Even if you have never assisted a client with the sale of a business, as a tax planner you have the potential to provide tremendous value in the planning process. Many business owners may also be navigating a sale for the first time and likely have little insight into the tax implications and how to set themselves up for savings. By training as a Certified Tax Planner, you can benefit S corporation owners looking to sell by helping them understand the nature of an asset sale and helping them allocate these assets in the most tax-advantaged way.
The most common type of business sale is when an entity sells its business assets, which could include a diverse array of asset types. For example, cash in the bank is an asset. However, selling cash for cash does not result in a gain or loss. If an S corporation has $100 in the bank and that $100 is transferred to the new business owner, then $100 of the sales price is going to be allocated to cash, and no taxation will result from the transfer alone.
An S corporation might have accounts receivable, notes receivable, or tax receivable. These represent money that customers owe the company for services that have already been performed or products that have already been provided. Since the sale has already occurred, these are taxed at ordinary income tax—a rate that taxpayers likely want to avoid since it can be as high as 37%.
The business may also have fixed assets, such as manufacturing equipment, furniture, vehicles, or other tangible assets. These are taxed at the often lower capital gains rates, but they can also be subject to depreciation recapture. Depreciation recapture is assessed when the sale price of the asset is greater than the tax basis—or the adjusted cost basis. Because the taxpayer has been able to benefit from deducting depreciation over the years, the asset’s adjusted cost basis is equal to the original cost minus the total depreciation expenses. This is what determines whether you are seeing a gain or loss on that asset.
So if a business has fixed assets that are fully depreciated (the asset has reached the end of its use and all that is left is salvage value), the owner may have recapture on any portion of the sales price that is allocated to fix assets. If the asset is sold at a gain, that recapture can be taxed at ordinary income tax rates of up to 25%.
When the sale of a business results in capital gain, the entity can report this on its tax return using Form 1120-S (U.S. Income Tax Return for an S Corporation) and Schedule K-1 (Partner’s Share of Income, Deductions, Credits, etc) to report separately stated items to the owners. Additionally, Form 4797 (Sales of Business Property) can be used to report any recapture or types of long-term capital gains, whether a section 1231 or section 1245 gain. Under section 1231, when a business sells property at a gain, they can apply the lower capital gains tax rate. Section 1245, on the other hand, applies to property that has allowable or allowed depreciation or amortization (debt paid off in equal installments over time), and this is taxed at ordinary income rates.
With an asset sale, part of the planning process involves deciding how to allocate the sales price. The balance sheet might include items like accounts or notes receivable, accounts or notes payable, liabilities, debts, and equity. The sales price of the business will be reduced by anything allocated to liabilities. So if the new owner is going to assume $10,000 of accounts payable, we would then take that $10,000 out of the purchase price. That amount becomes tax-free because we are simply reducing the sales price. This serves as an example of one of the basic tax strategies for the sale of an S corporation—to optimally allocate the sales price among different asset classes so that they become more tax-advantaged.
So who decides on this allocation? This depends on what has already occurred in the sales process. As a tax planner, you will want to start by reviewing any agreements signed between the buyer and seller. However, many contracts are surprisingly silent on the allocation of the purchase price. If no agreement is ever drawn up and signed, the decision falls to the IRS, and they will likely allocate the sales price so that it results in the biggest assessment of tax. Therefore, a key tax planning move is to advise your client on how to allocate the purchase price and get an optimal agreement in place before the sale is finalized.
For further training on tax planning for the sale of an S corporation or other businesses, sign up to become a Certified Tax Planner today!