Why is basis important to know when I sell my business?
When you sell your business, you will definitely want to know how much tax you owe. The amount of tax you pay will depend on your gain on the sale. Whereas business owners often think of income as gross revenue less expenses, gain is the profit you make when you sell something for more than you paid for it.
Determining your gain on the sale of your business
The general formula for determining gain is:
Gain = Sale proceeds - Basis
(And if your run this formula and get a negative number rather than a positive number, you have a loss.)
So let's breakdown that formula:
Sale proceeds are the amount of money you receive plus any property you receive in exchange for the thing you sold.
Basis is generally how much you originally paid for the property. But certain events may adjust basis or you may not start with a cost basis in the property.
How does basis work?
Although the formula is pretty straightforward, due to the ability of basis to change, the calculation of gain (or loss) can be more complicated. So let's run a couple of simple examples to explore how basis works.
Cost Basis
If you purchased all the shares in a company for $10,000 and your company is taxed as a C corporation, your basis in the company is going to be $10,000. If you sell the company for $100,000, then you will have $90,000 of gain. If your combined federal and state tax rate is 35%, then you would owe $31,500 in taxes. So at the end of the day, you walk away with cash of $68,500.
Basis of Contributed Property
If you contributed $10,000 of property to your solely owned corporation in exchange for all the stock in the company and your company is taxed as a C corporation, your basis in the company is still going to be $10,000. So you will have the same results as above: $90,000 of gain, $31,500 in taxes owed, and after-tax proceeds of $68,500.
Carryover Basis
Now, what if your father started the company and when he was ready to retire, he gifted you his shares in the company. Suppose your father started the company by contributing $1,000 to the company in exchange for all of the stock in the company. For gifts made during lifetime, the recipient of the gift has the same basis as the gift giver. This is usually referred to a carryover basis. If you sell then sell the company for $100,000, then you will have $99,000 of gain. If your combined federal and state tax rate is 35%, then you would owe $34,650 in taxes. This reduces your after-tax cash to $65,350.
Stepped-up Basis
Finally, let's see what would be the consequences if you inherited the property after your father's death. If the company was worth $50,000 when your father died, you would take a basis in the stock of the company equal to the fair market value at date of death, which is $50,000. This is called a step-up in the basis of the stock. When you later sell the company for $100,000, your gain will only be $50,000, which would trigger tax of $17,500 (at 35% rate) and your after-tax proceeds will be increased to $82,500.
Key Points
In all these examples, the sale proceeds were the same ($100,000). The difference in the tax consequences was all due to the basis. As these examples illustrate, basis is one of the most important pieces of information that you will need to determine to know how much tax you will pay on the sale of your business.
In addition, these examples all dealt with basis in a C corporation. The determination of basis for owners of an S corporation or partnership is not nearly as straightforward. Stay tuned for future blog posts exploring how to compute basis (and therefore the tax due) on a sale of your business.