Tax Inclusive vs. Tax Exclusive Analysis
Tax Inclusive
Income tax rates are typically computed on a basis, which means your tax liability is determined as a percentage of your total income. The tax is computed on the sum of your take-home and the tax itself — in other words, you are paying taxes on the tax.
Tax Exclusive
A better way to compare taxes is on a tax exclusive basis. With this method, you compare the tax paid to your take-home income. Tax exclusive computations show how much you pay to the IRS for each dollar you get to keep.
Example: Florida Tax Rates
The highest marginal income tax rate for Florida residents is 37% on ordinary income (OI). In comparison, the long-term capital gains (LTCG) tax rate is only 15% or 20%. The difference between tax inclusive and tax exclusive computations is shown below:
Tax Inclusive Computations
- Ordinary Income (OI): 100% - 35% = 65% take-home
- Long-Term Capital Gains (LTCG): 100% - 15% = 85% take-home
- Difference in tax rate: 20%
- Relative improvement: 20% ÷ 65% = 30.77% ≈ 31% more money kept if income is taxed at 15% LTCG rate instead of 35% OI rate
Tax Exclusive Computations
- OI: 35% ÷ 65% = 53.85% (≈ 54¢ paid per $1 kept)
- LTCG: 15% ÷ 85% = 17.65% (≈ 18¢ paid per $1 kept)
On a tax exclusive basis, the OI tax rate is 306% of the LTCG tax rate. Now you know the goal: achieve LTCG treatment.
Achieving Long-Term Capital Gains (LTCG)
Basic Rules
As a general rule, LTCG arises from the taxable sale of an asset held for more than one year, provided the asset is not classified as an ordinary income (OI) asset. Examples of OI assets include inventory and accounts receivable.
Exceptions
- Depreciation Recapture: Gain representing prior depreciation deductions is treated as OI.
- Related-Party Rule: Gains on sales of depreciable property to a related party do not qualify for LTCG.
Converting Business Income to LTCG
Business income usually generates OI because it comes from selling inventory or services (which are not assets). However, the business itself is not an OI asset. When selling a business, income can be converted to LTCG to the extent that the price is allocated to non-OI assets such as goodwill.
Goodwill
Economists define goodwill as the ability to generate future income — the present value of future cash flows. Goodwill is not an OI asset. Therefore:
- Sellers can report proceeds from goodwill as LTCG.
- Buyers can deduct the purchase price of goodwill over 15 years (IRC 197).
This creates a tax advantage for both parties: the seller enjoys LTCG rates, while the buyer receives deductions.
Strategies for Achieving LTCG
Leveraged Buy-Outs (LBOs)
An LBO is a sale of business assets where part or all of the price is paid via an installment note. The buyer runs the business and pays the debt with business income. Benefits include:
- Seller receives LTCG treatment.
- Buyer gets to deduct most, if not all, of the price over time.
- Debt is secured by business assets, adding asset protection.
Employee Stock Ownership Plans (ESOPs)
An ESOP is another vehicle for converting OI to LTCG while maintaining control. The process:
- Company sets up a retirement plan primarily investing in its own stock.
- ESOP borrows from a bank, secured by company assets.
- ESOP buys company stock with borrowed funds (seller receives LTCG).
- Company makes deductible contributions to the ESOP.
- ESOP repays the bank loan.
- Board of Directors votes the ESOP-held stock, maintaining control.
Conclusion
By shifting ordinary income to capital gains, business owners can dramatically increase after-tax income while preserving control. Tools such as LBOs and ESOPs make this possible, often resulting in a 20%+ reduction in effective taxes and additional asset protection benefits.
