The recent change in presidency is set to bring about substantial changes in the way high-net worth individuals are taxed in relation to capital gains. The Biden administration has proposed a plan that will essentially double the capital gains tax for those investors making over $1 million as a method of funding the $1.8 trillion American Families Plan. The goal is to eliminate the loopholes that allow Americans who make more than $1 million a year to pay a lower rate on their capital gains than working Americans pay on their work.
While the current top capital gains rate is 20%, the proposal will subject investors above the previously mentioned benchmark to a tax rate in line with the top income tax rate of 37%. However, it’s worth noting that along with the increase in capital gains tax, Biden also plans to increase the top income tax bracket to 39.6%. This will result in an overall 19.6% increase in the tax investors will face under the administration. The proposal has left many business owners around the country wondering how this change will affect their business and the overall economy.
Many people may be led to assume that the increase in capital gains taxes will only affect big businesses, rather than smaller ones. However, economic models and past history all show that significantly increasing the capital gains tax results in less capital investment, an outcome that affects businesses of all sizes. As for smaller businesses, the increase creates a hurdle to raising capital from outside investors that is needed to launch their businesses and grow. Without this capital raising, they are unable to hire workers. Also, from a revenue perspective, the proposal is self-defeating. Not only does it have negative implications on new investment, but those investors with pre-existing gains will put off the sales of their investments, resulting in less revenue. Furthermore, the proposal is estimated to impact two-thirds of overall capital investment, causing catastrophic effects on the creation of jobs and growth of the economy as a whole.
Another impact that raising the capital gains tax will have on business owners comes into play when they decide to exit their business and liquidate their life’s work, leading to a lifetime of growth taxed in a single year. For example, if a client decides to sell their $10 million business after the proposal goes into effect, they will end up paying 39.6% in taxes on the proceeds from the sale, leaving them with a little over $6 million, a number far lower than the appraised value.
With that being said, if a client is ready to sell, and the business is in a position that allows them to maximize the value right now, it could be wise to sell before the tax law comes into effect. However, keep in mind that it could take years to find the right buyer that is willing to pay top dollar for the business. Therefore, even if they choose to engage an M&A advisor to sell the business right away, it’s important to have a plan to minimize their tax liabilities in the event the sale occurs after the tax law has come into effect. Below are some different strategies your clients can use to minimize this liability:
While many advocates say the proposal will only affect high-income investors, resulting in some form of equilibrium in the taxation of low-income vs. high-income Americans, many do not see the trickle-down effects that will occur once capital gains taxes are raised. It’s important to look at the bigger picture and plan ahead so you can be prepared once the proposal goes into effect.
- Trust fund: Set up a trust fund in which they will be able to take distributions from on a monthly, quarterly or yearly basis. Putting the proceeds from the sale of a company in the trust prevents them from being taxed initially, since they have not received the proceeds yet. It is similar to a 401(k) or an IRA. The trust holds the proceeds and invests them in real estate, securities or other business ventures to generate a return to pay you back over time. They are taxed at the applicable tax rate associated with the amount they take out each year. If they take a distribution of interest the trust has earned, then they will pay ordinary income tax on said amount. If they take principal after the interest has been paid to them, then they would pay capital gains tax on that amount.
- Seller financing: Seller financing is a scenario in which the owner acts as a bank, allowing the buyer to make payments over time. Therefore, the owner will not be taxed immediately on the overall value of your company. They will be taxed in the applicable bracket based on the payment received each year. They will also earn interest utilizing seller financing.
- Earn out: Earn outs are a method of payment in which the proceeds from the business are tied directly to the performance of the company. Generally speaking, specific financial goals are set that determine the payment received each year. While this is an option that will minimize tax liability, it also carries significant risk as the payment is tied to performance. If the financial goals set in place are not met, you may not receive the proceeds initially agreed upon.
- 1031 exchange: A 1031 exchange can be useful to avoid paying capital gains tax on the real estate component of a company. The client sells an investment property and reinvests the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value. The proceeds from the sale must be transferred to a qualified intermediary, rather than the seller of the property, and the qualified intermediary transfers them to the seller of the replacement property or properties. Capital gains tax will then be deferred, thus freeing more capital for investment, and allowing the client to reap the benefits of the rental income that will be produced. This method could be paired with one of the strategies mentioned previously, allowing business owners to avoid and defer capital gains on not only the real estate, but the business as well.
- Tax strategists: Consulting a tax strategist could be beneficial in reducing capital gains tax liability when it comes time to sell a business. They can help with the allocation of the purchase price, as well as facilitating the strategies mentioned above, as many require a qualified third-party intermediary. M&A advisors are also great intermediaries to engage in order to help minimize tax liabilities when it comes time to sell. Not only will they help get the highest possible price, but many have networks consisting of tax strategists, lawyers, etc., that can help with one of the previous strategies.