(NOTE: This is a continuation of a case study looking into tax implications of starting up a small business. Click here to go back to the start)
Sole proprietorships are about as easy to set up as a couch–you choose where you want to do business, and you’re good to go. Selling the sole proprietorship is more like setting up an abstract desk from Ikea, cut into shapes reserved for the most advanced levels of math with instructions that would probably be easier to understand if they were written in Greek. If you are considering selling your sole proprietorship, I would highly encourage you to talk to an accountant, and, as much as it pains me to say it, a lawyer.
However, to help you out on that journey, here are the overall tax implications of selling a business that you should consider.
Since a sole proprietorship doesn’t have stock or partnership interests, you’re not technically selling your business, you’re selling the assets inside of it. That means you’ll have to take the overall sales price you’re getting and allocate it to the assets in your company. Hopefully you’ve kept good records up to this point, because otherwise this process will be a pain.
Continuing on with the case study, consider if Amy were to sell her nail wrap business for $5,000. Her only physical assets inside the company are her inventory worth $500, a tablet she bought last year and fully depreciated, a computer she bought 2 years ago for $1,000 and depreciated by $600, and a list of customers. After negotiating with the buyer, they come up with the following allocation of sales price:
Customer List: $3,000
The remaining $300, by default, would go to Goodwill.
In total, Amy received $5,000. Her basis, or what she has invested in the company, is the amount she has left in the assets in the company. The inventory is going to be worth $500. The tablet’s basis is zero, since it’s fully depreciated, and the computer’s basis is $400. To calculate the gain, you’d take total sales price less basis, or $5,000 – $900 = $4,100.
I know a lot of people are bothered that the customer list isn’t deemed to have any basis. Yes, it took a lot of time, effort and money to create that list, but this gets into the complicated field of intangibles. For purposes of this book, I’ll just say that the IRS does not allow basis for these self-created intangibles (i.e. not a physical product).
In Amy’s case, she doesn’t have any liabilities, but I should note that in a sole proprietorship all liabilities would be in your name. When you sell the business, you’ll either have to pay those off or work with the lender to move them to the new business owner.
Okay, so once you have that gain determined, what happens? In general, it’ll be reported on Schedule D. The gain will typically be a Capital Gain, which means it’s taxed at the preferential rate of a maximum of 23.8% including the new Obamacare-added Medicare tax.
Of course there will be exceptions, and these can get complicated. Basically, since you’re selling assets in your company, if the asset would have an ordinary gain if it’s sold on its own, you’ll have to report it as ordinary gain and get the higher ordinary tax rates. For example, if Amy bought the inventory at $500, but the value had risen to $600, that $100 difference would be taxable as an ordinary gain. Or with the computer example above, since she has already depreciated a part of it, the gain would be what’s called depreciation recapture, which means it would be taxed at ordinary rates.
I know I just rushed right that capital and ordinary ideas. Let’s just say you probably want an accountant to help you out with that portion.
Finally, in terms of filling out forms, you’d also attach a Form 8594 listing out the value of the assets you sold. The buyer will fill out an identical form. If there’s any discrepancy, you will almost certainly receive a note from your friendly neighborhood IRS agent politely requesting an explanation of the discrepancy.
That wraps up the overall transaction. Hopefully my guidance was a little more clear than the naked Ikea man’s puzzling instructions. If not, it’s like I mentioned before: it’s really not something you want to go into alone.
To wrap things up, there’s a couple other tax implications of selling a business to consider that I want to list off:
-If you are selling to a related person, the transaction will come under much greater scrutiny. The IRS really doesn’t want you to sneak a gift in to your daughter by selling her the business below market value, so you’ll have to be extra sure that your company’s valuation is reasonable
-You can always just walk away from the business instead of selling it. If you’ve created value in the business, you’re probably leaving money on the table, but it’s much simpler from the tax side–file a final Schedule C, and then you’re done
-You can also have a loss on the sale. This could help your personal tax return, though you can only take a maximum of $3,000 of capital losses per year unless you have other capital gains. Any losses you can’t use flow forward to next year.
-The cash you receive doesn’t have to be in one big pile. The buyer can work out an installment sale, where you receive money over time. This could be good for you, since spreading your gain our over multiple years might drop you into a lower tax rate bucket than if you just got one sum (and no, you can’t “income average”). Note that any installment sales must have an interest component (which is taxed at ordinary rates) or the IRS will come back and convert a portion of your capital gains into interest (known as imputed interest).
And finally, you’re out of your sole proprietorship. Hopefully all went well and you made enough to buy a nice condo in Maui for retirement. If not, good luck with your next venture.
Picture by Kate Palaña