With a flurry of deal-making activity over the past few years, and organic growth becoming increasingly difficult in today’s marketplace, business owners across the spectrum of industries are constantly considering their options in regards to selling their business. One of the most often overlooked factors in selling a business is the potential ordinary income tax obligations triggered by the sale of business assets. The sale of your business assets can occur when your business is set up as a flow-through. A flow-through entity generally includes sole proprietorships, partnerships, limited liability companies, and S-corporations. These entity types will allow an owner to sell their business assets, while another entity type, such as a C-corporation, would be limited to a sale of stock. Business owners typically expect to pay capital gains tax on the sale of their business assets; however, there are several scenarios in which ordinary income tax can be triggered. In other situations, deferred income could be accelerated by the sale of company assets, increasing the owner’s tax liability. Here are three of the most common areas that can trigger an unexpected tax burden when selling your business assets.
Businesses that report on the cash receipts and disbursements basis of accounting will likely have additional ordinary income when the assets of the business are sold. When the business assets are sold, a purchase price allocation will be required for the consideration paid. The purchase price is allocated to the various assets sold, and a portion of the sale proceeds are allocated to the accounts receivable. On the cash basis, these items have not previously been recognized as income, so the allocation of the purchase price to these assets is essentially the receipt of these amounts. That receipt represents ordinary income when collected, thus tax burden on these items is higher than if the amount were taxed as capital gain.
Deferring the recognition of certain revenue and advanced payments until the delivery of products or the completion of services may be the normal accounting practice of the company. Certain deferrals of this type are allowed under the tax law. The deferral results in an immediate tax benefit for the business by allowing revenue for the deferral year to be lower, since the deferred revenue is not yet required to be recognized as income. While there is a current benefit to deferring revenue, immediately upon the sale of assets, these advanced payments are required to be recognized as income. This acceleration will occur regardless of whether the products have been delivered or services performed, potentially creating an unexpected tax burden.
When tangible personal property is acquired, a business is likely allowed to deduct as much as 100% of the cost of the asset in the year of acquisition. In addition, any remaining cost of the property not deducted in the year of acquisition can be deducted as depreciation expense in the years that follow. While these deductions can provide tax benefits when taken, it can trigger ordinary income tax upon a sale of the business assets.
Similar to the accounts receivable example noted above, the sale price must be allocated to the various assets sold through a purchase price allocation. To the extent that the amount allocated to the fixed assets exceeds their tax basis at the time of sale, the difference is likely all ordinary income instead of capital gain. The reason for this shift comes from the depreciation recapture rules, which require any gain on the sale of tangible personal property to be classified as ordinary to the extent of depreciation taken on the asset during ownership. There can be a difference between the capital gains tax rate of 20% and a maximum ordinary income tax rate of 37%, which is not an insignificant difference.
The ordinary income recaptured through the accelerated depreciation could potentially be included as part of Qualified Business Income (“QBI”) for purposes of calculating certain owners Section 199A Qualified Business Income Deduction. In order to be included in QBI, the recaptured income from the tangible personal property that is sold, needs to be effectively connected with a trade or business. If the income can be included, this will serve to increase the potential 20% QBI deduction for an owner.
Business owners looking to sell should determine the impact their tax and accounting decisions may have on a potential transaction. While these tax and accounting practices related to accelerating deductions and deferring income present immediate tax benefits for a business and its owners, they will trigger ordinary income in the future. Often times the triggering event for the recognition of this ordinary income is with the sale of assets. It is crucial for business owners to discuss tax planning and structuring with their tax advisor to understand the tax consequences with the sale of their business assets.