When to Treat Resale as Capital Gains

Sorry, the most important detail was left out here: Company is an S Corporation which has existed for more than 10 years. I do realize that C Corporations cannot take advantage of capital gains.

Is this a company that normally keeps an inventory for sale? Inventory is not a capital asset. Capital assets are stocks, bonds, precious metals, and real estate (the financial definition). The sale prices of capital assets are driven by the market. In your case, I am assuming that the company sets the sale price, so any gains would be ordinary income. It does not matter how long the inventory is held before sale.

Holding a rare piece of technical equipment is absolutely no different than holding a painting or a house. The price is determined by the market, based on supply and demand. So they are not different types of items in the practical sense.

From the accounting point of view, I guess the question is does the law classify something as a capital asset based on just a fixed checklist (i.e., only paintings, houses, stocks, and metails, nothing else), or does the law classify something as a capital asset based on the process you use to do accounting for it, or based on other facts, etc.

"Will" wrote

They'll look at the intent as well as the actual use of that item. If you used it in the business (like machinery or a building) it's a capital asset. If it's strictly held for investment purposes - and it's NOT part of your ordinary business operations - it's a capital asset.

Items that you purchase and hold for ordinary resale to your customers - as "Rocinante" pointed out, regardless of how long you hold it - is treated as ordinary income from operations.

Timber says otherwise.

So for example if you collect art as an investment, then it is a capital asset and eligible for capital gains if you hold for a year. But if you are an art dealer, and you buy art to resell, it is never eligible for capital gains, even if you hold it for five years?

I guess the government just hates businesses that resell things and likes to give advantages to ones that buy and hold investments? Pretty hard to see the fairness in it.

Why not? Would it be fair to allow companies to only deduct the cost of inventory from sales and exclude business expenses?

How does the ability to deduct business expenses make it okay that a business has to declare a sale on inventory held for five years as ordinary income? I don't see the relationship?

Most resellers barely stay alive. They just barely etch out an existence and after expenses they might net 5%. It looks like the law is against them at every step: they have to depreciate slow-selling inventory over several years, which means in the first few years of business - or any time they grow rapidly - their positive cash flow is far less than the net income on the income statement, which overstates net income because of the inability to take their inventory costs fully in the year they are paid for. So the 35% tax on net income ends up being more like a 60% to 70% tax on real positive cash flow.

And if the reseller buys 20 items and sells three in year one, and has to hold the others for many years, they don't even get the consideration of a lower tax rate for buying and holding, further pinching cash flow.

To contrast, someone who is holding capital assets for investment is usually not doing it for a business purpose. That person usually does not need the cash for survival. Yet that person gets very advantageous tax treatment on that kind of income.

It reminds me of the fact that Microsoft and Cisco paid almost no income tax in their boom years during the 1990s because they were able to claim as an expense the "losses" they were taking on employee stock options, due to their rapidly rising stock prices. So the businesses with absolutely every advantage who don't need tax advantages to survive get away paying no tax at all, whereas typical struggling reseller businesses have every law written against them, at least for the important sources of income and expense.

Absolutely.

There are many retailers with inventory sitting on the shelves for that long. It doesn't magically turn into a capital asset over time.

Congress likes to tinker with people's actions. Many tax laws (tax rates, deductions, credits, etc) were created to tinker with the actions of society.

What reason should the taxpayers of America fund, in the form of deductions and credits, the children of other Americans? The tax code encourages the birthing of children by giving very generous reductions in taxes to those with kids. There's no real reason for that.

What reason should those who enjoy a fine beer or other alcoholic beverage be punished through the tax code? Yet there it is, excise taxes on all forms of alcohol, beer, wine, liquer. There's no reason for that either.

Absolutely. That's what Congress does best. Create very unfair laws.

They're the ones complaining about Walmart driving them out of business when they shouldn't have been in business in the first place.

Not always. Probably not even often. The business just made a bad decision on what inventory would sell and ended up ordering some items that just flat out didn't move, or, it just didn't move as fast as they thought it might.

In other cases, they bought a large quantity of items to get some discount, and they still have unsold inventory left. It's generally not an item that deteriorates over time, goes out of fashion, or otherwise would be unsellable next year. There's just an extra box of them on the shelf in the store room.

The simple answer is that the reseller businesses should learn how to take advantage of investments if they want to compete and operate as going concerns. They can cherry pick investments to sell in order to boost non-operating income. They can also use investment classification (e.g., available for sale securities) to move unrealized losses off the income statement and reduce its volatility. If you can't change the system, then work with it.

Can you explain this in more detail? I hope you are not saying that the solution to inventory laws overtaxing reseller businesses is to invest successfully in the stock market?!

And if you are making so much money on stock market investments that their profit can materially affect the cash flow of a business, maybe the better advise would be to quit the tax-disadvantaged business and focus on the investments?

Can you explain this one with an example? The problem in the example I gave wasn't how to take an unrealized loss. The problem was that reseller businesses barely manages any positive cash flow at all, but tax laws forbid taking large parts of real business costs the same year they are paid for. So tax law simply distorts the truth and creates a profit where none actually exists.

"Will" wrote

It's a sideline activity - unrelated to the business operations.

Say I operate as a CPA providing tax and accounting services. I can buy investments - buildings and artwork maybe - that might appreciate in value over any number of years. When sold these generate profits (gains if you will) that is taxed differently than profits (gain if you will) from by business operations.

