Revenue from sales of products or services is just one source of income for a business. Asecond income stream for many businesses is non-operating revenue from capital assetinvestments. Any business can hold capital investments, and many nonprofits rely on them forrevenue. Businesses can realize profits or losses in either revenue steam — but whenitcomes to capital assets, cost basis is the key to how a business calculates its gains andlosses.
There’s a wide spectrum of capital asset types in which businesses can invest,beginning withthe stocks, bonds and money market funds where many park cash-on-hand until needed. Butfactories and equipment are also capital assets, as are goodwill, patents and copyrights.Cost basis is the key to determining the gain or loss for all these capital assets.
What Is Cost Basis?
Just as a business calculates the costs in creating products, it must keep careful records onthe purchase of each capital asset, which is called the asset’s cost basis. The costbasiscan change over time as depreciation is taken or capital improvements are made.
Cost basis vs tax basis — what’s the difference?
When the business disposes of a capital asset, it calculates and reports to the IRS thecurrent adjusted cost basis of the asset, which is also called the tax basis. The profit or loss from the business’sinvestment in that asset is the difference between the sale price and the tax basis.
Key Takeaways
- Cost basis is the original price of a capital asset plus any costs associated withbuying the asset.
- Capital gains or losses are computed by subtracting the cost basis from the market valueat the time of sale.
- A business can choose from multiple cost basis methods to calculate the capital gain orloss.
Cost Basis Explained
When a business acquires a capital asset, such as stocks or other securities, real estate oreven another business, the initial purchase price becomes the original cost basis of thatinvestment. This initial cost basis includes any costs of acquiring the investment, such asattorney and advisor fees in the case of an acquisition. Cost basis for an asset can changeover time for many reasons. Consider an office building: Taking depreciation lowers thebuilding’s cost basis, but the cost of a new roof (which eventually will be required)is acapital improvement that adds to the cost basis.
Why Is Cost Basis Important?
The cost basis of an asset is important because it’s used to determine tax liability.When acapital asset is sold, the sale price minus the cost basis determines whether the investmentis profitable. When an entire business is sold, the profit or loss of each capital assetmust be determined separately using each asset’s cost basis.
Cost Basis Methods
When a company buys multiple investments of the same type over time, such as shares of stockin the same company, determining the cost basis when the investments are sold can becomefairly convoluted. The order in which the shares are sold can greatly impact thebusiness’ultimate gain or loss. When selling securities such as stocks, the IRS allows you to reportusing the special identification or first in, first out methods.
First In, first out (FIFO):
Using this method, stocks are sold in the order they were bought. If FIFO wereapplied to the example in the previous bullet, a business that sells 150 shareswould have a cost basis of $10 each for 100 shares and $25 for the rest, for a costbasis of $2,250. At a sale price of $35 per share, it would realize a gain of$3,000.
Specific identification (SpecID):
Using this method, the company identifies the stocks to be sold by specifying theacquisition date and price. That way, it could sell a custom mix with a cost basisof $10, $25 or $30 to achieve a specific cost basis to suit its needs.
Average cost (AvgCost):
This uses the average cost of all shares purchased as the cost basis. Using averagecost, if a business bought 100 shares of Company A’s stock at $10 per share,another100 at $25 and 200 more at $30, the average cost per share (and, therefore, yourcost basis for each share sold) would be $23.75 ($10 + $25 + $30 + $30 / 4). If thebusiness sold 150 shares at $35 per share, it would realize a gain of $1,687.50($5,250 - $3,562.50).
Highest in, first out (HIFO):
In this method, the highest priced stocks are sold first. So selling 150 shares fromthe example above would result in a cost basis of $30 per share and a realized gainof $750.
Last in, first out (LIFO):
With this method, the stocks purchased most recently are sold first.
The IRS does not formally recognize AvgCost, HIFO or LIFO. However, the SpecID method allowsfor some flexibility. For example, when SpecID is used to indicate the most recent sharesacquired, it’s essentially the LIFO methodology.
To decide which method works best for your business, you should consult a certified taxadvisor or financial planner. Once you decide upon a method, the key is to keep it ineffect.
How to Determine Cost Basis
The cost basis of an asset depends on the asset type and, in some cases, how the asset wasacquired. Here’s a breakdown of the most common assets and how the cost basis for eachisdetermined.
A business: The buyer divides the purchase price among all thecapital assets in the business, assigning a cost basis to each asset. The value ofan individual partner’s interest in a partnership is also considered a capitalasset.
