Timing Is Everything: Tax Planning for Capital Asset Disposal Is Complex Yet Necessary
Joy, David, Del Vecchio, Stephen C., Clinton, B. Douglas, Young, James C., Strategic Finance
One issue in an array of decisions involving capital assets is taxes. How to treat those gains and losses is likely your most important tax issue for capital asset investment planning regarding disposal decisions and the maximization of cash inflows over time. Complex and constantly changing tax rules significantly shape capital asset planning. And, as the adage goes, timing is everything.
Managing a company's assets involves constant review and planning. To help you with your planning, we'll look at how you can determine the timing of capital asset disposal for the beneficial treatment of gains and losses. We'll also offer a variety of tax-planning suggestions to help you seize the moment and start disposal planning.
Capital assets, which are generally referred to as Section 1231 assets, affect how a business produces its products or services, meets customer demand, and competes in the marketplace. In addition to committing significant organizational resources, replacing capital assets impacts your strategy and operations for a significant period of time. Since tax rules dealing with Section 1231 assets have grown in both number and complexity, you often have to carefully research transactions on an asset-by-asset basis to achieve optimal tax benefits.
To make matters worse, guidelines for determining when you should sell capital asset investments aren't well established. Further, the tax impact on the buyer's and seller's after-tax cash flows aren't typically symmetrical, and the disposition's tax treatment can have a significant financial impact on the seller. Finally, tax provisions that vary by entity type can affect an asset's rate of return over time.
If your goal is to maximize cash flows, the treatment of gains and losses affects your choice of useful life and depreciation method and encourages the continual critical evaluation of the investment during its useful life. Varying tax rules and tax rates have a huge impact on the following factors:
* The difference between before- and after-tax values,
* The rate of return over time,
* The form of asset ownership, and
* The type of assets in which to invest.
These factors determine the disposal date critical to maximizing cash flows over time.
If you sell an asset, you first determine the gain or loss by comparing the amount realized to the asset's adjusted basis (cost minus accumulated depreciation). Once you determine the recognized gain or loss, you classify it by determining the property's tax status and its holding period, which is either short term at one year or less or long term at more than one year.
Our tax law includes three tax statuses--capital, Section 1231, and ordinary:
* Capital assets are generally investments like stocks and bonds.
* Section 1231 assets are depreciable business assets or real estate used in business and held for more than one year.
* Ordinary assets are inventories and "inventory-like" assets such as copyrights, patents, etc., and accounts and notes receivable from the sale of inventory or services.
These classifications are necessary because Congress taxes capital assets uniquely. Depending on the taxpayer, capital gains are taxed at preferential rates, and the deductibility of capital losses is limited. At present, corporate taxpayers don't have a special capital gains tax rate and can only deduct capital losses up to the amount of capital gains. Disallowed capital losses, which are in excess of capital gains during a taxable year, may be carried back three years and carried forward five years to offset capital gains during those periods.
The general tax effects of gain and loss recognition would suggest that you avoid or defer gains and capture and possibly accelerate losses. But tax rules don't consistently encourage or discourage deferring or accelerating asset disposal. …