Let’s say you’re considering shutting down your sole proprietorship business or your single-member LLC business that’s been treated as a sole proprietorship for tax purposes. What are the tax implications of the impending shutdown? Good question. We are here to answer that question. Let’s get started.
Asset Sale Tax Implications
If you sell your business, you’re treated for federal income tax purposes as though you are selling the assets of the business. That’s because the existence of a sole proprietorship, or a single-member LLC treated as a sole proprietorship, is ignored under the federal income tax rules.
Therefore, you cannot sell a business ownership interest.
The “sale of a business” is an option only if you operated the business as a partnership, as an LLC treated as a partnership for tax purposes, or as a corporation.
Here’s the federal income tax impact of selling the assets of your sole proprietorship or single-member LLC business.
Allocate the Sale Price You first allocate the total sale price to the specific business assets you are selling.
You find the federal income tax rules for allocating the sale price in Section 1060 of our beloved Internal Revenue Code and related IRS regulations. For a pretty good plain-English explanation of the rules, see the instructions to IRS Form 8594 (Asset Acquisition Statement Under Section 1060).
Calculate Taxable Gains and Losses
You have a taxable gain if the allocated sale price exceeds the tax basis of the asset in question. The tax basis generally equals the original cost of the asset plus the cost of any improvements minus any depreciation or amortization deductions. You have a taxable loss if the allocated sale price is less than the tax basis of the asset in question. Calculate Taxes on Gains from Depreciable Real Estate When you sell depreciable real estate for a taxable gain, tricky federal income tax rules can come into play. Here’s what you need to know.
Section 1250 Ordinary Income Recapture
For federal income tax purposes, Section 1250 property is almost any depreciable real property.
When you sell Section 1250 property that has been held for more than one year for a taxable gain, the following tax treatment applies to gains recognized by you as an individual taxpayer:
- Gain equal to the lesser of (1) the additional depreciation taken on the property (as defined below)
or (2) the realized gain is treated as high-taxed Section 1250 ordinary income recapture.
- Gain in excess of any Section 1250 ordinary income recapture will usually be Section 1231 gain.
Section 1231 gains are usually taxed at the lower federal rates for long-term capital gains under
rules explained later in this analysis.
Calculating additional depreciation.
All depreciation taken on Section 1250 property held for one year or less is additional depreciation, and gain up to that amount of depreciation will be high-taxed Section 1250 ordinary income recapture.
There is often no additional depreciation on Section 1250 property that you’ve held for more than one year, because the property has often been depreciated using the applicable straight-line method.
Gain in excess of the Section 1250 ordinary income recapture amount (due to additional depreciation) will be Section 1231 gain if the property has been held for more than one year.
You know what can happen when you assume. These days, you may assume that Section 1250 ordinary
income recapture will not apply, because real estate you are selling has often been depreciated using the applicable straight-line method. If so, there’s no excess depreciation and no possibility for Section 1250 ordinary income recapture.
But watch out for
- Section 1245 ordinary income recapture if first-year Section 179 deductions have been claimed for
non-residential qualified improvement property, and
- Section 1250 ordinary income recapture if first-year bonus depreciation has been claimed for nonresidential qualified improvement property
These ordinary income recapture exposures are explained immediately below.
Ordinary Income Recapture When First-Year Depreciation Has Been Claimed for Non-residential Qualified Improvement Property
“Qualified improvement property” (QIP) means any improvement to an interior portion of a non-residential building that is placed in service after the date the building is placed in service—except for any expenditures attributable to the enlargement of the building, any elevator or escalator, or the building’s internal structural framework.
You can claim first-year Section 179 deductions for QIP. You can also claim first-year bonus depreciation for QIP.
When you sell QIP for which first-year Section 179 deductions have been claimed, gain up to the amount of the Section 179 deductions will be high-taxed Section 1245 ordinary income recapture.
When you sell QIP for which first-year bonus depreciation has been claimed, gain up to the excess of the bonus depreciation deduction over depreciation calculated using the straight-line method will be high-taxed Section 1250 ordinary income recapture.
