An “excess business loss” is any net business loss from all activities greater than the threshold amount. The threshold amount is $250,000 for single filers and $500,000 for married couples filing a joint tax return. An S corporation is a corporation with a valid 'S' election in effect. The impact of the election is that the S corporation's items of income, loss, deductions and credits flow to the shareholder and are taxed on the shareholder's personal return. Each limitation is addressed in the order shown.
According to some industry surveys, well over 90% of business sales are “asset” sales as opposed to “stock” sales. More times than not, this is driven by specific tax objectives of the buyer. It has major tax implications for the seller that are – more times that not – bad.In a recent series of articles, we discussed how a business seller’s tax strategy often depends on who the buyer is. In one installment, we noted situations when – given who the buyer is – the seller would want her or his business to be treated as a “C” corporation for tax purposes. What would initial seem like “tax death” turned out to be a tax-reducing strategy. These situations are the exception.
In that same series, we also discussed how “what is being sold” affects the business seller’s tax strategy. In this article, we will focus on when “what is being sold” might negate tension between the buyer’s preference for an “asset” sale and the seller’s preference for a “stock” sale. Before getting into specifics, let’s be clear that the discussions below deal with a business that is already treated as a “C” corporation for tax purposes. We are not talking about taking a business that a not already treated as a “C” corporation for tax purposes and converting into one. We’re trying to get out of a pickle, not get into one.
Back in 1944, an individual conducted business as an insurance broker via a corporation of which he and his wife were the sole owners. The couple dissolved the corporation and distributed the corporation’s assets – including the corporation’s goodwill – to themselves. The IRS argued that the distributed goodwill should be taxed as any other distribution. But, the Tax Court held that the goodwill was really due to the personal ability and relationships of the husband himself. As such, the goodwill was that of the person and not the corporation.
In 1998, the Tax Court considered a similar set of circumstances; this time involving an ice cream distributor. It affirmed its decision from a half-century earlier. “This Court has long recognized that personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract with the corporation. Those personal assets are entirely distinct from the intangible corporate asset of corporate goodwill.” Later that same year, the Tax Court again affirmed its position in another case. Finally, in 2002, the IRS conceded the issue in a Technical Advice Memorandum.
Here’s what it boils down to. If your company is taxed as a “C” corporation, is owned only by you and/or your spouse, and the company’s goodwill stems from your personal ability and relationships, that goodwill is not an asset of the company . . . it is yours as an individual. Thus, you would sell that goodwill as an asset of your own and not as an asset of your “C” corporation. When doing this, formality must be followed. The corporation sells its tangible assets and you personally sell your goodwill. Two separate transactions. Your personal sale of your goodwill is reported on Schedule D of your personal income tax return. Yes, the corporation will be taxed on gain realized on all other assets. And, yes, when the corporation subsequently distributes cash proceeds to you, it will be a dividend taxable to you. But, you will avoid the double-taxation on your personal goodwill. For most service businesses, it will be your personal goodwill that is the bulk of the firm’s value.
Now, let’s take the ice cream case a step further. The personal relationships with the suppliers and the customers were those of the owner as an individual. The only other meaningful asset of the “C” corporation is inventory. (For those who “drop ship,” you can disregard this part of the discussion.) A business can’t depreciate inventory. As such, there is no meaningful difference to the buyer or the seller between a “stock” sale and an “asset” sale. There’s no reset of depreciable basis for the buyer.
As for the seller, consider the instance when inventory is sold as an asset to the buyer. The “C” corporation has no profit on the sale and the proceeds are distributed to the seller as a dividend. There is only one level of tax to the seller. Alternatively, if we have a “stock” sale for the same price as the asset sale, there is also only one level of tax to the seller. Truly, the buyer and seller end up in the same spot either way.
Now, there is one exception that must be noted. If the amount of inventory is above a certain dollar amount, the dividend payment from the “C” corporation will be taxed at the seller’s ordinary income rate as opposed to the preferential capital gain rate seen in lower income tax brackets.
In this first installment on this subject, we have found that – at least for some business sellers – ownership of a “C” corporation is not a recipe for “tax death” upon sale of your company. In our next episode, we will examine other scenarios.
'>According to some industry surveys, well over 90% of business sales are “asset” sales as opposed to “stock” sales. More times than not, this is driven by specific tax objectives of the buyer. It has major tax implications for the seller that are – more times that not – bad.
In a recent series of articles, we discussed how a business seller’s tax strategy often depends on who the buyer is. In one installment, we noted situations when – given who the buyer is – the seller would want her or his business to be treated as a “C” corporation for tax purposes. What would initial seem like “tax death” turned out to be a tax-reducing strategy. These situations are the exception.
In that same series, we also discussed how “what is being sold” affects the business seller’s tax strategy. In this article, we will focus on when “what is being sold” might negate tension between the buyer’s preference for an “asset” sale and the seller’s preference for a “stock” sale. Before getting into specifics, let’s be clear that the discussions below deal with a business that is already treated as a “C” corporation for tax purposes. We are not talking about taking a business that a not already treated as a “C” corporation for tax purposes and converting into one. We’re trying to get out of a pickle, not get into one.
