All businesses have assets. For very small businesses, those assets may be office equipment. For large companies, assets may also include buildings, machinery, patents, copyrights and stocks and bonds for investing accumulated cash. The value of all those assets usually changes over time. Selling any asset, or an entire business, is what accountants call a taxable event — and that’s when the tax basis of each business asset becomes important.
What Is a Tax Basis?
Tax basis is an asset’s cost basis at the time that the asset is sold. Cost basis begins as the original cost of acquiring an asset. During the lifetime of the asset, its value may increase or decrease. That adjusted value is called the adjusted cost basis. When an asset is sold, the tax basis is the adjusted cost basis at the time of the sale. The difference between an asset’s tax basis and the sale price determines whether a business realizes a capital gain or loss and whether taxes are owed or, in the case of a loss, offset.
Cost Basis vs Tax Basis — What’s the Difference?
What is the difference between cost basis and tax basis? The two terms are often used interchangeably since tax basis is a snapshot of the cost basis when an asset is sold.
Tax Basis Defined
For your taxes, it’s important to keep track of when you acquired the asset and what your capital gains tax rate is. An investment asset held for more than one year is subject to capital gains tax, which for a C-Corp is currently 21% — though for certain types of assets, the capital gains rate can be up to 28%. Short-term capital gains are taxed as capital gains, not income. The tax rate is the same as the individual or corporate tax rate, but they are still capital gains and must be reported separately from income using a separate IRS form (8949) and 1049-D.
What Is Included in Tax Basis?
Along with the original price of an asset, the tax basis includes any acquisition costs, such as taxes, fees, commissions and shipping. While a business holds an asset, the tax basis may change. Annual depreciation decreases the tax basis, while capital improvements and reinvested dividends increase the tax basis. Mergers and bankruptcies can also increase or decrease an investment’s tax basis, while stock splits reduce the basis of individual shares but not the total investment basis.
Determining Tax Basis
In many cases, an asset’s tax basis depends on how it was acquired. For example, different tax bases apply to assets that were bought, received as a gift or inherited.
Stocks and bonds: The cost basis is the stock price plus any fees and commissions. It may adjust over time if the stock distributes dividends; reinvested dividends are added to the original cost basis, so the ultimate tax basis may differ from the original cost basis.
Gifts: The tax basis of a gift depends on whether it is sold for a profit or a loss. If you sell a gift for a profit, the tax basis is the previous owner’s cost basis because the IRS taxes an asset’s lifetime gain, regardless of who owns it. If the gift is sold for a loss, however, the tax basis becomes the lower of either the market value when you received the gift or the previous owner’s cost basis. This prevents the new owner from writing off — and benefitting from — a loss that occurred while the donor owned the asset. Thus, it is important to record the donor’s cost basis at the time the gift is given.
Inherited assets: The tax basis for inherited assets is the fair market value at the owner’s death. This may require researching historical values. With this rule, you are not liable for any appreciation during the decedent’s ownership, nor can you claim any losses while the decedent held the asset. If the inherited property is large enough for an estate tax, the executor can choose an alternate evaluation date up to six months after the previous owner’s death, making the tax basis the value on that alternate date. Regardless of how long an inherited asset is held, it’s taxed as a long-term capital gain or loss.
Like-kind property or exchange: Non-taxable exchanges such as like-kind exchanges, liquidating partnerships or corporate reorganizations take on the existing tax basis at the time of the exchange.
A business: The buyer of a business assigns each asset in the business a tax basis as a portion of the purchase price.
Partnerships: Each partner’s tax basis is the net value of the partner’s contribution and share of liabilities plus any income earned. Distributions decrease the partner’s tax basis.
How to Calculate Tax Basis
For most assets, calculating the tax basis is straightforward: The tax basis is the adjusted cost basis — or the original cost of the asset adjusted for other factors such as depreciation that affect the value — when the asset is sold. Tax basis starts as the initial purchase price plus all the costs of acquiring the asset, such as sales, property and excise taxes, shipping costs, installation and testing charges and commissions and fees. Whether following accrual accounting or cash basis accounting, the process of calculating the tax basis of an asset remains the same.
