By Kyle Francis
As if this past year hasn’t been enough of a rollercoaster, capital gains tax have the potential to almost double from 20% to 39.6% for profits made on the sale of stock or property for people who make more than $1 million in income. While 2022 may feel like a lifetime away, it leaves a narrow window for business owners to decide if now is the right time to consider retirement before the increase kicks in. No matter your industry, a qualified advisor can help you decide if it’s time to hang up your proverbial hat.
The capital gains tax rate has been low for the last 20 years and was on a course to eventually increase regardless of the pandemic. However, the pandemic has accelerated the need to up capital gains taxes to cover some of the massive revenue shortfalls. While the Paycheck Protection Program was a lifesaver for businesses, this and the many other COVID-19-related programs come at a cost. Putting $5 trillion into the economy only quickened the government’s trajectory for spending more than it’s earning. Regardless of who is in the Oval Office, it is more bearable for politicians to tax businesses and higher income earners rather than taxing individuals to cover the deficit we are facing.
The impact of selling your business can be minimized by closing the sale before January 1, 2022, to pull from stock losses and other investments that have declined in value, and using an installment of the sale to keep your taxable income below $1 million. As an example, the projected increase would reduce the net profit from the sale of a business valued at $3 million by $600,000 on the first day. While the value of your business won’t be affected, your net takeaway will.
Option 1: Stick your head in the sand
Sure, it can be easy to pretend it’s all going to fade away, but after so much speculation, we now know that an increase is coming. If you weren’t planning to retire during this time, be sure to understand that the amount taken out of your business as net income distributions is going to go down. These distributions are generally taxed at the capital gains rate as well.
Option 2: Act fast
And by fast, I mean yesterday. Seven months is plenty of time to grease the wheels and make something happen since the increase won’t likely be retroactive. This leaves time to get the best possible outcome for both the buyer and seller. Just first ask yourself: What is it going to cost you financially and emotionally? Is saving $100,000 on the sale of your business worth it to get a quicker transaction and what would that mean for the way that you are living your life? For example, let’s say you own a car wash that is worth one million dollars and no debt. It may make sense for that owner to consider a transaction this year as they would be able to net an additional $150,000 on the sale of the business because the capital gains rate is lower. On the other hand, maybe the owner loves operating the business and is not wanting to sell their business until some point in the future. They make this decision knowing that they will net less in the new tax environment.
Option 3: Diversify
Selling to a group – whether that’s a dental service organization or a conglomeration of any business – allows you to trade the 100% stake that you own for a certain amount of equity in the group that now owns your business and is compiling it with many others. One of the benefits of completing this kind of transaction is that it is not recognized as a taxable event under Section 721 of the IRS code. Just like a 1031 exchange for properties, a 721 exchange allows you to roll equity from the business that you currently own into a stake with a larger organization that owns the same kind of assets with no immediate tax consequences as you are allowed to defer those gains until a later date when they will be realized. This lowers your risk by not putting all of your eggs into one basket (the business you currently own) and rather keeping a smaller percentage of a much larger organization working for you. This is very similar to the difference between owning a single stock (like your business) and a mutual fund that owns many kinds of assets.
Yes, an increase in capital gains taxes is a hard hit for businesses that are now seeing numbers in the green, but the mergers and acquisitions landscape is looking up during this time. Those with money are looking to spend it. Some industries right now are seen by private equity groups as attractive investment opportunities. Additional taxes cutting into profits before it is time to sell may drive business owners to seek an affiliation or exit sooner rather than later.
The buyers of these businesses are going to be faced with the same type of tax environment over the coming years, but what is unclear is if that will affect valuation or not. Some of this may depend on how long the tax increase will last but with the high level of competition and the dry powder ready to be put to work, a higher tax rate on an investment might not affect valuations dramatically.
Even if you aren’t completely sold on retiring before the end of 2021, talking with your advisor and figuring out what your options are will only put you in a better position for when you are ready to sell your business. You can also consider working with a broker who will help you explore other financial options during this time, such as renegotiating a lease, rental rates or other concessions as commercial real estate also takes a hit during these uncertain times. Only time will tell the rest.
About the author: Kyle Francis
Kyle Francis is founder and CEO of Professional Transition Strategies, created to facilitate the sale of over 350 dental practices as a buyer’s representative, seller’s representative, or as a transaction broker.
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