What if You Don't Sell the Assets in Closing a Sole Proprietorship?

By Jeff Franco J.D./M.A./M.B.A.

The great thing about operating a business as a sole proprietor is that you can open and close it fairly quickly. Unlike other business entities, such as a corporation, it’s not necessary to sell or distribute the assets when closing your sole proprietorship. In fact, you can hold onto your business assets as long as you want without any immediate legal or tax consequences.

Sole Proprietorship Closings

Since the federal and state governments don’t recognize the business you operate as a sole proprietor as a separate entity, it’s unnecessary to notify any government agency that you are closing, or to provide any type of accounting of the assets you choose to retain for personal use. Essentially, once you close your sole proprietorship, your business assets are then treated the same as your personal property. However, if you sell the property in the future, you may face some special tax rules.

Like Kind Exchanges

For federal income tax purposes, you can defer the gain that would result from a sale of a sole proprietorship asset by engaging in a like-kind exchange instead. The like-kind exchange rules allow you to trade your business assets for similar property without having to pay tax on the gain – which is the difference between the fair market value of the asset you receive and the original cost of your asset minus all depreciation deductions taken – until you later sell the asset you receive in the exchange. To qualify for this tax deferral, the properties you exchange must be similar, such as real estate in exchange for real estate that must be either investment or business property.

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Future Asset Sale

As a sole proprietor, the IRS allows you to take depreciation deductions to recover the initial cost of acquiring business assets. If you take depreciation on a tangible or intangible business asset other than real estate, and you retain it after closing, the tax law refers to it as “1245 property,” which is subject to special tax rules. Since the IRS allows you to reduce your sole proprietor income with depreciation deductions, part of the gain you recognize on an eventual sale, up to the amount of total depreciation taken, is subject to ordinary income tax rates while the excess is subject to the capital gain rules.

1245 Property Example

To illustrate the tax implications of a future sale of your sole proprietorship assets, assume you close your business and decide to retain a business vehicle for personal use. Further assume that you purchase the vehicle three years prior to closing your business for $20,000 and take $8,000 of depreciation on your last three tax returns. Now suppose another three years pass and you decide to sell the car for $15,000. Since your basis in the car is $12,000 (cost minus total depreciation) you have a $3,000 taxable gain. However, the entire gain is taxable to you at ordinary income tax rates rather than at long-term capital gain rates. This is because the first $8,000 of gain, which is equal to the total depreciation, must be recaptured as ordinary income. If your gain is equal to $10,000 instead, $2,000 of the gain is taxed as a long-term capital gain.

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Sole Proprietorship & Capital Gains

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