How Might a Capital Gains Tax Increase Affect the Sale of Your Business?
If you follow tax news, you’ve probably been seeing a lot of headlines about possible tax increases on capital gains. President Biden talked about increasing the tax rates on capital gains throughout his campaign, and he recently provided a few details on the subject in a Treasury document that explains his revenue proposals. The statements have raised plenty of questions among business owners who might be considering the sale of a business. The problem is that it’s hard to come up with definite answers when there aren’t a lot of details available about how the president would implement his proposed changes. If you’re considering the sale of a business, here’s a brief overview of what we know about the Biden proposals at this time, along with some thoughts about next steps for potential sellers.
Biden Capital Gains Tax Proposals
In the general explanations of the Biden administration’s tax proposals, there are two key changes for capital gains taxation:
- Increasing the federal capital gains rate to 43.4% for taxpayers with adjusted gross income over $1 million. Not only would President Biden’s plan increase the capital gains tax rate from 20% to 37% (or 39.6%) if the proposal to increase the top individual income tax rate is also enacted). It would also keep in place the 3.8% tax on investment income that was enacted to fund the Affordable Care Act. (The Tax Foundation has published a map indicating what the combined federal and state rates on capital gains would be under current rules in each state.) If enacted as described in the document, the rate hike would take effect for gains recognized after the “date of announcement.” This appears to refer to April 28, 2021, the date that the Biden administration released its description of the American Families Plan that mentioned the rate hike.
- Eliminating the income-tax-free aspect of “stepping up” basis for gains in excess of $1 million per person by ensuring the gains are taxed if the property is not donated to charity. The explanation does include some proposed protections for family-owned businesses and farms that are given to heirs who continue to run the business, but at its core, the proposal represents a significant shift from decades of U.S. estate tax policy.
While these proposals provide us with some clear statements on President Biden’s intentions to increase taxes on capital gains, it’s way too early to assume that they will become law as written. It’s safe to assume that these proposed changes will be subject to considerable congressional debate. If any change actually does become law, it could look significantly different than what has been discussed so far. With so much uncertainty about where this debate is headed, how should these proposals influence investment and tax planning for individuals and businesses that might be affected?
Keep in mind that there are a variety of possible outcomes, including:
- After much discussion and debate, no changes are made.
- Taxes are increased in some manner, and the changes are retroactive to a date prior to the enactment of the law.
- Taxes are increased in some manner, and the changes are effective as of the date that the law is enacted.
- Taxes are increased in some manner, and the changes are effective as of some date after the law is enacted, possibly even phased in over several years.
Selling a Business
Many of the individual tax returns that include annual income in excess of $1 million are filed by business owners who are selling all or part of their enterprise, often to fund retirement. If you are one of those business owners and are within a few years of selling, it’s time to run some numbers. Given the lack of specificity in the proposed increases and the uncertainty about what any final changes might look like, you’re not going to be able to nail down anything for certain. But if you’ve been working toward a number that you need to get out of the sale of your business to fund retirement, you can model out how a few different proposed changes might affect that number. That means asking questions like the following:
- If the capital gain tax rate goes from 20% to 40%, how much higher does the sale price of my business need to be in order to deliver the number I need to retire?
- If current trends continue, how many more years would my business need to grow in order to reach that larger number?
- If changes were enacted, how much would I be able to get for the business if I sell before the increase takes effect? Or, would a buyer be wiling to pay more for the business to offset the increase in capital gains tax if the deal closed after the effective date of the rate change?
If you’re already thinking about selling, the keys to success that we described in a previous article will still apply whether the tax rates change or not. If you run the numbers and you decide that you want to test the market and put your business up for sale before the end of 2021, you need to start assembling your team and preparing your documentation now. Getting a deal done before year end would be tight but not impossible. Even though the current Biden proposal suggests a retroactive effective date, there’s no guarantee that any final legislation would make changes effective in April 2021. If you want to close the sale of your business before the end of this year out of concern that rates could be higher in 2022, you need to start the process as soon as possible. Also, depending on how many owners reach the same conclusion, you should be prepared for the possibility that a lot of businesses could be on the block in the same time frame, making for a buyer’s market.
Any changes in tax treatment could lead to modifications in the way that deals are structured, too. From a seller’s standpoint, a buyout over time may become more attractive in order to reduce the gain recognized in any one year. Tax rate changes will affect the comparative costs of stock versus asset sales. When considering a potential sale, you’ll want to model out more options, especially if you’re trying to plan based on the relatively vague language of the proposals as currently written. The situation may become clearer if and/or when legislative language becomes available, but even then everything is subject to change until a bill becomes law.
Focus on the Long Term
It’s important to remember that this is all based on just a few words in a Treasury document that provides a broad narrative description of proposed changes. We don’t even have the specifics of proposed legislative language to evaluate at this point, much less an actual law to interpret. You don’t want to jump to any conclusions today based on what may or may not happen.
However, this is an excellent time to proactively model out how different scenarios could affect the potential sale or purchase of a business. Test out the potential impact of various capital gain tax rates on the sale of your business. If you need to make a certain dollar amount on the sale in order to fund your retirement, look at the positive impact of growth over the next few years compared against the increased cost of various tax rates. By focusing on your long-term objectives while proactively preparing in the present, you can best set yourself up for success when it is time to sell.
If you would like to learn more about planning for the transfer of your business and modeling out the impact of different capital gain scenarios, please contact your KSM advisor or fill out this form.
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