In 2021 substantial noise was made in Washington, D.C. regarding various tax increases, notably a proposed large increase in capital gains tax rates. Although it’s likely that whatever passes will not be quite as high as proposed by the current administration, it’s becoming evident that an increase in the capital gains tax rate is coming, and even if it doesn’t pass, the speculation alone is still influencing transaction activity and will likely continue to do so for the foreseeable future.
Capital Gains Taxes
The Biden administration’s proposed capital gains tax increase will impact any transaction occurring after the Build Back Better act takes effect, if passed. The first portion of changes in what is dubbed Biden’s “Green Book” posits that for taxpayers whose income exceeds $1 million, long term capital gains as well as qualified dividend income will be taxed at ordinary income tax rates for the respective taxpayers.
Additionally, the proposed plan suggests that transfers of property among partnerships, trusts, and other similarly classified entities would now be treated as taxable transactions. Investment professionals receiving carried interest with income over $400,000 will now see their carry treated as income rather than capital gains and be taxed at ordinary income rates.
The plan also proposes that all business income of high-income participants in businesses who have historically had more passive roles and therefore not been treated as employees, such as limited partners and LLC members, be subject to at least an additional 3.8% tax derived from a self-employment tax in addition to other income tax increases. Additionally worth noting, the plan proposes to raise the corporate tax rate from 21% to 28%, which will also tremendously impact how deals are structured, if implemented.
As a result of all these impending increases, many sellers have rushed to sell their businesses and other assets, making for robust activity in M&A. Buyers have taken notice of this as well and have adjusted their strategy to gain the upper hand with desperate sellers eager for a quick deal. While the tax plan did not pass by the end of 2021 as originally expected, we highly recommend that those thinking of selling their businesses begin planning now.
What To Consider
While there are many aspects of planning a business sale (a more exhaustive list of things to consider can be found here), here are five key items to consider with respect solely to the impending capital gains tax increases:
- Timing: First and foremost, and most obvious, consider the timing of a deal close and plan for a close before the increase in capital gains is expected to go into effect. While many doubt that anything will be passed before April 28, it is safe to go ahead and plan to have your transaction closed at the latest within a month of that date.
- Avoiding Any Form of Deferred Payment: When structuring your deal aim to avoid deferred payments such as earn-outs, escrows, or installments as much as possible. Even if the deal closes before the tax plan passes, any associated income or payments related to the transaction collected after the passing of the tax bill will be subject to the new taxes.
- Allocation of Purchase Price: When using a valuation as the basis for a transaction, with the new proposed tax plan it may be favorable for both the buyer and seller to allocate as much as possible to PP&E, inventory, and accounts receivable. This may seem strange at first, but this allocation will give the new buyer as many deductions as possible in the early years of owning the business, which they should in turn reward the seller for with a more favorable purchase price.
- Consider a Tax-Free Merger: With the impending tax plans it will become increasingly advantageous—especially on larger transactions—to explore tax-free mergers or similar ventures with less tax implications as opposed to a straightforward sale.
- Place Less Emphasis on Profitability Pre-Sale: While it is traditionally advised to make efforts towards growing profitability in your business prior to pursuing a sale, with the corporate tax rate possibly increasing from 21% to 28% it may be advantageous to consider making this less of a priority and favoring growth in other areas of the business.
Although it is uncertain what will pass and what exact rates will be, it is almost certain that the longer business owners wait to sell their businesses, the less cash they will walk away from the deal with. Taking proper action beforehand could not only save sellers tremendous amounts on taxes, but could also result in a much more generous offer from a buyer as there is incentive on their end as well.
Written by Julien Meyer
At NorthStar, we work with sell-side businesses every day, helping them to arrive at a proper business valuation, attract qualified buyers, and structure deals to their advantage.
Schedule a Free Consultation with an M&A Advisor Now.
3 World Trade Center
New York, NY 10007
1111 Brickell Avenue
Miami, FL 33131
1925 Century Park East
Los Angeles, CA 90067