The Tax Implications of Closing Business Operations
Poole College's Nathan Goldman and Christina Lewellen discuss important factors that can affect the tax treatment of business dispositions and help business owners avoid tax surprises.
During the Covid-19 pandemic, many companies (both small and large) closed their doors due to widespread mandated business closures and consumers’ voluntary behaviors to stay home and avoid infection. In the post-pandemic era, many would assume that businesses that survived the pandemic should be thriving, as the U.S. GDP and other measures of economic stability have rebounded nicely. However, businesses did not rebound enough, and our economy now appears to be on the verge of a decline or recession as the Federal Reserve continues to enforce elevated interest rates. Consequently, the trend of businesses closing locations has continued into 2023. Earlier this year, large retailers like Bed Bath & Beyond, Foot Locker, Walmart and Amazon announced closing locations. Starbucks and Target have also recently announced closing storefronts in metropolitan areas. Nike also recently announced shutting down its flagship location in Portland.
Retail businesses have been hit especially hard due to changes in consumers’ buying behaviors and the growing trend of e-commerce. The distribution of consumers for “brick and mortar” retail and hospitality establishments has also changed due to the combined effect of the increased availability of remote work and housing affordability issues in urban areas that have motivated consumers to migrate to less populated areas.
Moreover, labor market supply issues have hit both retail and hospitality industries hard. Many employees in retail and hospitality businesses were forced to find different jobs during the pandemic, and many of these workers did not re-enter these industries after the pandemic ended due to greater opportunities for more flexible work arrangements. The worker shortage in certain industries and historically high inflation have substantially driven up wages, creating pressure on business’ bottom lines.
In sum, labor shortages and changes in consumer behaviors and locations have greatly strained many businesses. Given the nontrivial number of businesses that continue to “close up shop” or may be contemplating doing so due to macroeconomic trends, we examine the tax implications of shutting down a company’s physical operations in this article. We discuss some important factors that can affect the tax treatment of business dispositions and help business owners avoid tax surprises.
Taxable Gains From the Sale of Assets
A company that closes operations may sometimes be able to sell its assets. If the company can sell the assets, it will recognize a taxable gain or loss depending on the difference between the sales price and the remaining “tax basis” of the assets, which is the cost of the assets that has not yet been depreciated. If the company sells the asset for more than its tax basis, it will recognize a taxable gain and must pay tax on the sale. For example, if a company sells an asset in the current year for $100,000 that was purchased in a previous year for $150,000 and has received tax deductions for depreciation totaling $80,000 over past years, the tax basis (i.e., purchase price minus accumulated tax depreciation) will be $70,000, and the company will recognize a taxable gain of $30,000 ($100,000 sales price minus the tax basis of $70,000). Although it might seem as though the company is incurring a loss on the sale because the company sold the asset for $50,000 less than the initial purchase price, they will have to pay tax on the sale due to the effect of past tax depreciation on the tax basis. If the company’s tax rate is 21 %(the current corporate tax rate), the $30,000 gain from the sale will result in $6,300 tax due. Thus, business owners should make sure they know how the asset sales will be taxed and their tax basis to ensure they save some of the sale proceeds for taxes they may owe.
Taxable Losses From Asset Sales
In the previous example, the company sold the asset for more than its tax basis, resulting in a taxable gain. A company could also sell the asset at a lower price than the tax basis, resulting in a loss. Going back to the previous example, if the company instead sells the asset for $60,000, the company will now recognize a taxable loss of $20,000, which is the difference between the sales price of $60,000 and the tax basis of $80,000. Special tax laws specified in §1231 allow losses from the sale of business assets to be treated as “ordinary” in character, meaning that they can offset other business income with the loss. If the company’s tax rate is 21%, in theory the $20,000 taxable loss should reduce taxable income by $20,000 and reduce taxes owed by $4,200. However, while gains almost always result in taxes due, it is very important to understand that taxable losses often do not provide a current tax benefit. While several factors determine whether the loss creates a tax benefit, the company must have other taxable income within the business so that the loss can generate a tax benefit by reducing other taxable income.
When a company decides to no longer use assets, in some cases, it may not be able to sell the assets and, therefore, may have just to walk away from an investment. For example, Disney recently abandoned one of its recent investments called the Galactic Starcruiser Adventure which was located within a theme park, so they could not readily sell the buildings to another interested party. In our previous Poole Thought Leadership article, we review Disney’s asset abandonment and explain in detail the tax implications of asset abandonments. Asset abandonments are treated similarly to the taxable loss example we explain above, except that the sales price is effectively zero, so the taxable loss is the remaining tax basis. Continuing the example we explained above, the tax basis was $80,000, so an asset abandonment would result in a taxable loss of $80,000. If the company’s tax rate is 21%, the loss on abandonment could generate a tax benefit of $16,800 as long the company has at least $80,000 in other taxable income to offset the loss.
The Effect of the Type of Business
Most examples we provided above use the corporate tax rate of 21 %and are presented assuming that the business is organized as a regular “C corporation” like large publicly traded companies. If the company is a C corporation and has a net taxable loss from asset dispositions with no other current taxable income and does not plan to continue business in future years, the loss will never be able to generate a tax benefit.
Companies could also be organized as “pass through” entities such as partnerships or S corporations, meaning that the income or loss from the business will pass through to the tax returns of the company’s owners. In this case, the taxable gain or loss from the asset sale will pass through to the individual owners, and the current tax benefit will depend on tax rules for individuals and the business owner’s tax situation. Because these tax rules can be quite complicated, we recommend that business owners of pass-through entities consult with tax consultants before selling or liquidating assets to ensure that they structure the transaction in the most tax-efficient manner.
The Effect of Debt Cancellation on the Tax Bill
Sometimes, unprofitable businesses just go out of business and stop paying their loans, resulting in debt cancellation. Christina recalls having a client when she was in practice in this situation. We had to inform the client that debt cancellation results in taxable income and tax due. For example, if a business owner has $1 million in debt cancellation and a tax rate of 37%, the debt cancellation will result in $37,000 of tax due. Unfortunately, many unprofitable businesses do not have much cash on hand upon shutting down operations. Therefore, business owners with outstanding loans who can negotiate a debt forgiveness need to be aware that this forgiveness is going to cost them in tax dollars at least. In such circumstances, business owners may be able to settle a lower amount of tax with the IRS or work out a payment system to pay their tax due.
The current times can be challenging for business owners. If the business is taking a downturn, business owners might begin by doing a cost-benefit analysis to determine if they should continue business or keep their current assets. Continuing their business might include disposing of some unneeded assets and continuing with other parts of the business. Other businesses may be better off liquidating completely. If the business owners decide to liquidate assets or the entire business, it is vital for them to determine the most tax-efficient way of doing so before disposing of the assets. This strategy will also help avoid any unanticipated tax surprises.