What Are the Tax Implications of Shutting Down a Sole Proprietorship?

As you consider shutting down your sole proprietorship or your single-member LLC treated as a sole proprietorship for tax purposes, it’s crucial to understand the tax implications of this decision. Here’s an overview of key points you need to consider.

1. Sole Proprietorship Asset Sale Tax Implications

When you sell a sole proprietorship, you sell its assets, not the company. Federal tax rules tell you how to allocate the total sale price to specific business assets. This allocation is critical as it impacts the calculation of taxable gain and loss.

2. Sole Proprietorship Taxable Gain and Loss

• You have a taxable gain if the allocated sale price exceeds the asset’s tax basis (original cost plus improvements minus depreciation/amortization).
• You incur a deductible loss if the tax basis exceeds the sale price.

3. Special Rules for Depreciable Real Estate 

For depreciable real estate, specific federal income tax rules apply:

• Section 1250 ordinary income recapture. The portion of the gain on sale attributable to tax-code-defined “additional depreciation.” It’s taxed at ordinary income rates.
• Section 1231 gains. Gains from the sale or exchange of real estate used in a trade or business, which the tax code treats as long-term capital gains if the gains exceed any non-recaptured Section 1231 losses from the previous five years.
• Unrecaptured Section 1250 gain. The portion of gain from the sale of real estate attributable to depreciation deductions previously taken on the property that were not recaptured as ordinary income under Section 1250. The unrecaptured 1250 gain is taxed at a maximum rate of 25 percent.

4. Other Depreciable or Amortizable Assets

Gains attributable to depreciation or amortization deductions are recaptured and taxed at higher ordinary income rates. Remaining gains on assets held for more than one year are taxed at lower long-term capital gains rates.

5. Non-Compete Agreement Payments

Payments received under a non-compete agreement are treated as ordinary income but are not subject to self-employment tax.

6. Sole Proprietorship Tax-Saving Strategies

To minimize tax liability, strategically allocate more of the sale price to assets generating lower-taxed long-term capital gains and less to those generating higher-taxed ordinary income.

7. Tax Return Reporting

Report gains and losses on IRS Form 4797 and Schedule D for capital gains and losses. Use IRS Form 8594 to allocate the sale price and IRS Form 8960 to calculate the net investment income tax, if applicable (not likely).

8. State Income Tax

You may also owe state income tax on gains from the sale of your business.

Takeaways

Properly managing the shutdown of your sole proprietorship or single-member LLC involves careful planning and accurate reporting to optimize tax outcomes