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Understanding the Difference Between Ordinary Income and Capital Gains

Albert Einstein once said, “The hardest thing in the world to understand is the income tax.” If you find your taxes confusing, then you are certainly in good company.

Taxes are complex, especially when you own a business, and the process is further complicated by the fact that all ordinary income is not created equal in the eyes of the government.

Tax rates vary based on the source of the ordinary income and several other factors, and determining how your income will be taxed and at what rate can be difficult for even the most experienced financial professional.

Generally ordinary income from a sale is taxed in one of two ways, as ordinary income or as capital gain income.  Understanding the difference between the two is particularly important for business owners when it comes to selling a business.  You will want to know exactly how the transaction will be taxed so you can effectively negotiate prices and properly prepare for the tax implications of the sale.

The sale of stock in a corporation, or membership units in an LLC is typically a capital gain transaction.  The gain is generally computed by deducting the tax basis of the asset from the amount realized (generally, the selling price less costs of sale).  This amount is then taxed at capital gain rates.  For example, if you invested $1000 in your company in 2000, and then sold the stock of the company for $100,000 in 2015, your basis would be $1000 (although basis is affected by many things throughout the life of the business), the amount realized would be $100,000 (assuming no costs) and the capital gain would be $99,000.  

Capital gain rates depend on how long the asset is held. For assets held more than one year (“long term capital gains”) the rates will range from 0% to 20% depending on the taxpayer’sordinary income; and taxpayers with very high ordinary incomes (400,000 for singles, $450,000 for marrieds), will be subject to an additional 3.8% Net Investment Income Tax.  Assets held under one year are subject to ordinary income rates.  Given that stock sales are generally taxed at capital gain rates, they are favored by sellers.  Buyers, however, are disadvantaged, because they inherit the company’s assets at their depreciated value.  If the assets have been fully depreciated, the buyer is unable to depreciate them further.

In the case of an asset sale, real estate and fixed assets like equipment and furnishings will generally be taxed at ordinary income rates or special “recapture” rates to the extent they have been depreciated, and then capital gain rates will apply to the balance.  Capital gain rates will also apply to things like goodwill and intangible assets which often make up the larger share of an asset purchase.  On the other hand, assets like inventory, accounts receivable and agreements like covenants not to compete or consulting agreements are all taxed at ordinary income tax rates which, for 2016 will range from 10% to 39.6% for individuals, and 15% to 35% for corporations.  Buyers tend to favor asset purchases because they can depreciate or amortize the assets based upon the new values assigned to them (as allocated from the purchase price).  

The competing tax interests of buyers and sellers should always play into negotiations when entering into a business purchase and sale transaction.  Ignoring the tax consequences of a transaction could have severe economic repercussions. It is absolutely vital that you enlist the services and counsel of skilled tax and business attorneys such as those at Brown & Sterling before you sell your business.  If you’re considering selling your business within the next 3-5 years, now is the time to begin planning.  Give us a call.

Brown & Sterling

Brown and Sterling, P.S. is dedicated to helping small to mid-sized business owners and entrepreneurs of the Pacific Northwest. We’ve been advising businesses from formation through owner exits for over fifteen years. With a team of seasoned attorneys with expertise in business, taxation, employment law, and real estate law, our firm is uniquely situated to walk business owners through all of the intricacies of a business acquisition or sale.