Back in 1944, an individual conducted business as an insurance broker via a corporation of which he and his wife were the sole owners. The couple dissolved the corporation and distributed the corporation’s assets – including the corporation’s goodwill – to themselves. The IRS argued that the distributed goodwill should be taxed as any other distribution. But, the Tax Court held that the goodwill was really due to the personal ability and relationships of the husband himself. As such, the goodwill was that of the person and not the corporation.
In 1998, the Tax Court considered a similar set of circumstances; this time involving an ice cream distributor. It affirmed its decision from a half-century earlier. “This Court has long recognized that personal relationships of a shareholder-employee are not corporate assets when the employee has no employment contract with the corporation. Those personal assets are entirely distinct from the intangible corporate asset of corporate goodwill.” Later that same year, the Tax Court again affirmed its position in another case. Finally, in 2002, the IRS conceded the issue in a Technical Advice Memorandum.
Here’s what it boils down to. If your company is taxed as a “C” corporation, is owned only by you and/or your spouse, and the company’s goodwill stems from your personal ability and relationships, that goodwill is not an asset of the company . . . it is yours as an individual. Thus, you would sell that goodwill as an asset of your own and not as an asset of your “C” corporation. When doing this, formality must be followed. The corporation sells its tangible assets and you personally sell your goodwill. Two separate transactions. Your personal sale of your goodwill is reported on Schedule D of your personal income tax return. Yes, the corporation will be taxed on gain realized on all other assets. And, yes, when the corporation subsequently distributes cash proceeds to you, it will be a dividend taxable to you. But, you will avoid the double-taxation on your personal goodwill. For most service businesses, it will be your personal goodwill that is the bulk of the firm’s value.
Now, let’s take the ice cream case a step further. The personal relationships with the suppliers and the customers were those of the owner as an individual. The only other meaningful asset of the “C” corporation is inventory. (For those who “drop ship,” you can disregard this part of the discussion.) A business can’t depreciate inventory. As such, there is no meaningful difference to the buyer or the seller between a “stock” sale and an “asset” sale. There’s no reset of depreciable basis for the buyer.
As for the seller, consider the instance when inventory is sold as an asset to the buyer. The “C” corporation has no profit on the sale and the proceeds are distributed to the seller as a dividend. There is only one level of tax to the seller. Alternatively, if we have a “stock” sale for the same price as the asset sale, there is also only one level of tax to the seller. Truly, the buyer and seller end up in the same spot either way.
Now, there is one exception that must be noted. If the amount of inventory is above a certain dollar amount, the dividend payment from the “C” corporation will be taxed at the seller’s ordinary income rate as opposed to the preferential capital gain rate seen in lower income tax brackets.
In this first installment on this subject, we have found that – at least for some business sellers – ownership of a “C” corporation is not a recipe for “tax death” upon sale of your company. In our next episode, we will examine other scenarios.
Related Articles
- 1 What if a Company Sells a Depreciated Asset?
- 2 Distribute Net Profits Before Year's End for an S Corp
- 3 Acquisition Taxes on an S Corp
- 4 Do I Owe Taxes on Business Property of a Closed Business?
An S corporation is a pass-through business. That means that this kind of company pays no taxes. Instead, the firm's owners, generally called shareholders, pay all taxes, as well as penalties. The IRS explains that S-corps are businesses that 'pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.' Hence the term 'pass-through' business.
The S-corp capital gains tax rate is also governed by a 'pass-through' rule. Additionally, the taxes on the sale of a business S-corp have undergone some recent changes, with updates and revisions of U.S. tax laws in 2015 and 2018. So, selling an S-corp tax consequences are somewhat different than a few years ago. Understanding what is involved in the taxes on the sale of business S-corp can save you quite a bit of money if you find yourself in this position.
Do I Pay Tax When I Sell My Business?
While selling an S-corp does have tax consequences and the sale of S-corp stock may cause shareholders to pay capital gains taxes, you would have to pay taxes, regardless of the type of business you sell – and those taxes are likely to be much higher than the taxes on the sale of business S-corp. According to Wolters Kluwers:
'When you sell your business you may face a significant tax bill. In fact, if you're not careful, you can wind up with less than half of the purchase price in your pocket, after all taxes are paid!'
Wolters Kluwer, which helps business owners start, run and grow their companies, further explains that you would be taxed on any and all profit you make from selling a business. No matter how you structure the deal, 'the IRS will take its share at some point,' says Wolters Kluwers.
The key point to remember is that the profit you receive from the sale of your business will likely be taxed at capital gains rates. And, importantly, under current tax law and IRS rules, capital gains of individuals are taxed at a significantly lower rate than ordinary income.
Do Corporations Pay Capital Gains Tax?
