If you are a business owner whose exit strategy contemplates a potential sale transaction, the current Administration’s recent revenue proposals, as explained in the “Green Book,”1 should prompt you to take current action. Specifically, some proposals have the potential to impact the ultimate net cash value you might realize from a sale transaction.
Whether the proposals as currently described in the Green Book will ultimately be enacted into law remains uncertain. However, what is more certain is that business owners who proactively evaluate and revise their strategies for these uncertainties now will be better positioned to manage the outcome.
Increased Tax Rates
The current proposals include the following increases in tax rates which may impact the after-tax cash value realized.
- Long-term capital gains and qualified dividends taxed as ordinary income rates to the extent a taxpayer’s income exceeds $1 million ($500,000 for married filing separately). It is important to note the Green Book describes this proposal as being effective for gains required to be recognized after the date of announcement.2
- Increase in highest marginal rate for individuals to 39.6 percent and lowering of the taxable income threshold at which the highest marginal rate would apply for tax years beginning after Dec. 31, 2021.3
- Increase the corporate tax rate from 21 percent to 28 percent.
Taxpayers selling their ownership interest in a business operated as a C-corporation or S-corporation will generally recognize only capital gains upon the sale of their stock. In instances where the sale transaction is structured as an asset sale, is a sale of an ownership interest in a partnership or is a sale of a sole proprietorship, a portion of the gain may be taxed at ordinary or corporate income tax rates and a portion at capital gains rates. Additionally, for the sale of qualified small business (QSB) stock, the gain on the sale of the stock may be excluded.
Therefore, changes in the capital gains, ordinary and corporate income tax rates will affect the amount of after-tax proceeds to the seller at a static sales price.
Example Illustration Capital Gains Rate - Stock Sale
| Example Illustration Capital Gains Rate - Stock Sale |
| | Currently Enacted Rates | Proposed Rates |
| Sales Price | $15,000,000 | $15,000,000 |
| Stock Basis | $1,000 | $1,000 |
| Long-Term Capital Gain | $14,999,000 | $14,999,000 |
| | | |
| Federal Income Tax on Gain (20%, 39.6%) | $2,999,800 | $5,939,604 |
| | | |
| Net After-Tax Proceeds to Seller | $12,000,200 | $9,060,396 |
Example Illustration: Capital Gains and Ordinary Rates - Asset Sale Transaction S-corporation
| Example Illustration: Capital Gains and Ordinary Rates - Asset Sale Transaction S-corporation |
| | Currently Enacted Rates | 2021 Sale with Retroactive Proposed Capital Gains Rate | 2022 Proposed Rates |
| Sales Price - Net Equity | $15,000,000 | $15,000,000 | $15,000,000 |
| Assumed Liabilities | $500,000 | $500,000 | $500,000 |
| Adjusted Sales Price | $15,500,000 | $15,500,000 | $15,500,000 |
| | | | |
| Basis in Assets | $600,000 | $600,000 | $600,000 |
| | | | |
| Total Gain | $14,900,000 | $14,900,000 | $14,900,000 |
| | | | |
| Ordinary Gain - Depreciation Recapture | $3,725,000 | $3,725,000 | $3,725,000 |
| Capital Gain - Goodwill | $11,175,000 | $11,175,000 | $11,175,000 |
| | | | |
| Liquidating Distribution of Cash to Owners | $15,000,000 | $15,000,000 | $15,000,000 |
| | | | |
| Basis in Stock | $14,901,000 | $14,901,000 | $14,901,000 |
| | | | |
| Capital Gain (Loss) on Stock | $99,000 | $99,000 | $99,000 |
| | | | |
Tax on Ordinary
(37%, 37%, 39.6%)" | $1,378,250 | $1,378,250 | $1,475,100 |
"Tax on Capital Gains
(20%, 37%, 39.6%)" | $2,254,800 | $4,171,380 | $4,464,504 |
| | | | |
| Net After-Tax Proceeds to Seller | $11,366,950 | $9,450,370 | $9,060,396 |
Example Illustration: Capital Gains and Corporate Rate - Asset Sale C-corporation
| Example Illustration: Capital Gains and Corporate Rate - Asset Sale C-corporation |
| | Currently Enacted Rates | 2021 Sale with Retroactive Proposed Capital Gains Rate | 2022 Proposed Rates |
| Sales Price - Net Equity | $15,000,000 | $15,000,000 | $15,000,000 |
| Assumed Liabilities | $500,000 | $500,000 | $500,000 |
| Adjusted Sales Price | $15,500,000 | $15,500,000 | $15,500,000 |
| | | | |