But if I'm IN the real estate business of buying and selling real estate - or I'm in the art business of buying and selling artwork - then the gains and losses of any sales are treated as ordniary income.

Sorry. That doesn't float. The tax laws, at best, allocate expenses to the corresponding revenues. So if I were to start up a car dealership in the last week of December, and my only expense so far was buying up $3,400,600 worth of cars before year end. Yet only one car sold as of the end of December with a unit cost to me of $19,300. My only expense to date would be the $19,300. The remaining $3 million is inventory. It's always inventory till it's sold. Then I get to take a deduction for it's cost.

There are no tax laws that create profit where none truly exist. The laws shuffle the expenditures for a more realistic result.

What is the "litmus test" for whether a given source of income is a sideline activity or primary? Is there any hard rule, such as when the income accounts for more than say - 20% - of the total gross sales or net income?

I understand how tax laws treat that situation. But the practical reality is that for everyone except extraordinarily rich individuals, cash flow *is* the profit of the business. Because until a business reaches a really mature stage and has $10M stuffed on its balance sheets, its the cash from operations that is the lifeblood of the business. If a tax law creates a profit to tax where there was very little positive cash flow, that is a tax-disadvantaged business, particularly where there are not deep balance sheet assets.

And take your example to its conclusion. Let's assume that the car dealer sells $4M of cars per year, and nets 5% after all expenses on a cash-flow basis, so $200K / year of positive cash flow. Business keeps $3.4M of inventory on hand at all times (for simplicity in calculation here), so they essentially turn over their inventory about once every month. Now at end of year one operations they have to exclude 2/3 of the $3.4M inventory as undepreciated inventory and carry that forward? This assumes 3 year depreciation, and let's not get tied up in a precise calculation of depreciation (which I am sure I am doing incorrectly) and just talk about the general concept that some large amount of the inventory cost is not showing up on income statement. That leaves $2.27M of undepreciated inventory that they cannot claim on income statement. Now instead of $200K positive cash flow they have "profit" of over $2M? Goodbye to that car dealership....

I'm sure I must not be understanding something here, because in the above example the dealership has to sustain a $4+M tax bill over two years for the right in year three to show a meager $200K net income.

I completely messed up math in that last post. Sorry about posting that without proof reading. So try #2....

What is the "litmus test" for whether a given source of income is a sideline activity or primary? Is there any hard rule, such as when the income accounts for more than say - 20% - of the total gross sales or net income?

I understand how tax laws treat that situation. But the practical reality is that for everyone except extraordinarily rich individuals, cash flow *is* the profit of the business. Because until a business reaches a really mature stage and has $10M stuffed on its balance sheets, its the cash from operations that is the lifeblood of the business. If a tax law creates a profit to tax where there was very little positive cash flow, that is a tax-disadvantaged business, particularly where there are not deep balance sheet assets.

And take your example to its conclusion. Let's assume that the car dealer sells $40M of cars per year, and nets 5% after all expenses on a cash-flow basis, so $2M / year of positive cash flow. For simplicity, assume net earnings on income statement + undepreciated inventory costs are about the same amount.

The Business keeps $3.4M of inventory on hand at all times (for simplicity in calculation here), so they essentially turn over their inventory about once every month. Now at end of year one operations they have to exclude 2/3 of the $3.4M inventory as undepreciated inventory and carry that forward? This assumes 3 year depreciation, and let's not get tied up in a precise calculation of depreciation (which I am sure I am doing incorrectly) and just talk about the general concept that some large amount of the inventory cost is not showing up on income statement. That leaves $2.27M of undepreciated inventory that they cannot claim as expense on income statement.

Now instead of net $2M positive cash flow they have "profit" of over $4.3M?

You do enough experiments around this and you start to generalize some conclusions about resellers that they either:

OR

OR

If they cannot do one of those then tax law around inventory destroys them.

"Will" wrote

I know you're looking for a door in to the candy store, but it's based on the facts and circumstances of ~~each~~ transaction.

Take Coca Cola. They probably have a bottle of Coke from the 1800's (or whatever) that they have on display in their museum of Coke. That bottle has never really been "for sale" in the normal course of their business. If sold, it would most likely be considered a capital asset and a capital gain on such asset. If not for the corporate tax laws, the sale of that one bottle would not be taxed the same as a sale of a bottle of Coke that was made yesterday.

And business profits - or more appropriately - profits from a business activity - are taxede differently than the casual and infrequent sale of capital assets, investments, etc.

$10 mil? Please.

And recent tax laws have addressed any disadvantage - mainly in accrual accounting from booking a sale before the cash is recceived - so there's no worry.

Then he has profit. His tax is only on the profit.

I'm unclear as to where you get your ideas from.

Inventory isn't "depreciated". Inventory only gets expensed once it gets sold.

This assumes 3 year

See above.

Yup.

So that even worsens the situation. The company has to exclude $3.4M of inventory which increases the income statement profit by this much each year. In the example I gave from the reposting of the original message with the math error, $40M in annual sales, $2M in net positive cash flow becomes now now becomes $5.4M of "income". 35% tax rate on that is $1.9M thus nearly wipiing clean all of the positive cash flow in taxes. Effectively there is a 95% corporate tax rate on that business' net positive cash flow.