Bryce Welker

May 9, 2019

Selling your online business is a big decision, especially if it’s a small business. The tax impact of such a sale can also be substantial. Before you sell your business or decide to buy a competitor’s firm, you’ll need to understand important tax law concepts, such as owner’s basis and capital gain, as well as the potential business tax liability the seller faces.

This is a technical subject, which is why the team at CPA Exam Guy suggest you seek professional advice—preferably from a certified public accountant (CPA) if you are US-based.

How Sole Practitioners Pay Taxes

Most business owners in the US operate as sole practitioners, and they post their company’s income and expenses on Schedule C of their personal tax returns (Form 1040). As a result, their business’ profits are added to the other income listed on their personal returns, including dividend and interest income, and the W-2 earnings from their spouses’ employment (assuming that the spouses file jointly).

Assume, for example, that Julie owns Lakeside Collectibles, an online retail business. For the 2018 tax year, Julie reports a $60,000 profit from Lakeside; that $60,000 is added to the interest income on her bank account and her husband’s Form W-2 income. They file a joint return and pay income taxes based on their joint income.

As an aside: depending on location, the terms “sole practitioner” and “sole proprietor” can be used interchangeably. Check your local tax laws or contact the Internal Revenue Service (IRS) if you are confused about which one may apply to your situation.

What Is Ownership Basis?

When an owner sells a business, the capital gains are calculated as the sales proceeds minus the owner’s basis in the firm. Owner’s basis (or owner’s equity) is the dollar amount that has been invested in the business as of the date of sale. Many owners have difficulty tracking this account balance, which can cause complications when calculating business taxes.

The formula for calculating the owner’s basis is as follows:

Initial capital investment + additional capital contributions – withdrawals

Note the following:

Capital Contributions

When an owner invests any type of asset into their business, their capital account increases. The term “capital” refers to the total dollar amount of assets the owner has invested in the business.

An asset is defined as a resource that a company uses to generate sales and profits. Most owners invest cash (an asset) into new businesses, but they may also contribute other assets, such as equipment, hardware, or software.

Over time, an owner may contribute additional capital (cash, equipment, etc.) to finance company growth.

Assume, for example, that a business needs $40,000 in computer hardware to manage higher sales and production requirements. The firm carries an average cash balance of $30,000, and the company and doesn’t have enough cash on hand to both pay for this purchase and continue to operate. In such a case, the owner may decide to contribute $40,000 in cash in additional capital so that the business can purchase the necessary equipment.

Withdrawals

Retained earnings represent profits that are kept (retained) in the business in cash to allow for business expansion. Assume, for example, that Julie’s company has a $90,000 balance in retained earnings, which represents three years’ worth of profits that were kept in the business.

A withdrawal is a payment to the owner in excess of company earnings. If, for example, Julie takes $70,000 out of the business at the end of 2018, in which she earned $60,000 in profit, the first $60,000 of this sum is considered profit, but the additional $10,000 is a withdrawal that reduces Julie’s capital investment in her business. This $10,000 comes from her retained earnings balance.

If any of this is too overwhelming or confusing, consider working with an accountant! He or she can review your transactions for the year with you, remind you of due dates, and manage your tax forms.

Using the services of an accountant can free up your time so you can focus on brand building, growth planning, and other aspects of your business. If you use the services of other experts to leverage your time and get better results, why not do the same with your taxes and accounting work?

How Capital Gains Are Calculated

If Julie sells her business for $700,000 and her owner’s basis is $500,000, she generates a $200,000 capital gain.

Because Julie is a sole proprietor who reports her business profit on Form 1040, she calculates her capital gains tax on Schedule D of Form 1040. Here are the steps that Julie takes to complete Schedule D:

  • Short-term vs. long-term gains: If a taxpayer sells an asset that has been owned for a year or longer, the gain from this asset is defined as long-term. This distinction is important because long-term gains are currently taxed at a lower rate than are short-term gains. In this case, short-term gains refer to gains from an asset that has been owned for less than one year.
  • Tax rates on long-term gains: For the 2018 tax year, the tax rates on long-term capital gains are either 0%, 15%, or 20%, depending on your taxable income, filing status, and several other factors.
  • Tax rates on short-term gains: For the 2018 tax year, the tax rates on short-term capital gains match the tax brackets used for ordinary income. These rates range from 10% to 37% depending on your total taxable income.

Given the current tax structure, you should avoid selling a business that you’ve owned for a year or less, because the capital gains tax rate for this sale may be much higher than they would be for a business you’ve owned for a year or longer. If a buyer has a strong interest in purchasing such a business, you’ll need to demand a sale price that covers the higher business taxes you’ll pay on this short-term gain.

If Julie is in the 15% capital gains bracket, she will pay ($200,000 15%), or $30,000, in capital gains taxes after completing Schedule D. A capital gain is added to other sources of income on Form 1040.

Capital gains can be reduced by the dollar amount of capital losses generated during the same tax year. If, for example, Julie had $5,000 in losses on online sales of common stock, those losses can reduce the $30,000 capital gain on the business sale. Hence, a lower gain reduces her total tax liability.

Preparing for a Business Sale

Finding a buyer for your company can be exciting, and a sale can generate a big financial benefit for you. However, business owners need to consider the tax implications of selling a company before going forward with the process.

In closing, here’s what’s important for every small business owner to remember:

Carefully account for your owner’s basis and have an accountant review the basis changes each year. Work with a tax expert to understand how the sale will be taxed as well as what your projected tax liability is.


Author

Bryce Welker is an active accounting and finance speaker, blogger, and tutor. While prepping for his CPA exam he felt the need to develop his own study method and share it with others. As the founder of Crush the CPA Exam, he has helped thousands of candidates pass the CPA exam on their first attempt. Currently, he is a thought leader in the accounting space and has written articles for Forbes, Inc., Accounting Today, Huffington Post, AccountingWEB and many other large media publications.

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