Capital Gains/Ordinary Income

April 13, 2006

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When you sell your business, you are really selling a collection of assets, some tangible (such as real estate, machinery, inventory) and some intangible (such as goodwill, accounts receivable, a trade name). Unless your business is incorporated and you are selling the stock, the purchase price must be allocated among the assets that are being transferred. According to IRS rules, the buyer and seller must use the same allocation, so the allocation will have to be negotiated and put in writing as part of the sales contract.

Allocation of 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 gains, rather than to assets on which gain must be treated as ordinary income. The reason is that the tax rate on long-term capital gains is limited to 20 percent for property held for more than 12 months (15 percent for sales and exchanges beginning May 6, 2003), while the tax rate on ordinary income can be as high as 35 percent in 2003 through 2010. Most small business owners who are successful in selling their company are in high tax brackets, so the rate differential is very important.

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.

Recapture of depreciation. Gain on depreciable personal property (that is, any property other than real estate), including amortizable intangible property such as business goodwill, is treated as ordinary income to the extent that the gain mirrors depreciation you've already claimed on those assets. In this way the depreciation is "recaptured."

Let's say that you purchased a used truck in 1994 for $10,000. The truck was operated only in your business, and you sold it 2 1/2 years later for $7,000. During the time you owned it, you claimed $6,160 in depreciation on the truck. Your basis in the truck at the time of the sale was $3,840 ($10,000 - $6,160 = $3,840).

Your gain taxed as ordinary income is the lower of your depreciation deductions claimed ($6,160) or your amount realized from the sale minus your tax basis ($7,000 - $3,840 = $3,160). So, in this case all of your gains would be taxed as ordinary income.

If by some miracle the truck had been sold for $12,000, the total gain would have been $8,160 ($12,000 - $3,840 = $8,160). Of this gain, $6,160 would have been taxed as ordinary income and $2,000 would have been taxed as long-term capital gain.

If you've depreciated any real estate sold on or after May 7, 1997, the depreciation you claimed over the years will be "recaptured" and taxed at a special rate of 25 percent. Formerly, the rule was than if you depreciated real estate using accelerated depreciation (ACRS), the difference between the depreciation you claimed under ACRS and what you could have claimed using straight-line depreciation is "recaptured" and treated as ordinary income.

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: (1) cash; (2) CDs, government securities, readily marketable securities and foreign currency; (3) all other assets except intangible assets (see definition below) and (4) intangible assets such as goodwill. 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.

Goodwill and other intangibles. Prior to August 11, 1993, goodwill was not depreciable at all, and other intangible assets of the business (such as the value of patents, trademarks, trade names, copyrights, a trained workforce, the value of business records, covenants not to compete, customer relationships, supplier relationships, licenses or permits) were depreciated only if the taxpayer could demonstrate that they had a limited useful life. Therefore, if you started your business from scratch or purchased it before 1993, it's likely that you were unable to depreciate your goodwill. Now, however, all of these intangible assets are known as "Section 197 intangibles" and your buyer must amortize them over a 15-year period. However, they are only amortizable if they were acquired after August 10, 1993 by purchase, gift, etc. — you still can't amortize self-created intangibles.