Unrecaptured Section 1250 Gain
Gain attributable to real estate depreciation calculated using the applicable straight-line method is called “unrecaptured Section 1250 gain.”
Unrecaptured Section 1250 gain is taxed at a flat 25 percent federal rate, unless the gain would be taxed at a lower rate if it was simply included in your taxable income with no special treatment.
These ordinary income recapture exposures are explained immediately below.
Ordinary Income Recapture When First-Year Depreciation Has Been Claimed for Non-residential QualifiedImprovement Property
“Qualified improvement property” (QIP) means any improvement to an interior portion of a non-residential building that is placed in service after the date the building is placed in service—except for any expenditures attributable to the enlargement of the building, any elevator or escalator, or the building’s internal structural framework.
You can claim first-year Section 179 deductions for QIP.
You can also claim first-year bonus depreciation for QIP.
When you sell QIP for which first-year Section 179 deductions have been claimed, gain up to the amount of the Section 179 deductions will be high-taxed Section 1245 ordinary income recapture.
When you sell QIP for which first-year bonus depreciation has been claimed, gain up to the excess of the bonus depreciation deduction over depreciation calculated using the straight-line method will be high-taxed Section 1250 ordinary income recapture.
Unrecaptured Section 1250 Gain
Gain attributable to real estate depreciation calculated using the applicable straight-line method is called “unrecaptured Section 1250 gain.”
Unrecaptured Section 1250 gain is taxed at a flat 25 percent federal rate, unless the gain would be taxed at a lower rate if it was simply included in your taxable income with no special treatment.
Example 1. You are a married joint-filing individual with 2024 joint taxable income of $380,000. Most of that income is from a large unrecaptured Section 1250 gain from selling a rental property that you operated via a single-member LLC that has been treated as a sole proprietorship for tax purposes.
Since all your taxable income falls within the 10 percent, 12 percent, 22 percent, and 24 percent federal
ordinary income tax rates, those rates are used to calculate the federal income tax liability on your
unrecaptured Section 1250 gain. As you can see, those rates are less than 25 percent. Good.
So, in this example, the 25 percent rate does not apply.
Example 2. You are an unmarried single filer with 2024 taxable income of $200,000 before considering a large unrecaptured Section 1250 gain from selling a rental property that you operated via a single-member LLC that has been treated as a sole proprietorship for tax purposes.
The flat 25 percent rate applies to your entire unrecaptured Section 1250 gain, because the ordinary
income rates on the extra income from the gain would be higher than 25 percent.
Key point. You can offset unrecaptured Section 1250 gain with any Section 1231 loss incurred in the year of the
gain. Next, you can offset the unrecaptured Section 1250 gain with any capital loss carryover into the year of the gain and any net capital loss incurred in the year of the gain.
These capital losses offset unrecaptured Section 1250 gain before they offset garden-variety capital gains.
Calculate Taxes on Gains from Other Depreciable or Amortizable Assets
For other depreciable or amortizable assets (such as furniture, equipment, purchased software, and purchased intangibles), gains attributable to depreciation or amortization deductions are taxed at higher ordinary income rates.The current maximum federal ordinary income rate is 37 percent.
Any remaining gains on depreciable or amortizable assets held for more than one year are generally taxed at lower long-term capital gains rates under the rules for Section 1231 gains.
The current maximum federal rate for long-term capital gains is 20 percent, but that maximum rate hits only those with high incomes.
- If you’re a single filer in 2024, the 20 percent rate kicks in if your taxable income exceeds $518,900.
- For a married joint-filing couple, the 20 percent rate kicks in if your taxable income exceeds $583,750.
- For a head of household, the 20 percent rate kicks in if your taxable income exceeds $551,350.
Calculate Tax Impact of Ordinary Gains and Losses Ordinary gains and losses result from selling assets other than capital assets and Section 1231 assets. Such other assets include
- inventory,
- receivables,
- and real and depreciable business property that would be Section 1231 property if held for over one
year.
