordinary income tax. Also, since Dave is paying ordinary income tax on the section 1245 depreciation recapture, that has to be paid in the year of the sale even in the case of an installment sale.
There are a lot of variables to consider when selling your business and, keep in mind, how your actual business is structured can affect the taxation of the deal too. For instance, if your business is a sole proprietorship, a partnership or an LLC, then assets sold are typically treated separately for the purpose of calculating the taxation. However a corporation and, sometimes LLC’s, have the option of either selling its assets separately or selling its stock which has a very different tax repercussion than an asset sale. I’m not referring to a stock sale of a corporation currently – just the sale of assets to an unrelated buyer.
If you have a tax question, please submit it to firstname.lastname@example.org and I’ll make it the topic of a future show. For more information on this and other tax topics, visit my website at www.actservices-inc.com.