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, but capital gains tax works the same way with personal assets (like a home) or with investments (stocks and bonds, for example).
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, 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.1
Capital Assets are all types of property that are held by a company for investment and useful business purposes. Capital assets are those assets used by the business to make a profit.
The basis of an asset is adjusted during the time you own it, based on such things as improvements (increasing basis) or depreciation (decreasing basis).1
For example, if you own business equipment, you may add to the basis by upgrading the equipment, and the equipment will lose value over time from depreciation. The cost at purchase plus the changes creates an adjusted basis at the time you sell the equipment.
Then, 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, which are profits on sales of specific types of business assets and on capital shares of corporations by shareholders.
Capital gains are taxed differently, depending on how long they are held. Generally, 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 figure your capital gain tax rate, 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 usally taxed as ordinary income, based on your personal tax rate.
- The net long-term capital gain is taxed is usually no higher than 20% for most taxpayers, but there are some exceptions.1
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.
Even though your business and its assets are sold as a "package," there must be a determination of capital gain or loss on each asset. 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).
Some property may have to be recognized as ordinary income vs. capital gains for tax purposes.
Each asset must also be looked at to see if it's a short-term or a long-term capital gain/loss.2
This process of analyzing assets and determining how gains and losses are taxed is a job for an 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.
After the individual assets have been analyzed and capital gains/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 sell'ers 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.3
Here's a simple example:
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, equals $50,000.
The difference of $50,000 is for goodwill and other intangible assets.
Selling a Corporation or Partnership
The interest (investment) of an owner in a partnership or corporation is treated as a capital asset when that interest is sold.
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.4 (See IRS Publication 541 Partnerships for more details on capital gains on partnership shares.)
Owners of a corporation are shareholders, and they have capital gains or losses when they sell their shares.5
The capital gain of a partner or a shareholder is not the capital gain of the business. The owner's capital gain or loss is recorded on their personal tax return on Schedule D - Capital Gains and Losses.
See IRS Publication 544 for more information on the tax implications on the sale of business assets.
What to Do Before You Sell Your Business
To minimize capital gains, and get all the information you need for your advisors:
Gather information on 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 less your gain when you sell it.
Take inventory. 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.