Ordinary gains can also result from various recapture provisions, the most common of which is “depreciation recapture.” Ordinary gains are taxed at higher ordinary income rates. Ordinary losses are generally fully deductible in the year the loss is recognized.
Depreciable and Amortizable Assets Held for Over One Year
For purposes of meeting the definition of Section 1231 property, the term “depreciable property” means tangible
and intangible business assets that can be depreciated over a number of years; depreciated under the first-year bonus depreciation rules; or written off in the first year under the Section 179 deduction rules.
Such assets are Section 1231 property if they are held for more than one year.
They are ordinary gain/loss property if they are held for one year or less.
Favorable Tax Treatment for Section 1231 Losses (and Gains)
Both gains and losses from selling Section 1231 assets receive favorable federal income tax treatment.
Net Section 1231 Gains
If your Section 1231 gains for the year exceed your Section 1231 losses for the year, all the Section 1231 gains and losses are treated as long-term capital gains and losses—assuming the non-recaptured Section 1231 loss rule (explained later) does not apply.
Section 1231 losses can be used to offset Section 1231 gains, and any net Section 1231 gains qualify for the lower tax rates on long-term capital gains, unless the non-recaptured Section 1231 loss rule (explained later) applies.
Net Section 1231 Losses
If your Section 1231 losses for the year exceed your Section 1231 gains for the year, all the Section 1231 losses and gains are treated as ordinary losses and gains. This means the net Section 1231 loss for the year is fully deductible as an ordinary loss, which is the optimal tax outcome for losses.
Net Section 1231 Losses Are Extra-Beneficial Because They Can Create or Increase an NOL
Because net Section 1231 losses are classified as ordinary losses, they can create or increase a net operating loss (NOL) for the year. This fact is a potentially valuable bonus, because you can carry forward an NOL indefinitely and
use it to reduce taxable income in future years when tax rates may be higher.
But . . . Beware of the Non-Recaptured Section 1231 Loss Rule
Now for the bad news about Section 1231 losses: the dreaded non-recaptured Section 1231 loss rule.
This unfavorable provision is intended to prevent taxpayers from manipulating the timing of Section 1231 losses and gains in order to receive favorable ordinary loss treatment for a net Section 1231 loss recognized in one year followed by receiving favorable long-term capital gain treatment for a net Section 1231 gain recognized in a later year.
Here’s how the rule works.
The non-recaptured Section 1231 loss amount for the current tax year equals the amount of net
Section 1231 losses that were deducted in the preceding five tax years, reduced by any amounts that have already been recaptured.
A non-recaptured Section 1231 loss is recaptured by treating current-year net Section 1231 gains as high-taxed ordinary income rather than lower-taxed long-term capital gains—to the extent of the non-recaptured Section 1231 loss amount for the current year.
Non-recaptured Section 1231 losses from the earliest years are recaptured first. The non-recaptured Section 1231 loss rule ceases to apply to a net Section 1231 loss that is not recaptured within the following five years.
Calculate Taxes on Gains from Selling Self-Created Intangibles
The Tax Cuts and Jobs Act (TCJA) included a change that stipulates that certain self-created intangible assets no longer qualify as capital assets and therefore no longer qualify for lower-taxed long-term capital gain treatment when sold. This unfavorable change applies to the following:
- Patents
- Inventions
- Models and designs (whether or not patented)
- Secret formulas and processes
“Self-created” means created by the personal efforts of the taxpayer. That would be you. So, this rule can come into play if your sole proprietorship business includes one or more self-created intangibles.
As under pre-TCJA law, the following types of intangibles are also generally excluded from the capital asset
definition:
- Copyrights
- Literary, musical, and artistic compositions
- Letters and memoranda held by the taxpayer for whom they were prepared or produced
- Similar property
- Musical compositions or copyrights in musical works, unless you elect to treat them as capital assets
Calculate Tax Impact of Losses from Selling Business Assets
You can generally deduct losses from the sale of business assets in full. But as explained earlier, deducting Section 1231 losses can potentially cause the unfavorable non-recaptured Section 1231 loss rule to come into play.