| Basis in Assets | $600,000 | $600,000 | $600,000 |
| | | | |
| Total Gain Asset Sale | $14,900,000 | $14,900,000 | $14,900,000 |
| | | | |
Corporate Income Tax on Gain
(21%, 21%, 28%) | $3,129,000 | $3,129,000 | $4,172,000 |
| | | | |
| Liquidating Distribution of Cash to Owners | $11,871,000 | $11,871,000 | $10,828,000 |
| | | | |
| Basis in Stock | $1,000 | $1,000 | $1,000 |
| | | | |
| Capital Gain (Loss) on Stock | $11,870,000 | $11,870,000 | $10,827,000 |
| | | | |
"Tax on Capital Gain
(20%, 37%, 39.6%)" | $2,374,000 | $4,391,900 | $4,287,492 |
| | | | |
| Net After-Tax Proceeds to Seller | $9,496,000 | $7,478,100 | $6,539,508 |
Generally, the fair market value of most businesses will be driven in significant part by the business’ level of earnings before interest, tax, depreciation and amortization (EBITDA). Accordingly in a very simplistic example, a business might need to operate at a level sufficient to increase its average EBITDA by more than 20 percent just to achieve the same after-tax proceeds it might have otherwise realized from a sale at current value under existing tax law.4
Example Illustration: Stock Sale - Growth for Same After Tax Proceeds
| Example Illustration: Stock Sale - Growth for Same After Tax Proceeds |
| | Currently Enacted Rates | Proposed Rates |
| EBITDA | $3,000,000 | $3,973,445 |
| Industry Multiplier | 5 | 5 |
| Estimated Market Price | $15,000,000 | $19,867,225 |
| | | |
| Stock Basis | $1,000 | $1,000 |
| Estimated Long-Term Capital Gain | $14,999,000 | $19,866,225 |
| | | |
| Federal Income Tax on Gain (20%, 39.6%) | $2,999,800 | $7,867,025 |
| | | |
| Estimated After-Tax Proceeds | $12,000,200 | $12,000,200 |
Additionally, while EBITDA is a pre-tax measurement which in itself would not be directly impacted by tax rate changes applicable to operating income, an increase in the tax rate applicable to annual earnings would potentially impact cash flows to support borrowing, expansion and returns to investors. As a result, the ordinary income tax increase may indirectly influence market pricing altering the multiple of EBITDA potential acquirors are willing to pay.
A Clear Call to Action
Business owners may decide to employ varying strategies in response to the current proposals and corresponding uncertainties they create. Some business owners whose exit plan contemplates a sale in the next few years may choose to alter their timeline and accelerate a sale into the 2021 year. Owners with a longer-term exit plan might explore other planning options, such as meeting requirements for qualified small business stock gain exclusions. Transaction terms and structuring may also be utilized as planning tools.
Which planning tools are best suited for each business owner’s unique strategy will vary depending upon their overall objectives, facts and circumstances. While each business and business owner are unique, all business owners stand to benefit by taking action now to understand how current tax policy proposals may impact them and assessing their options.
How DHG Can Help
At DHG, we understand that a successful transition of your business is one important piece of a bigger picture. While tax may be part of the puzzle, it isn’t the only piece that’s needed to design and execute a strategic plan that completes the whole picture.
DHG and its affiliates have dedicated teams of professionals with the relevant knowledge and experience in tax as well as other facets of a well formed and executed plan. For more information, reach out to us at tax@dhg.com.
Footnotes
[1] General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals. Treasury’s general explanations of an Administration’s fiscal year revenue proposals have commonly been known as the “Green Book.” The Fiscal Year 2022 Green Book may be viewed here.
[2] This statement in the Green Book is generally interpreted as referencing April 28, 2021, as the proposed effective date since this was the date of release of the American Families Plan fact sheet, which included the capital gains tax increase.
[3] Under current law the highest marginal rate for individuals is 37 percent for tax years beginning before Jan. 1, 2026.
[4] Assumes all gain subject to single level taxation, at long-term capital gains rate and increase in applicable capital gains rate of taxpayer from 20 percent under current law to 39.6 percent under proposed.