A business owner should never make decisions solely on the basis of potential changes in tax rates. Pursuing a transaction at the wrong time, when the business isn’t well-positioned or in weak market conditions, would likely result in an even greater loss of value. However, owners who are already considering an exit sometime over the next few years and whose businesses are well-positioned currently should be evaluating whether now is the best time to do a transaction – taking advantage of current market conditions and tax policies. Depending on when likely tax increases could go into effect, it will likely take an owner several years of hard work and growth just to recover to a level of net proceeds they could achieve in the current environment.
First the facts:
No one can say for certain when, whether or by how much capital gains rates (or any other tax rates) may increase in the near future. However, President Biden has proposed several tax increases that most tax professionals believe will be acted upon sometime in 2021. Although these changes could be implemented retroactively to the beginning of this year, most also believe that is unlikely. Far more likely is that any changes passed this year would go into effect going forward, or possibly as of January 1, 2022.
President Biden has proposed an increase in the capital gains tax rate from 20% to 39.6% (the ordinary income rate) for high income brackets. This rate is the one that applies to most proceeds realized by an owner in the sale of a business.
The impact of such an increase to the capital gains rate on the proceeds potentially received by the seller of a business is straight-forward and significant.
Example*:
If a business is sold with pretax equity value of $20 million, the current federal capital gains taxes at 20% would be $4 million (net of $16 million before any applicable state taxes).
If the proposed capital gains increase goes into effect and roughly doubles, $20 million in pretax proceeds would face federal capital gains taxes of approximately $8 million (net of about $12 million before applicable state taxes).
In other words, an owner potentially stands to lose 25% of their net proceeds the day after such an increase in the capital gains rate might be implemented, as compared to the day prior.
The bottom line is that an owner may have to increase the equity value of their business by 33% after such an increase goes into effect, just to net the same after-tax proceeds.
This means that faced with the higher capital gains rate reflected above, an owner would need to work to grow the value of their business by 3% per year for 10 years to net the same proceeds they could achieve under the current tax environment (unadjusted for inflation). They could work harder and grow value by 5% per year for the next 5 years to get back the proceeds they had lost, or even harder to grow 10% per year over the next 3 years and do the same.
The examples above also exclude the possible impact of other proposed tax increases, policy changes, or the potential significant reduction of personal estate tax exclusions. Needless to say, every single business owner needs to understand the impact of all these things right now, so that if they wish to enact a strategy to mitigate the impact, modify estate plans or accelerate the timetable of a liquidity event, they might have time to do so before these changes go into effect. All these things can take months to accomplish, so time is of the essence for an owner to evaluate what they choose to do.
* Note: Every business owner’s tax circumstances are different, owners should consult with their tax professionals to understand clearly how an example such as this may apply to their own specific circumstances.
Business Owners should act now to understand the impact of these potential changes to be able to make informed decisions about things that will be significantly impacted by proposed tax changes. These things are important – an Owner’s future plans for retirement, their families, their legacies, their philanthropic objectives, etc., typically depend heavily on the value they can create and eventually access in their business. An Owner always has the right to make decisions and drive the bus however they choose – but all should want to drive that bus with a clear view of what lies on the road ahead.