The Wall Street Journal reported last week that President Biden plans to propose an increase in the capital gains tax for taxpayers earning more than $1 million from the current 20% to 39.6%, which, when added to the Obamacare 3.8% surtax, would tax capital gains for most selling business owners at nearly 44% (not accounting for state capital gains taxes). For states like New York and California with higher tax rates, this would equate to an overall tax burden on a sale of over 50%.
There are several unanswered questions about this potential tax increase, most notably whether it will have enough support in the House and Senate to pass (Goldman Sachs believes there will likely be a compromise at 28%, the capital gains tax rate of a few years ago before being reduced to the current 20% rate). It is also unknown whether this tax would be retroactive to the beginning of 2021, or would be effective only for capital gains earned after January 1, 2022.
For most business owners looking to sell, an increase of this magnitude will be significant. An owner selling his or her business worth $25 million would face an additional tax of almost $5 million. Instead of having after-tax cash of $20 million (before any state taxes or the Obamacare 3.8% surtax), under this new proposed increase, an owner would end up with approximately $15 million.
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The question for many business owners will be whether they should start their sale processes now to attempt to close before 2022. There are several factors to consider.
First, every business owner should work with a financial planner to prepare a personal financial plan to determine how much after-tax cash they require to support their retirement and other objectives.
Second, business owners should work with a valuation firm or investment bank to understand the current estimated value of their business and how much cash they should expect to receive upon the closing of a sale of their business (even though a company might be worth $25 million, most transactions will not provide 100% cash at closing). With this estimate, an owner can work with their tax planner to run different scenarios to determine whether this new proposed capital gains tax would reduce their cash at closing to a level that would not support their goals.
If the owner determines with their tax planner that their after-tax proceeds under a higher capital gains tax will not support their goals, then they should consider accelerating their time to go to market (assuming the proposed tax is not retroactive). Alternatively, I would expect some owners who are not quite ready to sell to potentially delay their sales under the hope that these rates decrease over time with a new administration.
It is now late April, so an owner would have 8 months to start and close a sale process – not impossible, but it would be a sprint to do everything correctly. An owner will need to hire an investment bank, prepare their go-to-market and due diligence materials, contact buyers, and then work through a letter of intent and the closing process. In a normal transaction environment, we advise business owners to expect their sale process to take between 6 to 12 months.
Assuming a large number of business owners conclude they will need to accelerate their plans, it will become more challenging to find advisors who have enough time and bandwidth to manage the influx of transactions, and it is likely many buyers will have their plates full with transactions, thus further limiting the number of opportunities available. As the end of 2021 nears, the pressure on buyers, sellers and advisors will accelerate.
As a result, it is critical for business owners seeking to sell before the end of 2021 to get started now and to prepare their business for the rigors of a transaction. If you would like to discuss your own plans, please don’t hesitate to reach out – we are here to help. You can reach us at chris@classvipartners.com.
AUTHORED BY:
Chris Younger | Managing Director | Class VI Securities, LLC | Class VI Family Office, LLC
Chris co-founded Class VI in 2005 with a mission to Enable the Entrepreneurial Spirit. Sharing a passion for what entrepreneurs mean to our community, Chris and his business partner David Tolson felt they could do a better job for business owners and have had a great time helping clients ever since.
Prior to Class VI, Chris spent more than 20 years gaining experience in executive management, marketing, sales, law, and mergers and acquisitions.