The Hidden Costs of Taxes

The gain from the sale of tangible assets such as computers or furniture will have two components to the gain. The net tax basis of the assets sold is the original purchase price minus all the depreciation expense written off to date. Once the gain is calculated by subtracting the net tax basis from the sales price, it is split into two pieces. All of the depreciation expense ever taken is recaptured first and taxed as ordinary income. The remainder of the gain is taxed at the capital gain rate. As a practical matter, however, virtually all of these types of assets never sell for more than their original price, so all the gain will be ordinary income.

Gain from selling assets such as office supplies is simpler because it does not have the two components. Since the seller has probably already expensed the supplies, all of the value received for these assets will be taxable as ordinary income.

A buyer is going in the other direction with a twofold strategy. First, put as much of the purchase price as possible into assets with short lives. Generally, the first $24,000 of the five- and seven-year asset classes (equipment, computers, and furniture) can be expensed in the year of purchase. The remaining basis attributed to those assets is then written off over their relatively shorter lifetimes. Second, pay as much of the purchase price as possible in the form of compensation for services rendered during the transition period after the sale. Make payments to the seller as an independent contractor and not an employee, so that the purchase price is written off as quickly as possible with no FICA surcharge. This gives the lowest possible tax liability at a time of high non-deductible principal payments on purchase debt.

In summary, the ultimate cost to the buyer and net after-tax cash received by the seller depends on how the purchase price is allocated among the assets. Factoring in the tax consequences of this allocation will give the buyer or seller the true cost to purchase or actual gain from selling. Buyers and sellers not clear on these issues would find it worthwhile to consult with their tax advisor.