What Net of Tax Means and How It Affects Business Taxes
What Is Net of Tax?
Net of Tax is an accounting definition that takes into account the estimated tax on a business or investment transaction. At its simplest, net of tax is calculated by considering the income from a transaction and subtracting the tax paid on that income. Net of tax is also sometimes referred to as "after-tax" and other times as "purchasing power," since the tax reduces the amount you are able to use for spending.
How Does Net of Tax Work?
Any business or investment transaction that involves income should be considered as net of tax. The net of tax calculation is different depending on the type of income:
- Ordinary or earned income is income from your business activities, like sales of products and services.
- Capital gains income is income from the sale of business assets (everything from vehicles and equipment to the entire business) or investments.
At its simplest, for example, if you earn $50,000 a year as a freelance business owner, you must pay income tax on that income. Since you are a business owner, you don't have payroll tax withholding. You must pay estimated taxes throughout the year. Including the cost of income taxes and self-employment taxes on your income can show you your true income for the year.
How Is Net of Tax Calculated?
Net of tax is calculated differently depending on whether your income is ordinary income or income from capital gains.
Let's look at ordinary income first:
For a business, ordinary income that is subject to tax is net income (profit); you get net income by subtracting expenses from income. Your net income from your business in the example above is $50,000. To get the net of tax calculation you must subtract the taxes due on that income: income tax and self-employment tax (Social Security and Medicare).
Your income tax rate is set by your total income for the year minus deductions and exemptions. For the sake of simplicity, let's say this business income is your only income; your tax rate on this income would be 25 percent, based on the tax rate for that level of income. and your filing status. So your net of tax income is $37,500. (Self-employment tax has been left out of the calculation).
How Does Net of Tax Work for Capital Gains?
The most common use of the net of tax strategy is in the sale of business assets that result in capital gains. The amount of capital gains taxed depends on the basis (cost) of the asset and the amount it is worth at sale.
Capital gains taxes are based on two factors: the type of asset, and how long the asset is held. Capital gains tax rates differ for real estate, stocks and bonds, collectibles, and other types of assets. The rates also differ based on the length of time the asset is held; the longer you have the asset, the lower the capital gains tax rate.
A quick example:
You bought stock for $100,000 two years ago, and you can sell it now at $120,000. The $20,000 is subject to capital gains. If your tax rate is 25 percent you will only receive $15,000 net of tax.
How Does Net of Tax Work for the Sale of a Business?
If you are considering selling your business, including a net of tax calculation into your discussions can save you a lot on your tax bill. How you categorize certain parts of the sale price can mean lower taxes. Spreading out the payments on the sale can also spread out the taxes over several years.
There may be other strategies you can use to minimize the tax effect of your business sale. Before you begin negotiations, get a tax professional who can help you with this complicated calculation.
Why Is Doing a Net of Tax Calculation Important?
Let's say you are trying to decide whether to sell some business assets. You aren't sure whether to sell this year or next. Doing a net of tax calculation for both years can show you which year might be the best, giving you the lower tax effect.
Net of tax calculations is also helpful because they allow you to look at different ways to reduce your taxes. For example, you may want to sell some investments, but you want to pay the least possible tax. Some of the investments may be in stocks and bonds, while some might be in IRAs. Considering net of tax can help you decide which are the best investments to sell and the best time.
Whether you are a small business owner or an investor, net of tax calculations are a useful tax planning tool. Talk to your tax professional about using these calculations to cut your tax bill.