Tax basis calculations get more complicated over time as the adjusted cost basis evolves when different factors are added or subtracted. With stocks, for example, reinvested dividends buy additional shares and therefore are added to the adjusted cost basis. For real estate, the value of buildings depreciates but the value of land does not. So, if a company purchases land then sells it for a profit, there is not depreciation to subtract. Operating expenses such as maintenance costs, however, do not affect the cost basis.
For businesses structured as partnerships, the IRS recently changed its reporting requirement for partner capital account balances. A partnership still reports each partner’s share of income, deductions and credits to the IRS on a Schedule K-1 form. However, partnerships now need to use a transactional tax basis method to report a partner’s tax basis capital. Form 1065 walks the partnership through the reporting of a partner’s contributions, share of profit or loss, withdrawals and distributions and other increases or decreases using tax basis principles. The capital gains rate is based on the individual partner's personal income — this is true for all pass-through business (LLC, S-Corp, etc.).
With a business’s investment holdings, such as stocks and mutual funds, shares are typically bought and sold at different times and prices. As a result, the IRS allows two different methods that can be used to calculate tax basis when those investment assets are sold.
Average Cost (AvgCost): The sum of all the share purchases (and purchase costs) divided by the total number of shares owned.
First-in, firstout (FIFO): Shares are considered sold in the order they were originally purchased.
Adjustments to Tax Basis
While an asset is owned, its tax basis can increase or decrease. For example, tax basis may increase from capital improvements and be reduced by casualty and theft losses. Other costs, such as depreciation, can decrease the tax basis. Let’s say a business buys a building for a cost/tax basis of $80,000. The company adds a new $15,000 kitchen for employees, making its adjusted tax basis $95,000. A flood causes $20,000 in damages to the basement floor, reducing the tax basis to $75,000. The company gets an insurance reimbursement of $10,000, which it uses plus an additional $10,000 to repair the floor, restoring the tax basis to $95,000. Finally, $3,167 of the building is depreciated (assuming a 30-year life). The adjusted tax basis is now $91,833 but will continue to decline due to depreciation. When the building is sold, the gain or loss is calculated as the sale price minus the tax basis — aka the adjusted cost basis.
These special events cause adjustments to the tax basis of a business’s investment holdings:
Stock splits: When stocks split, the tax basis is redistributed among the new number of shares. For example, let’s say a business buys 100 shares of stock with a $20 per share cost/tax basis for an investment of $2,000. If the stocks split 2-for-1, the business redistributes its $2,000 investment over the 200 shares, adjusting the tax basis to $10 per share.
Dividends: When a business chooses to reinvest dividends from a stock or mutual fund, the tax basis increases. Take, for example, a mutual fund capital distribution that is added to a business’s investment, buying additional shares at the current market value. If the business owns 125 shares with a cost/tax basis of $50 per share, and the current market value is $75, a reinvested dividend of $.60 per share is $75 and buys one more share. If using the FIFO method, the tax basis of the first 125 shares sold is $50 and that of the newly acquired share is $75.
Tracking Tax Basis With Accounting Software
Keeping detailed records of each asset’s tax basis and acquisition date is essential for many reasons, such as minimizing tax liabilities.
Tax preparation software can help small businesses determine the amount of taxes due, but it requires the business to keep records and manually enter the tax bases, acquisition dates and when assets are sold. As a result, data entry errors could occur. For all but the smallest of businesses, the sheer number and diversity of assets and investment securities make automated tracking of assets’ tax bases via business accounting software a real boon.
Tax basis can be explained as the adjusted cost basis of an asset at the moment the asset is sold. But tracking tax basis requires careful records, not just of the original price and acquisition date, but also of any adjustments made while the asset is held, and robust financial management software to keep track of assets makes this easier. Keeping sound records of every business asset’s original cost basis, plus all the adjustments that may affect their cost bases over time, becomes a larger challenge as the business grows.
Tax Basis FAQs
For most business assets, calculating tax basis starts with the original cost of the asset, including any purchase costs, such as sales commissions and shipping fees. Then adjustments are added or subtracted. For example, depreciation reduces an asset’s tax basis while capital improvements increase it.
To determine the tax basis of equipment or facilities, start with the original purchase price and then add the cost of all capital improvements made to the property while you owned it. Then subtract any depreciation you might have taken on it in prior tax years.