Selling a Business

If you sell your sole proprietorship business, each of the assets sold with the business is treated separately.

So, you would need to determine the adjusted basis of each and every asset in the sale (you can lump some of the smaller items together, however, in categories such as office machines, furniture, production equipment, etc.). The problem becomes one of allocation; if you negotiate a total price for the business, you and the buyer must agree as to what portion of the purchase price applies to each individual asset, and to intangible assets such as goodwill. The allocation will determine the amount of capital or ordinary income tax you must pay on the sale.

Allocation of the price can be a big bone of contention. The buyer wants as much money as possible to be allocated to items that are currently deductible, such as a consulting agreement, or to assets that can be depreciated quickly under IRS rules. This will improve the business's cash flow by reducing its tax bill in the critical first years.

The seller, on the other hand, wants as much money as possible allocated to assets on which the gain is treated as capital gain, rather than to assets on which gain must be treated as ordinary income. The reason is that the maximum tax rate on long-term capital gains is 15 percent in 2013 (20 percent for taxpayers in the top 39.6 percent tax bracket), while the tax rate on short-term gains or ordinary income can be as high as 39.6 percent through 2013. Most small business owners who are successful in selling their companies are in high tax brackets, so the rate differential is very important.

Tip

Beginning in 2013, a new 3.8 percent net investment income tax may be imposed on individuals whose modified adjusted gross income exceeds $250,000 for joint filers, $125,000 for married taxpayers filing separately, and $200,000 for others. Trusts and estates with income over a certain amount are also subject to the NII tax. Form 8960, Net Investment Income Tax� Individuals, Estates, and Trusts is attached to the tax return. For 2013, the IRS has provided taxpayers the ability to rely on more than one set of net investment income tax rules. The best choice varies by taxpayers and depends on the taxpayer's unique situation. Consult your advisor to determine which approach would be best for you.

Any gains on property held for one year or less, inventory, or accounts receivable are treated as ordinary income. Amounts paid under noncompete agreements are ordinary income to you and amortizable over 15 years by the buyer, unless the IRS successfully argues they are really part of the purchase price. And amounts paid under consulting agreements are ordinary income to you and currently deductible to the buyer.

IRS allocation rules. As you can imagine, the IRS has come up with some rules for making allocations of the purchase price. Generally speaking, they require that each tangible asset be valued at its fair market value (FMV), in the following order:

Cash and general deposit accounts (including checking and savings accounts but excluding certificates of deposit)

Certificates of deposit, U.S. Government securities, foreign currency, and actively traded personal property, including stock and securities.

Accounts receivable, other debt instruments, and assets that you mark-to-market at least annually for federal income tax purposes. (Although there will be special limitations imposed on related party debt instruments)

Inventory and property of a kind that would properly be included in inventory if on hand at the end of the tax year, and property held primarily for sale to customers

All assets that don't fit into any other category. Furniture and fixtures, buildings, land, vehicles, and equipment usually fall into this category.

Intangible assets (other than goodwill and going concern value). Copyrights and patents generally fall into this category.

The total FMV of all assets in a class are added up and subtracted from the total purchase price before moving on to the next class. Thus, intangible assets such as goodwill get the "residual value," if there is any. However, remember that FMV is in the mind of the appraiser. You still have some wiggle room in allocating your price among the various assets, provided that your allocation is reasonable and the buyer agrees to it. Your odds are even better if your allocation is supported by a third-party appraisal.

According to IRS rules, the buyer and seller must use the same price allocation, so the allocation will have to be negotiated and put in writing as part of the sales contract. The allocation must be reported to the IRS on Form 8594, Asset Acquisition Statement Under Section 1060, which must be attached to the tax returns of both parties for the year in which the sale occurred. The allocation will be binding on both parties unless the IRS determines that it is not appropriate.