Planning for taxes ahead of a potential sale often takes place over several years. One of the most important components to review and analyze during a pending sale is a business’s balance sheet, and in particular, its tax basis balance sheet.
In Michael’s post, he explained the concept of an asset sale in detail. One of the most important aspects to a seller when reviewing the tax implications of a pending asset sale is the tax basis of the assets being sold. In an asset sale, the assets sold typically consist of accounts receivable, inventory, fixed assets, and intangibles – most notably, the business’s goodwill.
The resulting gain from the sale of these assets will have differing tax results. For example, the sale of the accounts receivable, inventory, and a significant portion of the fixed assets is likely to be taxed as ordinary income, which is subject to the highest marginal tax rate. The sale of intangibles, on the other hand, is likely to generate a gain that is subject to preferential capital gain tax treatment.
The question becomes, what can be done now to take advantage of this allocation methodology and shift more of that future gain to the intangible bucket?
The concept of cleaning up a business’s tax basis balance sheet is often an afterthought. However, an annual review of the fixed asset ledger for older assets sitting on the balance sheet as well as current year additions could pay significant dividends in both the short term and in the long term.
The simplest illustration is reviewing a fixed asset ledger and finding computer or office equipment (or a litany of these items) from 10 to 15 years ago residing on the balance sheet detail report, albeit fully depreciated. In our world, we refer to these assets as “ghost assets.” From the outside looking in, this may not appear to be an issue. Although the asset is reported on the ledger, the net value is being reported as zero given it has been fully depreciated.
However, from a tax perspective, the simple listing of that asset will be problematic when the time comes to report the gain from the sale of the asset. This is because a portion of the selling proceeds will be allocated to all assets on the tax balance sheet, and to the extent you have fully depreciated assets, the gain associated with those fully depreciated assets may be taxed as ordinary income and subject to the highest marginal tax rate.
If we performed a thorough housekeeping of the fixed asset ledger prior to a sale, the proceeds associated with those ghost assets would be allocated to a more favorable class of assets, most likely one that would be given capital gain tax treatment.
The simple illustration above explains the value of ensuring your balance sheet only reports the business’s actual fixed assets. The maintenance associated with removing ghost assets is something that should be evaluated annually.
In addition, during an annual review of fixed asset expenditures, it is imperative for current year additions to be viewed through a “tax lens,” as the reporting of an addition may be entitled to expense treatment for tax purposes, and therefore, never make it to the tax basis balance sheet.
This is where the “repair regulations” come into play. Another colleague of mine, Lawrence Silver, wrote an article several years ago explaining the importance and value of these regulations to taxpayers. The repair regulations offer immediate expense treatment for certain improvements to property, which would otherwise be capitalized and depreciated over several years. As we learned above, the ultimate gain from the sale of these assets may be subject to ordinary income recapture and taxed at the highest marginal tax rate. Repair regulations, therefore, provide tax benefits in the form of immediate tax deductions as well as in the long term from not having to list the eligible assets on the tax basis balance sheet.
I should emphasize that the IRS allows taxpayers to review and correct their tax basis balance sheets for ghost assets as well as assets that would have been eligible for expense treatment under the repair regulations. The IRS requires the filing of a Change in Accounting Method when these situations occur. This automatic filing allows for a prospective adjustment to be made on the current year tax return, which often results in immediate tax savings.
During the pandemic, many clients have sought opportunities to utilize all tax incentives available to them in order to free up cash. The above examples provide a roadmap that allows business owners to follow a simple plan to save taxes in the long term, while also generating immediate tax deductions.
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