Capital gains are a different type of income from ordinary income on business profits. Taxes on capital gains taxes come into play in the sale of a business because capital assets are being sold. This article focuses on capital gains on business assets as part of the sale of a business,
What Are Capital Gains (and Losses)?
An asset is something of value that your business owns, like buildings, machinery, equipment, and vehicles. When you sell a capital asset (used for investment or to make a profit), you can sell it at a gain or loss. The difference between the original cost (called the basis) and the sales price is either a capital gain or a capital loss.
For example, if you own business equipment, you may add to the basis by upgrading the equipment or reduce the basis by taking certain deductions and by depreciation. The cost at purchase plus the changes create an adjusted basis at the time you sell the equipment. The difference in this adjusted basis and the sales price is either a capital gain or a capital loss.
How Capital Gains Tax Works
Capital gains tax is a tax charged on all capital gains. These gains are taxed differently, depending on how long they are held. If you own the asset for more than a year before you sell it, your capital gain is long-term. If you hold it one year or less, the gain is short-term.
To calculate your capital gains tax rate for your tax return, you must separate short-term and long-term capital gains on all the assets you sold during the year to get a net short-term and net long-term capital gain (or loss).
- A net short-term capital gain is usually taxed as ordinary income, based on your tax rate.
- The net long-term capital gain is taxed is usually no higher than 15% for most taxpayers, but there are some exceptions.
Selling Business Assets in the Sale of a Business
Here's where it gets complicated: When you sell a business, you sell many different types of assets. Each asset is treated as being sold separately to figure the capital gain or loss.
The IRS says, "The sale of a trade or business for a lump sum is considered a sale of each individual asset rather than of a single asset."
The process of selling business assets is complicated because each type of business asset is handled differently. For example, property for sale to customers (inventory, for example) is handled differently from real property (land and buildings). Each asset must also be looked at to see if it's a short-term or a long-term capital gain/loss.
After the individual assets have been analyzed and capital gains and losses determined, the next step is allocating the price of the business to each business asset transferred from the seller to the buyer.
The term "consideration" is a contract term meaning what each party gives in exchange. The buyer's consideration is the cost of the assets being bought. The seller's consideration is the amount realized (money plus the fair market value of property received) from the sale of assets.
This process is used to figure out how much of the consideration is for goodwill and other intangible property.
Example of Capital Gains in a Business Sale
This is an oversimplified example of capital gains in a business sale. The purchase price of a small business is $500,000. The fair market value of all the assets being sold as part of the package is $350,000 (including individual assets and the capital gain or loss on each) minus the fair market value of liabilities at $100,000, which equals $50,000. The difference of $50,000 is for goodwill and other intangible assets.
This process of analyzing assets and determining how gains and losses are taxed is a job for a business appraiser and a tax expert. What might seem like a simple business task can become complicated quickly, and getting the tax wrong is not a good idea.
Selling a Corporation or Partnership
The interest (investment) of an owner in a partnership or corporation is treated as a capital asset when it's sold by the owner. The capital gain of a partner or a shareholder is not the capital gain of the business; it's the gain or loss to the owner.
For a Partner in a Partnership
Capital gains taxes may be due on any gain received from the sale of the individual's partnership interest or from the sale of the partnership as a whole. Using the example above, a two-person partnership might split their share of the proceeds from the sale of the partnership 50/50. In this case, each partner might have capital gains of $25,000. But that's oversimplified, because of the value of the individual assets being sold and whether the gains were short-term or long-term.
For an Owner of a Corporation
Owners of a corporation are shareholders, and they have capital gains or losses when they sell their shares, not necessarily when the business is sold.
What to Do Before You Sell Your Business
Here are some tips to minimize capital gains, and get all the information you need for your tax return.
Gather Information on Your Assets
Find all the records relating to your purchase and improvement of each business asset. Include costs to purchase the asset and set it up (like training costs) and costs for improvements (but not maintenance). The higher the basis for each asset, the lower your gain when you sell it.
If you have products, parts, or materials for products you sell, take inventory so you know the value of that asset.
Get a Business Valuation
Find an appraiser and get a valuation of your business, including the value of all assets. This will help you get to a realistic selling price and estimate your possible capital gains tax.
You need to know about how capital gains tax works, but it's just as important to start planning for selling your business with the help of tax and legal advisors to minimize capital gains.
Frequently Asked Questions (FAQs)
How do I declare capital gains taxes on the sale of a business?
You will receive tax forms after the end of the year when the business is sold. The forms will include information about the short-term and long-term gains or losses from your share of the business sale. For your tax return, add up all your gains (or losses) for the year on IRS Form 8949, then transfer the information to Schedule D Capital Gains and Losses and include it on personal tax return. Don't try to do this yourself; get help from a tax professional.
Is there a way to minimize the capital gains tax I must pay for selling my business?
One way to defer (postpone) capital gains on the sale of your business is by reinvesting the proceeds in a tax-qualified Opportunity Zone. Your investment in an opportunity zone must be made within 180 days of the sale through a Qualified Opportunity Fund. These funds invest in economically distressed communities in the U.S. This IRS article has more information on Opportunity Zones and taxes.
Where can I get more information on capital gains in the sale of my business?
See these IRS publications for more details
- IRS Publication 544 for tax implications on the sale of business assets
- IRS Publication 541 Partnerships for capital gains on partnership shares
- IRS Publication 550 Investment Income and Expenses for capital gains for corporate shareholders