One of the most important issues that business owners face is the impact of the capital gains tax when they sell their companies. If you were fortunate to have sold your company before January 1, 2013, you need to read no further. Either by luck or great planning you were able to exit your business when cap gains taxes were at historic lows.
For the rest of you who still are sitting with the vast majority of your net worth tied up in one asset – your business – you need to carefully consider the future of capital gains taxes. We are often asked by business owners who missed the window to sell in 2012, “Where are capital gains tax rates heading?” We would love to be able to answer that question definitively. However, if history is any indicator of future trends, it is a safe bet that capital gains taxes will be going higher BEFORE they ever drop again.
The American Taxpayer Relief Act (ATRA) was passed by Congress at the beginning of 2013, and among the many components of the bill, the cap gains tax was raised from 15% to 20% for individuals making more than $400K annually and $450K for married couples. This does not count the Medicare tax on investment income of 3.8% for individuals with income higher than $200K ($250K for married couples). At the start of negotiations, the pain of this increase could have been much worse as the upper income level was originally set at $200K.
So that is good news; the bad news is this: As the search for new revenue expands, how high could capital gains taxes go? And what implication does that have for owners of privately held companies?
The president has already gone on record as saying that in addition to spending cuts, he will also be “seeking additional revenue” in 2013 and beyond. In fact, the original agreement that the president and Speaker Boehner ironed out in mid-December actually had $1.3 trillion in new revenue as opposed to the $600 billion that the final agreement contained. As you can see, based on the president’s original goal, ATRA is several hundred billion dollars short in new revenue.
Given our current and growing national debt, is it safe to assume that we will quite likely see increased and new taxes in the coming years? Obviously the answer to that question is yes. One of the favorite taxes used to generate funds has traditionally been the capital gains tax. Even though the current rate of 20% on upper income folks seems high, if you look at the past record of cap gains taxes, we are still at the lower end of the range.
Historically, the capital gains tax has actually been much higher than 20%. In fact, from 1917 to 1921 the highest cap gains tax rate was more than 70%, and for several years in the 1930s the rate was nearly 40%. The post-World War II average is approximately 25.5%. Even though 20% sounds painful in 2013, it has been much worse.
What does this mean for the owner of a privately held business? The implications are pretty dramatic: If you expect capital gains tax rates to increase, how does that impact your exit planning? Obviously no one wants to pay more than 20% of their hard-earned investment income in taxes. But what about 25% or 30%? As you can see from the chart above, not long ago cap gains taxes were well above that range.
The decision to exit a privately held company needs to be based on more than just cap gains taxes. The reality is you need to sell when the market is ripe, when buyers are active, and when cash on corporate balance sheets is abundant. However, your tax advisor would probably also counsel you to consider that timing can impact how much you retain post-sale.
Since we are not tax experts, you should meet with your advisor to discuss your specific situation. What we are experts in is finding premium buyers for our clients. And given the M&A market right now, we are having success in helping entrepreneurs diversify their holdings.
If you would like to learn more about how you too can protect your most valuable asset and retain as much as possible when you do sell, you need to attend a Generational Equity M&A conference. We hold these throughout North America, and they are designed to help business owners learn how to navigate the M&A process. These workshops are complimentary and no-obligation, and we are often told by business owners that the hours they invested to attend are the best use of their time in years.
No matter what, don’t bet that capital gains taxes will go down anytime soon.
Carl Doerksen is the Director of Corporate Development at Generational Equity.
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