Every small business owner worth their salt knows that, from a taxation standpoint, capital gains are something to be avoided at all costs.
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But do you know why capital gains can be so deadly? Better yet, do you know how to minimize your capital gains exposure before the tax man comes knocking on your door at the end of your company's fiscal year?
With the right strategy, you can limit capital gains and keep more of your money where it belongs - in your bank account.
What are capital gains?
Basically, a capital gain is the result of selling an asset for a higher price than you originally purchased it for. Theoretically, this could apply to any asset your business owns, but it is most commonly applied to assets such as investments and real estate.
For IRS purposes, there are two types of capital gains: short-term capital gains (less than 1 year), and long-term capital gains (more than 1 year). It's important to note that long-term capital gains are taxed at a lower rate than short-term capital gains and regular business income as a way of encouraging long-term investment.
It's also important to note that capital gains are not taxed until the asset is sold. As long as you own the asset, you will not be taxed for any increases in the asset's value - a key consideration when it comes to designing a strategy to minimize your capital gains liability.
How can I minimize capital gains taxes?
Timing is everything when it comes to minimizing your company's exposure to capital gains. When an asset appreciates in value, the result is a capital gain. But when an asset depreciates in value, the result is a capital loss. The flipside of capital gains tax is that capital losses can be used to offset your tax liability. Therefore, the best strategy to minimize your capital gain tax liability is to time the purchase and sale of your assets in a coordinated manner, offsetting capital gains with capital losses whenever possible.
A good rule of thumb is to avoid selling assets that will result in a large capital gain until you have a corresponding capital loss. In the meantime, consider selling assets that will result in smaller capital gains, saving your big gains for a more financially appropriate moment. This can be an inconvenience, but if you plan it right it usually only means holding off a year or two to sell a big ticket asset or selling one a little earlier than you had planned so it can be included in the current tax year.
Another strategy many small businesses employ is purchasing equities as a way of indefinitely prolonging a capital gain. Investing in a publicly traded stock gives you the ability to put off paying the capital gain until you sell the business or until a more opportune time. The length of time you wait is entirely up to you, but any strategy you can use to delay paying taxes is generally a good one.
If you decide to liquidate a stock, it's still a good idea to make sure you've owned it for at least a year. Otherwise, you will responsible for paying tax at short-term capital gain rate which is 5% higher than the long-term capital gain rate that kicks in after the one-year mark.