By Mark E. Battersby / Published June 2020
It is no surprise that many pressure cleaning contractors and business owners fail to understand the tax ramifications of disposing of business property. Under our often confusing and complex current rules, there are numerous ways to dispose of business assets, such as selling, scrapping, exchanging it for another business asset, or even giving it away. That’s why it is important to consider asset dispositions before they happen.
If proof is required, new, more restrictive rules created as part of the 2017 Tax Cuts and Jobs Act (TCJA) mean that a business can no longer treat trade-ins of business vehicles, equipment, or machinery as a non-taxable event. Instead, when the old assets are traded for a new one, income taxes must be paid on the gain, if any.
Even with a simple sale, the tax treatment can be quite complex. The legal structure of the pressure washing business determines the tax rate that applies on capital gain income. Unlike individuals who enjoy preferential tax treatment for long-term capital gain, incorporated businesses have capital gains added to the operation’s ordinary income and are taxed at the corporate tax rate.
The capital gains realized by pass-through entities, such as partnerships and S corporations, flow through to the owner’s individual income tax return. Therefore, the capital gain income is taxed at rates that apply to individuals.
In most cases, gains and losses are netted against each other. If the ultimate result is a net loss, that amount is fully deductible against ordinary income. If the result is a net gain, then the income is considered long-term capital gain, which is more favorable than ordinary income treatment. Of course, if there is gain on the sale of tangible personal property, tax is levied in two ways:
Any pressure washing operation can, of course, elect not to use the installment method of reporting sales by including all the gain in income in the sale year. Many businesses, however, generally sell their unused or unneeded equipment, machinery, and other business assets on the so-called installment method, creating income as payments are received.
The amount of gain from installment sales is measured once (gross sale proceeds minus selling expenses) and is expressed as a gross profit percentage. This percentage is then applied to each payment as it is received, and gain is included in each year in which the seller receives a payment.
In almost all cases, the buyer in an installment sale will compensate the seller by incorporating interest payments into the transaction. This interest paid by the buyer is taxed separately at ordinary tax rates, while the actual gain is taxed at the individual short-term or long-term rates, depending on the length of time the underlying asset was held. Again, it’s ordinary income treatment for incorporated businesses.
In order to qualify as an installment sale under our tax rules, the seller sells property to a buyer and must receive at least one payment in a year other than the sale year. However, while most pressure cleaning businesses can usually sell assets on the installment method, that doesn’t apply to inventory-type property. An equipment dealer or distributor can, for example, sell one of its service or delivery vehicles on the installment method, but not its products or inventory goods.
It wasn’t too long ago, before the passage of the TCJA, that a pressure cleaning business would exchange so-called “like-kind” business property and be able to defer any taxable gain until the property was ultimately sold. Deferring a tax bill for the gain from a sale until a later year can, in many cases, reduce the amount of tax as opposed to reporting the entire gain in the current tax year when profits and/or tax rates may be higher.
Beginning with exchanges after the December 31, 2017, passage of the TCJA, deferring recognition of gain using a like-kind exchange will only work with real estate. Real estate, called real property by the IRS, includes land and generally anything built on or attached to it.
With a 1031, a so-called “tax-free” exchange rather than paying taxes when a capital gain is realized, those proceeds can be reinvested into an asset of a similar value or “like-kind.” Unfortunately, as mentioned, after January 1, 2018, exchanges of personal or intangible property such as equipment, machinery, vehicles, etc., no longer qualify for nonrecognition of gain or loss in like-kind exchanges. Under the new law only real estate qualifies.
Losses from the abandonment of business or investment property are generally deductible as ordinary losses—as long as the abandonment is not treated as a sale or exchange. Of course, abandonment of property held for personal use is nondeductible.
In order for property to be abandoned, two things must occur. First, the property’s owner, the pressure cleaning business, must take action that clearly shows it has given up rights to the property. Second, the owner must show intention that demonstrates that the owner has knowingly relinquished control over it.
In other words, the abandoned property’s owner must take clear, decisive action that indicates the property is no longer wanted. Inaction, that is, failure to do something with the property, or non-usage, is not enough to demonstrate that right to the property has been relinquished—even where such non-use has occurred for years.
An involuntary conversion is an event that is not initiated by the business but rather refers to the conversion of a pressure washing operation’s property into similar or disimilar property due to condemnation (actual or threatened), theft, seizure, requisition (usually instigated by a government unit), or destruction. An involuntary conversion does not include any voluntary acts, such as when the business destroys its own property.
Consider these involuntary conversions:
When the condemned property is not replaced, the difference between any reimbursement and the property’s basis or book value is usually a capital gain. If the compensation is less than the property’s basis, a capital loss results. What’s more, an involuntary conversion resulting when property is stolen or destroyed is usually a capital loss.
Depreciation recapture is a provision in U.S. tax law that allows the IRS to collect taxes on any profitable sale of business assets where a fast or bonus write-off has been taken. Since depreciation of an asset reduces ordinary income, a portion of the gain from the disposal of the asset must be reported as ordinary income, rather than the more favorable capital gain.
Our tax laws lay out recapture rules for two types of depreciable property: personal and real property that perform specific functions (Section 1245), and buildings and their structural components (Section 1250).
Unused, unworkable, unrepairable, or obsolete business property can be disposed of in a variety of ways. Under our tax rules, a disposition occurs when a pressure washing business sells, exchanges, retires, abandons, suffers an involuntary conversion, or destroys its property. Each has tax consequences, and, thanks to the complexity of the tax rules, professional guidance may be necessary to reap the most benefit and smallest tax bill.