Selling or Closing Down a Sole Proprietor Business? Here’s How it Impacts Your Taxes

Several years ago, a client of mine told me that he wanted to retire and was closing his successful retail store. He wanted to have a big inventory clearance sale and be done with it. My first thought was, closing? Why aren’t you selling?

To my great surprise, he hadn’t thought of that. Why slash inventory prices when he could obtain so much more in a package sale of the business? And why not get something for all those hard years of creating a successful venture? There’s value in the lease since he certainly had one of the best locations in town. There’s also value in the customer list, the store fixtures, furniture, equipment and a covenant not to compete. So my client called a broker who valued the business at several hundreds of thousands of dollars, found a buyer very quickly. He walked away a very happy camper.

Do not forget that your business is an asset with value. Even if you have a one-person shop that only provides a service, you will likely find a buyer who sees value in your customer list. Of course you will probably need to provide your own services during a transition period to the new owner, but there’s value in a consulting contract during that transition period.

But if you decide to just shut it down, note that there are no tax ramifications. You simply pull down the sign and walk away. You must file a final Schedule C with your tax return and you are done. If you sell off some of the equipment, furniture and fixtures, you may have a gain if you sell them for more than you paid for them, less the depreciation already taken.

If you sell the entire business, however, there are tax ramifications. You are selling a group of assets and  must therefore allocate the purchase price accordingly. Let’s take the above example. My client sold his business for $350,000--part of the sale will be classified as ordinary income, but the part allocated to the sale of hard assets will be taxed at capital gains rates, which is usually more advantageous because those rates are generally lower than the rates for ordinary income.

The portion of the sale allocated to equipment, furniture, fixtures, leasehold improvements, and vehicles taxed at capital gains rates was $250,000. His original cost was $200,000. Over the years he had deducted depreciation in the amount of $100,000. So he will pay capital gains on $50,000 profit. But note that he must recapture the depreciation and pay taxes on $100,000 at ordinary income tax rates.

The remaining $100,000 of the sale price is allocated as follows: $50,000 for customer list (goodwill) and $50,000 for covenant not to compete, which are taxed at his regular income tax rate.

Selling costs such as legal fees and commissions paid to a broker are deductible expenses.

The new owner wanted to finance the sale. He put down $100,000 and promised to pay the remainder over five years at 8% interest. Because my client did not receive the entire balance at the close of escrow, he can elect to pay taxes on the installment sale method. This basically allows him to pay the taxes as he receives payments each year. He will report the interest received on Schedule B of his Form 1040 and using a special formula for installment sales, he will calculate the taxable portion of the principal received on Form 6252 and pay taxes on that sum.

Before selling your business, contact your tax pro to determine the best allocation of the selling price and learn what your tax liability will be.

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebook