Do Small Businesses Pay Capital Gains?

Do Small Businesses Pay Capital Gains?

Posted by Amr Tenney on Nov 21, 2022

consulting-business-stuff-IS-1176848544Taxes in the United States have a long and volatile history. The authority to impose Federal income taxes originates in the 16th Amendment to the U.S. Constitution, ratified in 1913. Congress set the first income taxes that same year, along with the first taxes on profits. In 1921, Congress established the distinction between short- and long-term capital gains in the Revenue Act of 1921.

The original defining holding period was two years rather than the current one-year demarcation. Also, the tax rate for long-term capital gains was 12.5 percent. Over the years, the rates have occasionally been increased and subsequently reduced, with long-term capital gains rates currently limited to 20 percent for the highest-income taxpayers.

What business sales qualify for capital gains?

If a company sells clothing, the retail or wholesale sales that comprise its business are not capital. However, suppose the company sells a building or a piece of equipment. In that case, that transaction is a capital transaction, and the difference between the basis (purchase price plus adjustments) and the sales price is the capital gain or loss.

If you sell the entire business, that transaction will typically be a capital event. Remember that the time you have held the asset will determine whether the sale results in a short-term or long-term gain (or loss).

How does a small business allocate tax obligations?

You may find some tax benefits if you have an LLC (Limited Liability Corporation). An LLC can be a sole proprietorship, a partnership, an S-corp, or even a C-corp. In many cases, if the LLC is an individual, one-person business, the income and expenses will be reflected on the owner's tax forms, like a 1040 and Schedule C form.

The IRS will automatically treat your LLC as a disregarded entity and sole proprietorship if you are the only owner/member. However, that doesn't mean you shouldn't establish an LLC because it may offer some legal protection. If the LLC has more than one member, the IRS will treat it as a partnership unless you structure it as a C-corp or an S-corp. C-corporations pay taxes at the company level, while S-corporations pass the income to the owners.

Tax rates on capital gains

Your small business is likely a pass-through entity, meaning it reports any profit or loss on its owners' tax returns. Pass-through entities have an advantage over other structures because income is only taxed at the individual level rather than being taxed first at a corporate level. In that case, the capital gains tax rate will depend on your overall income (remember that short- and long-term capital gains are taxed at different rates). So, if your small business sells a property at a profit, the rate for the income will be determined by your individual tax bracket. However, keep in mind that the highest rate for long-term capital gains is still 20 percent, which is substantially less than the top rate of 37 percent for ordinary income.

However, like an individual, your company may be able to execute a 1031 exchange to defer the obligation to pay capital gains taxes on the sale. To qualify for an exchange, the asset being replaced must be held by the LLC, not by an individual member of the company.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. 

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. 

Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. 

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