Corporations do pay capital gains taxes, but they are taxed at a rate similar to individuals, based on the amount of income – or capital gains, they realize. To understand this, it's important to first define capital gains. Capital gains are 'profits from the sale of a capital asset, such as shares of stock, a business, a parcel of land, or a work of art. Capital gains are generally included in taxable income, but in most cases, are taxed at a lower rate,' says the Tax Policy Center, a joint effort of the Urban Institute and Brookings Institution. According to the Tax Policy Center:
'A capital gain is realized when a capital asset is sold or exchanged at a price higher than its basis. Basis is an asset’s purchase price, plus commissions and the cost of improvements less depreciation.'
Capital gains can be either short term or long term. Those gains that you (or a corporation) holds for less than a year are short term. Those that you (or a corporation) own for more than a year are long term. The IRS looks at capital gains just as it looks at income: They represent money a corporation, or its shareholders, have earned. The corporation then pays taxes on the capital gain, or the income it has realized by selling an asset.
What Is the Capital Gains Tax Rate for Selling a Business?
Long-term assets are taxed at lower rates, up to 20 percent, while those that are short-term are taxed at ordinary income (tax) rates up to 37 percent, says the Tax Policy Center. Tina Orem, in an article titled, '2018 Capital Gains Tax Rates – and How to Avoid a Big Bill,' published on the website Nerd Wallet, explains:
'In 2018 the capital gains tax rates are either 0 percent, 15 percent or 20 percent, for most assets held for more than a year. Capital gains tax rates on most assets held for less than a year correspond to ordinary income tax brackets (10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent or 37 percent). '
The IRS, essentially, considers the sale of a business as the sale of a group of assets that make up that business. So, if you sell a business and realize capital gains, the income you've earned from the sale, after allowable expenses, are your capital gains. You pay taxes on those gains either as short- or long-term rates, depending on how long you hold those gains.
The Tax Policy Center notes that there have been some major changes recently. The Tax Cuts and Jobs Act (TCJA), enacted at the end of 2017, kept the capital gains tax rates for long-term assets, but changed the tax rate for short-term capital gains to zero capital gains tax if the income (or capital gains) is below $38,600 up to 20 percent if the income is $479,000 or above.
How Is the Sale of an S-Corp Taxed?
When talking about the S-corp capital gains tax rate, it's important to take a look at what selling an S-corp tax consequences would be. Stephen L. Nelson, a CPA and the author of more than two dozen books on accounting, explains what the taxes on the sale of business S-corp would be. Since an S-corp is a 'pass-through' business, shareholders pay all of the taxes, not the firm itself. Nelson gives the hypothetical example of an S-corp owned equally by Tom, Dick and Harry; each owns one-third of the company. According to Nelson:
'If the corporation makes $300,000 in profit, the corporation doesn’t pay the income tax on this profit. Instead, each shareholder includes his share of the corporation profit – $100,000 per person – in his or her taxable income. The shareholders pay the taxes owed on the $100,000 of corporate profit on their individual income tax returns.'
If the S-corp is sold, the company itself pays no taxes, even if the sale results in capital gains. (Remember that the IRS considers the sale of any corporation as the sale of its combined assets.) These assets are called 'goodwill and going concern,' according to the IRS. So on the sale of goodwill tax treatment of an S-corp, the value of those assets depends on the assessment (or goodwill) of the purchasing party.
Suppose that Tom, Dick, and Harry invested a total of $300,000, or $100,000 each, to start the company. That $300,000 would be their 'basis.' Anything above that basis achieved in a sale would be considered capital gains. Because the S-corp is a 'pass-through' business, it pays no capital gains taxes on the sale. Instead, Tom, Dick, and Harry would each pay taxes on their share of the capital gains achieved from the sale of the S-corp, and they would be taxed at the same rate as their individual income taxes. If the S-corp were sold for $400,000, that would represent capital gains of $100,000. Tom, Dick and Harry would each pay taxes on one-third of the profit, $33,333, at their individual income tax rates. The S-corp would get off Scott free, paying no capital gains taxes.
Little wonder, then, that about 95 percent of American businesses are pass-through firms such as sole proprietorships, partnerships, and S-corps, according to Reuters news service. The thought of a business paying no capital gains taxes when it is sold (or even makes a profit) is just too tempting a tax advantage to pass up.
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About the Author
Leon Teeboom has written for such newspapers as 'The Los Angeles Times' and 'The Orange County Register.' He has also written for/and worked as an editor at 'The Press-Enterprise' as well as two business publications and several online media companies.
Cite this Article Choose Citation Style
Teeboom, Leon. 'Capital Gains Taxes on Sale of S Corporation.' Small Business - Chron.com, http://smallbusiness.chron.com/capital-gains-taxes-sale-s-corporation-63100.html. 17 December 2018.
Teeboom, Leon. (2018, December 17). Capital Gains Taxes on Sale of S Corporation. Small Business - Chron.com. Retrieved from http://smallbusiness.chron.com/capital-gains-taxes-sale-s-corporation-63100.html
Teeboom, Leon. 'Capital Gains Taxes on Sale of S Corporation' last modified December 17, 2018. http://smallbusiness.chron.com/capital-gains-taxes-sale-s-corporation-63100.html
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