Small Business Guide: A Primer on Capital Gains Tax
When it comes to minimizing tax liability, small-business owners can use all the help they can get. One area where it pays to understand tax law is capital gains tax.
Sell capital assets (investments such as real estate and stocks) through your business and the difference between the amount you paid for the assets and the amount you sold them for is considered a capital gain or loss.
When capital gains are involved, you owe capital gains tax, says Ken Moll, founder and principal for Integrated Executive Solutions (IES), which assists small businesses with strategic planning that encourages company growth. “Effective capital gains management leads to a smaller tax bill, which means you have more working capital and better cash flow,” he says.
Capital gains tax directly affects how small-business owners deal with assets, which makes proper handling of this tax issue important, says Kevin Cloward, a certified public accountant and senior manager at Saddington Shusko. Any slip-ups in dealing with capital gains can cost small-business owners valuable tax dollars and result in substantial legal and accounting fees.
What Are Capital Assets?
Capital assets are any property other than inventory, specified literary or artistic property, business accounts receivable and certain U.S. publications. Examples of capital assets include, but aren’t limited to, stocks, bonds and real property.
How the Tax Works
The capital gains tax is a tax for capital assets that are sold at a higher price than their "basis," which refers to the cost to acquire the asset less any depreciation, amortization or fees to dispose of the assets. So if you were to sell a piece of property for more than you bought it, your taxable capital gain will be your profit from the sale minus any fees, such as title insurance.
At what rate you are taxed for an asset depends on if it is considered capital property or dealer property. “Capital property is generally held for investment, whereas dealer property is usually meant for sale,” Cloward says. “If you are considered to be a dealer in an asset, it will be considered inventory, and capital gains tax treatment won’t be available. Intent is everything. Dealer property versus capital property is the subject of much litigation throughout the history of the tax courts so much care must be exercised in determining the character of the asset being sold.”
Short and Long-Term Gains
How long you hold a capital asset affects how much tax you owe. Short-term capital gains refer to assets that are sold within one year of when they were acquired, and these are taxed at a higher rate than long-term gains. “The capital gains tax rate for short-term capital gains are taxed at the ordinary income tax rate, which can be up to 35 percent for 2012 and up to 39.6 percent for 2013, unless the Bush tax cuts are extended,” Cloward says.
Long-term capital gains apply to assets held longer than one year and generally result in a lower tax. “The current rate for long-term capital gains is generally 15 percent for 2012 and is scheduled to increase to 20 percent in 2013,” Cloward says. “The new Medicare tax will tack on another 3.8 percent in 2013 on your capital gains (regardless of the holding period) if your adjusted gross income (AGI) exceeds $200,000 for individuals and $250,000 for taxpayers filing jointly.”
Due to the substantial differences in tax rates, generally, if you have an asset that is going to result in a gain, it is beneficial to refrain from selling it until after 12 months so that the gain will be taxed at the lower rate, says Moll. In light of the pending Medicare tax, however, Cloward suggests consulting with your accountant about whether or not to sell appreciated capital assets in 2012 or wait until 2013.
Deferring or Reducing Capital Gains Tax
Besides holding assets for longer than 12 months, there are other methods of deferring and reducing capital gains, such as installment sales. This method of reporting for a non-dealer is available if at least one payment is to be received after the close of the taxable year in which the sale occurs. The taxpayer can then defer the gain as payments are received in subsequent years.
A Section 1031 exchange also provides the opportunity to defer gains. This involves purchasing a "like-kind" piece of property within 180 days of the sale of another. It must be property held for investment or used in the trade or business. The basis and debt of the new property must equal or exceed the basis and debt of the property sold.
You might also be able to offset capital gains with capital losses. If you have excess capital losses of up to $3,000, they can be deducted against ordinary income, and remaining capital losses can be carried forward indefinitely.
Now that you know the basics of capital gains tax, you can use this information, along with the expert advice of your accountant, to make financially advantageous tax decisions that will increase cash flow for your company.
A freelancer since 1985, Julie Bawden-Davis has written for many publications, including Entrepreneur, Better Homes & Gardens and Family Circle. Julie blogs via Contently.com.
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