By Michael Laird
Certified Public Accountant
Your portfolio is one of your most valuable business assets. Maybe you worked for years to build up a great group of solid accounts, or you bought one superb portfolio from a colleague. Now that you are ready to sell it, you might ask, How much profit will I make on the sale?
It could be as much as 20 percent.
You are probably aware that the proceeds from a portfolio sale are taxable. Usually the sale will generate mostly taxable long-term capital gains, as it is with the sale of most intangible business assets. Usually? Mostly? The difference in meaning between those two words is critical to proper tax management in the selling of a portfolio.
It may seem confusing that a portfolio sale is treated the same under Section 1231 of the Internal Revenue Code as any other sale that falls under Section 1245 for business personal property.
Gain on the sale of a portfolio that you built yourself over a period of more than one year is simply long-term capital gain - much like goodwill or a going concern value in the sale of an entire trade or business.
Gain attributable to accounts acquired in the prior 12 months would not be treated as short-term capital gain unless the entire portfolio had been acquired less than one year and one day prior to the sale.
The only other trigger for less favorable tax treatment of a portfolio compiled in a time period of one year or more is that you will have to recapture as ordinary income any Section 1231 losses deducted in the last five years. You can save time and worry by asking your accountant if this applies to you. Most likely it does not.
The sale of a purchased portfolio is even more confusing. The first wrinkle is that any portfolio or portion of a portfolio purchased in the 12 months prior to a sale triggers short-term capital gain under Section 1231. Short-term capital gain tax rates currently equal ordinary income tax rates.
The portion of the sale subject to short-term treatment depends on several factors, such as:
The next wrinkle in selling a purchased portfolio is more complex. Do you recall the amortization deductions (write-offs) that reduced your tax bill while the portfolio generated positive cash flow? Well, those deductions are now at the front of the line waiting to be added back into income.
When a partially or fully amortized portfolio is sold, all of the prior amortization deductions must be recaptured and reported as ordinary income. These types of portfolios are subject to self-employment tax, if applicable, in the year of the sale - before any capital gain is recognized, just like any other Section 1245 property.
Here is an example of how this could happen: If you amortize portfolios over three years and sell a fully amortized $300,000 portfolio, you would have to purchase a $900,000 portfolio very early in the year of the sale or at the end of the previous year to fully offset the ordinary income. If you amortize over five years, the size of the portfolio you would need to purchase would escalate to $1.5 million.
Installment sales are, for the most part, available to spread any capital gain over more than one tax year. Before you
groan or roll your eyes at the prospect of an installment sale, consider a couple of situations in which it may be beneficial.
In the second instance, a credible buyer is offering a higher price for an installment sale than a cash buyer. The credible buyer may be a trusted partner with whom you already share income, or he or she may be a key employee you believe is ready to shoulder the responsibility of a portfolio. In addition, installment sale treatment may be applied to any holdback (withheld money) that is payable in a subsequent tax year. Please note that spreading the capital gain over multiple years through an installment sale will not alleviate the immediate ordinary income effect of recapturing amortization.
All recapture is required to be taken into income in the year of the transaction, even if no cash is received in that initial year under Section 453(i). Keep in mind that, if you are not selling a purchased portfolio, amortization recapture is not an issue.
There may be ways to mitigate some of the recapture effects. If you currently receive, or have received in the past, W-2 compensation or self-employment income from the entity or business selling the portfolio, you could set up a qualified retirement plan such as a 401(k), a profit-sharing plan or even a defined benefit pension plan.
Depending on your financial circumstances, the deductions for contributions to these plans can offset some of the recapture income. These plans may not work well if you continue to employ W-2 employees, or if you own significant interests in other entities that have W-2 employees.
Be aware that selling assets with capital losses will not likely help offset amortization recapture. Unlike depreciation recapture on Section 1250 real property, such as a building which is treated as a higher rate capital gain, amortization recapture on Section 1245 is an ordinary income item.
That said, if you have other business personal property to sell at a loss, you can use those losses to offset the recapture. However, you most likely do not have unrecognized losses available if, like the rest of us, you use Section 179 and the shortest possible depreciation schedules to maximize current deductions for the purchase of business assets.
The one likely exception is that company car you drive. Most cars depreciate at $3,000 to $4,000 per year for the first few years, and then less than $1,800 for the next 100 or so years, quite likely creating a potential tax loss, especially if you traded in a car in the past. By the way, you may have heard of tax-deferred or Starker exchanges on real estate. That option may be available for your portfolio sale too.
Hopefully, after reading this article, you haven't thrown in the towel at the mind-numbing complexity of the federal tax code and decided to just keep the portfolio after all. A healthy bit of planning and discussion with your accountant or tax preparer can go a long way toward ensuring that the IRS gets the compensation it requires from a portfolio sale.
If you sell your portfolio correctly, it will save you from one day having that polite IRS agent knocking on your door.
In publishing The Green Sheet, neither the author nor the publisher is engaged in rendering legal, accounting or other professional services. If you require specific tax advice or other expert assistance, seek the services of a competent professional. For further information on this article, e-mail Mike Laird, CPA, at firstname.lastname@example.org or call him at 847-255-7212.
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