Preface: Form 4797 is a commonly misunderstood tax form for business owners. This blog is to help you understand sales of business property listed on the Form 4797.
Form 4797 – Sale of Business Property
When your business sells a forklift, or a customer list, how does your tax accountant report the gain? Answer: On Form 4797 “Sale of Business Property.” The IRS tax code requires the reporting of a sale of business property in a different section of the tax code than ordinary revenues, from say a sale of inventory (Section 471.) The most common gain and loss code sections for business property are Section 1231, Section 1245 and Section 1250.
Section 1231 gains and losses can be taxed as either ordinary income or loss, or capital gain, depending on the characteristics of the transaction. Section 1231 assets are the exchanges of 1) real property, e.g. leasehold improvements; or 2) depreciable property used in a business and held for more than a year, [typically property that is held for rental or royalties income] or 3) Section 197 intangibles such as goodwill, customer lists or copyrights. Note: the origin of the Section 197 intangible is a key factor in the tax attributes of the transaction, e.g. self-created intangibles are always ordinary income. Other section 1231 property include sales or exchanges of livestock, unharvest crops, or timber. To determine if your asset sale is ordinary or capital you must net all section 1231 gains and losses for the year. If you have a net section 1231 loss, it is an ordinary loss. If you have a net section 1231 gain, it is ordinary to the extent of non-recaptured section 1231 losses from prior years. Non-recaptured section 1231 losses are the net section 1231 losses from the previous five years. Therefore, if your business had a section 1231 loss in any of the five preceding tax years, the section 1231 gain is an ordinary gain to the extent of the non-recaptured losses.
To detail, if your business sold leasehold improvements four years ago with a loss of $15,000 and a customer list (a section 197 intangible) for a $10,000 gain in the prior tax year, a current year section 1231 gain of $20,000 would be netted with the prior five year section 1231 gains and losses ($15,000 loss from leasehold improvement+ $10,000 gain from customer list = $5,000 loss, the non-recaptured section 1231 loss). Therefore, $5,000 of the $20,000 current year gain would be treated as ordinary income, and $15,000 as a capital gain. Hotchpot complexities, such as this, are why you pay a tax accountant.
Section 1245 property is property that is 1) Personal – tangible or intangible 2) Tangible property for manufacturing, production, transportation, etc. Most business equipment, e.g. machinery, furniture, is classified as section 1245 property. Gains treated as ordinary income on the sale of section 1245 property include the lesser of depreciation and amortization on the asset, or the gain realized on the disposition. An example would detail the sale of a $75,000 backhoe with $40,000 of depreciation. The cost basis in the asset, net the depreciation allowance of $40,000 is a $35,000 book basis. Market value is most often different than book basis, e.g. gain or loss on disposition. If the asset is sold for $50,000, the gain is $15,000 ($50,000 sale price – $35,000 book basis = $15,000 gain.) The entire gain is ordinary since it does not exceed the depreciation of $40,000. If the asset was sold for $85,000, the gain would be $50,000 ($85,000 sale price – $35,000 book basis = $50,000 gain). $40,000 of gain, the depreciation recapture, would be ordinary income, and $10,000 in excess of cost basis would be a capital gain. Sales of section 1245 assets are listed on Part III of the form 4797. Section 1245 assets can also be sold in bulk and aggregated on the form 4797.
Section 1250 property includes real estate as business property or real property that is depreciated and has never been section 1245 property. Recapture income on section 1250 property is ordinary income and un-recaptured income (income in excess of cost basis) is taxed at a maximum 25% capital gains rate (lower capital gain rates in some instances.) If you own real estate in your business, such as an office building, the asset is section 1250 property. You should always talk with your tax advisor before buying real estate in your business, to plan proper entity structuring, and optimize future tax attributes.
Section 1231, 1245 and 1250 assets in your business should always be listed on a fixed asset report. You should have a fixed asset report for federal tax, state tax and AMT, (and if you have accountant prepared financials, such as a reviewed financial statement, a financial asset report.) Your tax accountant should periodically discuss the reports with you to determine the accuracy of cost basis and accumulated depreciation that is relevant to gain and loss reporting on asset dispositions.
Before you transact any sale of major assets in your business, speak with your tax advisor for proper calibration of the tax attributes.