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If you sell your sole proprietorship business, each of the assets sold with the business is treated separately.
So, you would need to determine the adjusted basis of each and every asset in the sale (you can lump some of the smaller items together, however, in categories such as office machines, furniture, production equipment, etc.). The problem becomes one of allocation; if you negotiate a total price for the business, you and the buyer must agree as to what portion of the purchase price applies to each individual asset, and to intangible assets such as goodwill. The allocation will determine the amount of capital or ordinary income tax you must pay on the sale.
Allocation of the price can be a big bone of contention. The buyer wants as much money as possible to be allocated to items that are currently deductible, such as a consulting agreement, or to assets that can be depreciated quickly under IRS rules. This will improve the business's cash flow by reducing its tax bill in the critical first years.
The seller, on the other hand, wants as much money as possible allocated to assets on which the gain is treated as capital gain, rather than to assets on which gain must be treated as ordinary income. The reason is that the maximum tax rate on long-term capital gains is limited to a maximum 15 percent through the end of 2012, while the tax rate on short-term gains or ordinary income can be as high as 35 percent through 2012. Most small business owners who are successful in selling their companies are in high tax brackets, so the rate differential is very important.
Any gains on property held for one year or less, inventory, or accounts receivable are treated as ordinary income. Amounts paid under noncompete agreements are ordinary income to you and amortizable over 15 years by the buyer, unless the IRS successfully argues they are really part of the purchase price. And amounts paid under consulting agreements are ordinary income to you and currently deductible to the buyer.
IRS allocation rules. As you can imagine, the IRS has come up with some rules for making allocations of the purchase price. Generally speaking, they require that each tangible asset be valued at its fair market value (FMV), in the following order:
The total FMV of all assets in a class are added up and subtracted from the total purchase price before moving on to the next class. Thus, intangible assets such as goodwill get the "residual value," if there is any. However, remember that FMV is in the mind of the appraiser. You still have some wiggle room in allocating your price among the various assets, provided that your allocation is reasonable and the buyer agrees to it. Your odds are even better if your allocation is supported by a third-party appraisal.
According to IRS rules, the buyer and seller must use the same price allocation, so the allocation will have to be negotiated and put in writing as part of the sales contract. The allocation must be reported to the IRS on Form 8594, Asset Acquisition Statement Under Section 1060, which must be attached to the tax returns of both parties for the year in which the sale occurred. The allocation will be binding on both parties unless the IRS determines that it is not appropriate.