Stocks and bonds: The purchase price is the initial cost basis,including any brokerage fees or commissions, plus reinvested dividends (if any).
Gifted assets: The cost basis of assets given to a business iseither the fair market value or the donor’s cost basis.
Inherited assets: The cost basis for inherited assets is the fairmarket value on the day the previous owner died.
Intangible assets: The cost basis for intellectual property, such aspatents, copyrights, trademarks, trade names and franchises, is the cost to createor acquire those assets. In an acquisition, the cost basis for goodwill is thedifference between the value of the company acquired and the amount paid for thebusiness.
How to Calculate Cost Basis
How a business calculates cost basis for capital assets can become fairly complex —sincedifferent factors can apply to different capital investments — but they all start withtheinitial purchase price plus any costs of acquiring the investment. The purchase priceincludes not only cash, but also any amounts paid in debt obligations, services or realestate. Costs to acquire the investment can include sales, real estate and excise taxes;shipping costs; installation and testing charges; and commissions and fees.
Cost basis calculations get more complicated over time, as a cost basis is adjusted bysubtracting or adding different factors. With stocks and bonds, for example, reinvesteddividends are added to the cost basis. For real estate, depreciation is subtracted from thecost basis and any capital improvements are added. Maintenance costs, however, are anoperating expense and do not affect the cost basis. So, a factory’s cost basis mightincludethe initial cost of construction, minus depreciation over time, plus the major refit fiveyears down the road — but not the salaries of the people who worked there all thoseyears.
Accuracy in Tax Reporting Cost Basis
Well-kept records are key to proving an asset’s cost basis to the IRS. When a capitalassetis sold, the gain or loss is calculated as the current market price minus the cost basis.
Why is cost basis reporting accuracy so important?
Cost basis reporting accuracy is vital because an asset’s adjusted cost basis becomesits taxbasis for computing tax liability when the asset is sold. If the difference is positive, thebusiness realizes a gain; if negative, it means a loss. The length of time the businessholds the capital asset is also important in computing tax liability. Any investment assetheld for more than one year is subject to capital gains tax, which could be 0%, 15% or 20%depending on the investor’s filing status and income for personal filings. Other taxrateswill apply for businesses. For example, the tax rate for a C-Corp is currently 21%,regardless of income. And for certain types of assets, the capital gains rates can be up to28%. Short-term investments — assets held for up to a year — are taxed ascapital gains. Thetax rate will be the same as the individual or corporate tax rate, but must be reportedseparately from income using a separate IRS form (8949) and 1049-D.
Choosing a Cost Basis Method
Certainly, the fair market value of an asset plays a large part in deciding which cost basismethod to use. FIFO is simple and has the virtue of maximizing gains if the asset value hasincreased while minimizing losses if the value has decreased. SpecID gives the company themost control in tax planning because specific shares can be selected for sale.
Pros and Cons of the Methods for Calculating Cost Basis
| Cost Basis Method | Pros | Cons |
|---|---|---|
| FIFO | Often maximizes gains if the asset value has increased | Often minimizes losses if the asset value has decreased |
| SpecID | Most precise control of gains and losses | Complicated and requires careful records |
| *LIFO | Usually results in a comparatively low tax burden with prices haveincreased | The taxes that are incurred will often be taxed at higher short-termcapital gains rates |
| *HIFO | Minimizes gains and maximizes losses | May force short-term gains on recently acquired shares |
| *AvgCost | Simplest method | Does not maximize gains |
Cost Basis Comparisons
The table below shows the impact of applying cost basis methods to two scenarios. In bothscenarios, Company A owns 300 shares of ABC company stock. The first 100 shares were boughtat $400 each, the second 100 shares at $200 each and the third 100 at $600. Now the companywants to sell 150 shares and must decide which of the basis methods to use to maximize gainsand minimize losses. The table shows how the methods compare in gains or losses for ascenario in which the share price has climbed to $700 and a second scenario in which theprice has fallen to $300. As the table makes clear, the different cost basis methods yielddifferent results in each scenario.
