We all know how important it is to understand how tax laws affect the dayto-day operations of a construction business. But misunderstanding and misapplying the laws during the sale of your company can result in astoundingly costly mistakes – especially if you operate your business as a “pass-through” entity.
The sale of a business usually falls into one of two categories: the sale of assets or the sale of stock – “units” in the case of a partnership or limited liability company.
Gains from the sale of assets can often create unfavorable tax results – sometimes as high as 35 percent. So sellers usually prefer to sell their stock or units, thinking the gains will be treated as capital gains, which are normally taxed at 15 percent as long as the seller has owned his or her interest for more than 12 months.
But if you’re the owner of a “passthrough” entity, which is generally a partnership, S corporation or LLC, you need to be aware that selling your stock or units doesn’t necessarily mean all of the gains will be treated as capital gains.
More specifically, you should consider some often-overlooked requirements – the look-through rules. They require you to “look through” to the underlying assets of the business to determine whether any part of the gain from selling your ownership interests should receive different treatment.
The rules are fairly complicated and don’t always apply in the same manner to S corporations as they do to partnerships and LLCs. But the results of their application to a sale can be to essentially convert what you may have expected to be a capital gain taxed at a 15 percent rate into something much more costly.
So how can you get into trouble? One example is depreciation on machinery, equipment or vehicles. It can trigger ordinary income on a sale – and can be taxed at a rate of up to 35 percent rather than the 15 percent you might have been anticipating.
While you owned your business, you were able to depreciate a portion of these assets every year for wear and tear. And for assets that fall in this category, the IRS allowed you to use an accelerated depreciation schedule based on the assumption that these assets depreciate more in the earlier years of use.
But if the sale of the equipment results in a gain, the depreciation must be recaptured and taxed as ordinary income. Any gain beyond the allowable depreciation may qualify for a more favorable capital gains tax treatment.
Moreover, if you operated your construction business using the cash method of accounting, meaning for tax purposes you reported income only when you actually collected it, any uncollected accounts receivable can also result in some of the gain being taxed as ordinary income.
Even if some assets do qualify for capital gains treatment, not all capital gains are treated equally. For instance, gains attributed to recaptured depreciation on a building are treated as capital gains rather than ordinary income. But, unlike “normal” capital gains they’re taxed at a special 25 percent rate.
Keep in mind that this 25 percent rate applies only to the extent the gain on the sale of the building is attributed to depreciation taken in prior years. Any gain above the depreciation recapture will be taxed at the 15 percent rate.
Gains attributed to the sale of collectibles (such as artwork or rare coins) are also considered capital gains. In this case, instead of the gains being taxed at a 25 percent rate, they’re taxed at an even more unfavorable 28 percent rate. This situation, however, rarely applies to construction companies.
As you can see, the look-through rules are complicated – and potentially costly. That’s why careful planning is a must to avoid, or at least minimize, their tax impact on the sale of your construction business.