When you run a business as a sole proprietorship, it means you personally own the business assets. In case of a single-member LLC treated as a sole proprietorship, the law treats you as if you personally own the assets.
So, in both cases, selling the business automatically becomes asset sale for tax implications. As a result, you will need to report any taxable income or losses from the sale on your personal tax return, which is Form 1040.
You can also choose the option ‘sale assets’ of a business operated as a corporation, partnership, or a multi -member LLC treated as a partnership. But sellers often prefer ‘selling your ownership interest,’ for two reasons:
- No ongoing business-related liabilities.
- Tax advantages from the sale are generally treated as a lower-taxed long-term capital gain.
In contract, buyers prefer asset sales for the following reasons:
- Buyers can avoid exposure to unknown future liabilities related to the business.
- When you buy assets, their basis is “stepped up” to match the price you paid for them. This means that the new basis of the assets is adjusted to reflect their current value at the time of purchase.
- The buyer claims bigger depreciation and amortization deductions for furniture, equipment, buildings, and intangibles.
- If the buyer decides to sell some of the assets shortly after purchasing them, the higher basis resulting from the purchase can help reduce the taxable gains when those assets are sold or converted into cash.
As you see, buyers prefer asset sales for its irresistible benefits. So, in most cases, you have to close the deal by accepting an asset sale. In this blog, we will discuss asset sales and maximize tax savings.
Step-by-Step Process to Sell Business as an Asset Sale
Step 1: Identify all the assets.
Identify individual assets that will be included in the sale. This typically includes tangible assets (such as real estate, equipment, and inventory) and intangibles (such as patents, trademarks, and customer lists). It is important to create a comprehensive list to ensure all relevant individual assets are considered.
Step 2: Determine the fair market value (FMV).
Deciding an FMV of each asset needs to be determined. The FMV represents the price that the asset would sell for on the open market between a willing buyer and a willing seller. It is important to be accurate and use realistic values to avoid potential issues with tax authorities.
Step 3: Allocate the sale price among the different assets.
This allocation should be based on the FMV of each asset. It is crucial to consult with a tax advisor to ensure the allocation is reasonable and in compliance with tax regulations.
Step 4: Determine gain or loss on each asset.
The gain or loss is calculated by subtracting the asset’s adjusted basis from its allocated value. The adjusted basis is typically the original cost of the asset, adjusted for depreciation or other adjustments.
Step 5: Identify the tax treatment.
Identifying the tax treatment of the gain or loss on each asset will vary depending on the type of asset. For example, gains or losses on tangible assets are generally classified as capital gains or losses, while gains or losses on certain intangibles may be treated as ordinary income. Connect with prominent CPA Rancho Cucamonga.
Note: You report your gains and losses from your C corporation on Form 4797 (Sale of Business Property). You file this with your or your C corporation’s federal income tax return for the sale year. Again, consult with a tax professional to determine the specific tax treatment for each asset.
Step 6: Consider depreciation recapture.
If any assets were previously depreciated, the portion of the gain attributable to depreciation may be subject to recapture as ordinary income.
Step 7: Prepare Form 8594
To report the asset sale on the tax return, both the buyer and seller need to complete Form 8594 (Asset Acquisition Statement Under Section 1060). This form summarizes the allocation of the sale price among the assets sold.
How to Allocate the Sales Price to Assets for Tax Savings?
When it comes to an asset sale by a sole proprietorship, a single-member LLC treated as a sole proprietorship, an S corporation, a partnership, or a multi-member LLC treated as a partnership, one of the most significant opportunities for tax savings lies in how you allocate the total sales price to certain assets.
The goal is to allocate more of the price to assets that would generate lower-taxed long-term capital gains while minimizing the allocation to assets that would result in high-taxed ordinary income.
Maximizing Capital Gains
To maximize tax savings, allocate a larger portion of the sales price to assets that would result in long-term capital gains. These assets often appreciate over time and are subject to lower tax rates. By assigning a higher value to land, buildings, and certain intangibles, you can take advantage of the more favorable federal capital gains rates.
Minimizing Ordinary Income
Conversely, allocate a smaller portion of the sales price to valuable assets that would generate this type of income. These assets, such as receivables, inventory, and heavily depreciated or amortized assets, are typically taxed at higher ordinary income tax rates. By minimizing the allocation to these assets, you can reduce the tax burden associated with the sale.
Consulting with a tax professional from the best CPA for small business will ensure you make informed decisions and optimize your tax-saving opportunities.
Using the Required Residual Allocation Method
The Required Residual Allocation Method, also known as the residual method, is a tax allocation approach used when allocating the sale price of a business to its various assets. This method is required by the Internal Revenue Service (IRS) for tax reporting purposes in certain situations when it comes to asset sale.
Here is how this method works:
Allocate the sale price to specific assets.
Allocate the sale price to assets classes that have predetermined values. These asset classes typically include cash and cash equivalents, certain types of securities, and assumed liabilities. The values assigned to these asset classes are determined by specific tax rules or regulations.
Allocate the remaining amount.
Then, allocate the remaining amount, known as the residual, among other tangible and intangible assets of the business. This allocation is typically based on the FMV of each asset. The residual allocation should be done in a reasonable and consistent manner, considering the specific circumstances of the business sale.
The Required Residual Allocation Method ensures that the sale price is allocated among the assets in a manner that complies with IRS regulations. This method of asset sale helps provide clarity and consistency in tax reporting for both the buyer and the seller.
Using the Required Residual Allocation Method is not always mandatory. In certain cases, taxpayers may have the option to use alternative allocation methods if they can demonstrate that their chosen method results in a more accurate and appropriate allocation of the purchase price.
How to Avoid an IRS Audit?
Both the seller of assets (you or your business entity) and the buyer (the other guy, gal, or business entity) must independently report the sale and purchase price allocations used in the deal by attaching Form 8594 to your respective federal income tax returns on asset sale.
The IRS can then decide to inspect the two forms to see whether the parties used different allocations. The tax code does not prohibit different allocations, except when the sales agreement itself is the basis for the allocations.
But if different allocations are used, you raise the risk of an audit, and an audit may expand beyond just the asset sale transaction—both undesirable scenarios!
It is in your best interest to ensure that the buyer reports the same allocations on Form 8594 as you report on Form 8594. Consider including this as a requirement in the asset sale agreement. This can help avoid an IRS tax audit.
Given the complexity of tax regulations, it is advisable to work with a qualified tax professional to ensure compliance with the IRS requirements and to determine the most suitable allocation method for selling a company.
Our seasoned tax professionals, at GNS CPAS Accountancy, a leading CPA Ontario, can help you navigate the process of selling your business smoothly. You can rest all the accountancy- and tax-related things to our experts and focus on more important things in the process.
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