| Cost Basis Method | Shares Sold @ Cost Basis | Gain/(Loss) @ Selling Price = $700 | Gain/(Loss) @ Selling Price = $300 |
|---|---|---|---|
| FIFO | 100 @ $400 and 50 @ $200 | $55,000 ($300 per share for 100 shares plus $500 pershare for 50) | ($5,000) (+$100 per share for 100 and -$100 for 50) |
| SpecID | Any selection is possible. To maximize gains, let’s assume: 100 @$200and 50 @ $400 | $65,000 ($500 per share for 100 shares plus $300 pershare for 50) | $5,000 ($100 per share for 100 shares minus $100 pershare for 50) |
| *LIFO | 100 @ $600 and 50 @ $400 | $25,000 ($100 per share for 100 shares plus $300 pershare for 50) | ($35,000) ($300 per share for 100 shares and $100 pershare for 50) |
| *HIFO | 100 @ $600 and 50 @ $400 | $25,000 ($100 per share for 100 shares plus $300 pershare for 50) | ($35,000) ($300 per share for 100 shares and $100 pershare for 50) |
| *AvgCost | 150 @ $400 | $45,000 ($300 per share) | ($15,000) (-$100 per share) |
*Reminder: The IRS does not formally recognize AvgCost, HIFO or LIFO. However, the SpecIDmethod allows for some flexibility.
Examples of Cost Basis
Most stock transactions are straightforward. The cost basis is the price paid plus anycommissions, with little or no adjustment. In some special cases, however, such as mergers,stock splits and bankruptcies, the cost basis is affected by actions beyond thebusiness’scontrol.
Mergers:
If a business owns stock in a company that merges with another company, the businessusually receives payment in stock, cash or a combination of stock and cash (calledcash to boot). With stock payments, the merging company determines the new number ofshares and market value, requiring an adjustment to the original cost basis. Anall-cash merger is effectively the same as selling all shares, and the gain or lossis calculated at that time using the original cost basis. In cash-to-bootsettlements, any fraction of a share resulting from the exchange ratio triggers acash payment for that fraction.
Stock splits:
When stocks split, the total investment does not change. The current cost basis isdivided among the new number of shares. For example, in a 2-for-1 split, the costbasis of each share is cut in half.
Bankruptcies:
If a business claims Chapter 7 bankruptcy, its shares lose all value. A loss cannotbe claimed until either the company’s stock is sold (often for a penny) or isdeclared to be worthless. In Chapter 11, however, the shares could continue to betraded and, depending on the settlement, the cost basis could remain unchanged.
Tracking and Reporting on Cost Basis With Software
Given the need for a high level of reporting accuracy to produce trusted cost basiscalculations for tax purposes, good business accounting software plays animportant role. Software can help businesses keep detailed records of costs and dates ofpurchase for their capital assets. A range of business accounting software is available fortracking not only operating revenue and expenses, but also the cost basis for capital assetsand other investments.
In addition to producing goods and services, businesses can realize a second stream ofrevenue from capital assets and capital investments. Many factors go into calculating thecost basis of an asset, including how it was acquired and the costs associated withacquiring it. Keeping careful records of the cost basis and acquisition dates of capitalassets is essential for calculating gains and losses when the assets are sold. Good businessaccounting software can help with all that record-keeping, tracking and, when the time comesto sell an asset, identifying the best cost basis method to use for tax planning purposes.
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Cost Basis FAQs
What does cost basis mean?
Cost basis is the total cost that an individual or business pays for a capital asset, whethera home, an office building or investment securities like stocks and bonds. It’s usedtocalculate the taxable gain or loss when the asset is sold.
How do you calculate cost basis?
Calculating cost basis can be simple or complex, depending on the circ*mstances. If you buyshares of a non-dividend-bearing stock from a no-fee online brokerage, your cost basis isthe price you paid. But if you paid a commission, or if you invest in dividend stocks, thenthose fees get added into the cost basis when you sell. With property, like a home or officebuilding, depreciation can lower the cost basis over time while capital improvements —forexample, a new roof or HVAC system — add to the cost basis.
Do you pay taxes on cost basis?
You don’t pay taxes on the cost basis of an asset, but cost basis is used to calculatethetaxable gain when an asset is sold. You pay tax on the difference between the sale price ofthe asset and the cost basis, i.e., Taxable gain = Sale price - cost basis. If you sellstock for $10,000 that originally cost you $9,000, you must pay tax on the $1,000difference.
What is included in cost basis?
The initial purchase price is the core of the cost basis for any capital asset or investment.That includes costs of acquisition, like attorney and advisor fees. Over time, factors likedepreciation of the asset or capital improvement can add or subtract from the cost basis ofcertain assets, like buildings. In the case of securities, reinvested dividends cause thecost basis for those securities to rise.
Is cost basis the same as cash basis?
Cash basis is an accounting method that records expenses or income when a payment is made orcash is received. It’s not as insightful as accrual accounting,which combines the current and expected future cash inflows and outflows. And cost basis isthe cost of an asset and is used to determine taxable gain/loss when it’s sold.