Calculate Taxes on Non-compete Agreement Payments
As part of a deal to sell your business, you might enter into an agreement not to compete with the buyer. Payments that you receive under the agreement are treated as high-taxed ordinary income.
The good news: non-compete payments are not subject to self-employment tax.
Because it’s not subject to self-employment tax, report the non-compete agreement income on the “Other income” line on Schedule 1 of Form 1040.
Tax-Saving Strategy
With an asset sale by a sole proprietorship or a single-member LLC that’s been treated as a sole proprietorship for tax purposes, the most important tax-saving opportunity revolves around how you allocate the total sale price to specific assets being sold.
To the extent possible, you generally want to allocate more of the sale price to assets that would generate lowertaxed long-term capital gains (such as land, buildings, and purchased intangibles) and less of the sale price to assets that would generate high-taxed ordinary income (such as receivables; inventory; and furniture, equipment, and purchased intangibles that have been heavily depreciated or amortized).
Self-Employment Tax
You may owe self-employment tax on gains from selling receivables or inventory. Thankfully, you don’t owe self employment tax on gains from selling other business assets.
3.8 Percent Net Investment Income Tax (NIIT)
When you sell business assets from a venture that has been operated as a sole proprietorship or as a singlemember LLC that has been treated as a sole proprietorship for tax purposes, you may also owe the 3.8 percent NIIT on Section 1250 ordinary income gains, Section 1245 ordinary income gains, unrecaptured Section 1250 gains, and Section 1231 gains.
The extra hit from the NIIT can be an unpleasant surprise. Thankfully, however, the NIIT can only bite income and gains from a passive business activity, and yours is probably not passive.
Tax Return Reporting
Report gains and losses from selling business assets on IRS Form 4797 (Sale of Business Property), which you file with your Form 1040 for the year of the sale.26 Gains and losses that are treated as capital gains and losses are transferred to Schedule D (Capital Gains and Losses).
When the assets being sold constitute a business, report how the total sale price is allocated to the specific assets being sold on IRS Form 8594 (Asset Acquisition Statement Under Section 1060).28 Also report the amount
allocated to any non-compete agreement.
In the year you sell the assets of your business, you will have a short tax year for depreciation calculation purposes, unless the sale occurs on the last day of your tax year.
Calculate the self-employment tax that you owe (if any) on Schedule SE, and include it with your Form 1040 for the year you sell your business.
Calculate the 3.8 percent NIIT that you owe (if any) on IRS Form 8960, Net Investment Income Tax—Individuals, Estates, and Trusts.31 Include Form 8960 with your Form 1040 for the year you sell your business.
For federal income tax purposes, shutting down your sole proprietorship business generally does not require other special tax reporting.
Report the business income and deductions for the part of the year up to the sale date on Schedule C of Form 1040. Report the taxable gains and losses from selling the business assets in the manner explained earlier. If required, include Schedule SE and IRS Form 8960 for the year of sale.
Finally, you may owe state income tax on gains from selling your business.
Takeaways
Shutting down a sole proprietorship or a single-member LLC treated as a sole proprietorship for tax purposes
involves several key tax implications.
When selling your business, you sell individual assets rather than the business itself. Properly allocating the sale price to specific assets is crucial, as it affects the calculation of taxable gains and losses.
For depreciable assets, a gain is taxable if the sale price exceeds the tax basis, while a loss is deductible if the sale
price is lower.
Depreciable real estate is subject to specific rules, with some gains taxed as high-taxed ordinary income under Section 1250 or lower-taxed long-term capital gains under Section 1231. Additionally, first-year depreciation deductions for certain properties may lead to ordinary income recapture.
Self-created intangibles and non-compete agreement payments also have distinct tax treatments, often subjecting you to the higher rates imposed on ordinary income. To mitigate tax liability, strategically allocate more of the sale price to assets generating lower-taxed gains.
Ensure accurate tax reporting using appropriate IRS forms, and be prepared for potential state income tax obligations on gains from the sale.
