We have all heard the saying that “nothing is certain in life but death and taxes.” For business owners who are looking to retire in the next few years, either one severely impacts their planned exit and retirement outcome. The first is obvious, but hopefully will not happen and is probably out of the owner’s control if it does. But not so obvious, and which can be managed by the business owner, is the impact of changing tax laws on the sale of their company.

The Bush tax cuts that generally lowered tax rates had sunset provisions making them expire at the end of 2010. This included a reduction of the individual’s capital gains tax rate from 20% to the current rate of 15%. As you know, through great political pressure brought on by conservatives in Washington, President Barrack Obama extended the sunset for two years, making the expiration date December 31, 2012. Thus without extraordinary action and unexpected legislation from the current Congress and White House, the federal capital gains tax rate will return to the 20% level on January 1, 2013. On top of that, capital gains will be subject to an additional 3.8% Medicare tax imposed by Obama’s health plan, resulting in a total capital gains tax rate of 23.8%. Of course, tax rates can change even further over the next year or two, but it is very unlikely that they will decrease.

As we consider and project future tax rates, it is helpful to review historical capital gain rates. The top federal rate on long-term capital gains was reduced from 35% to 28% in 1978. Over the next 25 years, the rate see-sawed between 20% and 28% before declining to the current 15% rate in 2003. Given the Super Committee’s debt reduction mandate and the discussion of the “Buffet Rule” which arguably involves increasing tax rates on capital gains and dividends, another extension of the 15% long-term capital gains tax rate seems unlikely.

As mentioned earlier, the federal long term capital gains rate is scheduled to return to its pre-May 2003 rate of 20% on January 1, 2013. Also beginning on January 1, 2013, the national health care reform legislation applies a 3.8% Medicare tax on capital gains and investment income for single taxpayers with income over $200,000 ($250,000 for married taxpayers). Thus, for every $1,000,000 in gain on the sale of your business, business owners will pay an additional $88,000 in tax in 2013 and beyond.

How does this impact your retirement and exit planning?

Let’s take an example of a business sale generating a $10 million capital gain to the owner in each year 2012 and 2013:

What this illustrates is that you would pay approximately 59% more in capital gain taxes in 2013 over 2012 assuming no change in tax laws. If we reverse the math, it means that you would have to sell the business for $1.15 million more to generate the same after tax cash in 2013 as you would have received if you had sold it for $10.0 million in 2012. This computes to an 11.5% increase in equivalent sale price, which in reality may take the business owner much longer than a year to achieve in higher value in order to net the same after-tax proceeds.

We believe that as the tax impact of the expiring capital gain tax rate will become more apparent as the year 2012 unfolds, many business owners who are planning to retire over the next several years will accelerate their plans in order to maximize their after-tax cash value of their business. This may result in an unusually large number of businesses offered for sale in the latter half of the year. And as economics has taught us, an increase in supply can lead to a reduction in prices, so savvy business owners may be smart to begin the process sooner rather than later.

It is also important to allow adequate time to sell your business. The entire process of selling a business generally takes between six to twelve months and can be very complicated. And since we are less than 15 months away from the 15% expiration date, the window will close fast and get crowed. If you are considering selling your business in the near future, we recommend that a business owner contact a tax advisor and an investment banker as soon as possible.

BY JIM SOWERS AND STEVE ZACHARIAS

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The professional team at Transact AOCP would be glad to meet with you on a highly confidential basis to explore your options in this regard. Please contact any member of Transact AOCP team if you would like to meet for this purpose. We will also give you some general business valuation guidance at absolutely no charge during that meeting.

About Transact AOCP
Transact AOCP is a mergers and acquisitions advisory firm focused on serving closely held companies with less than $100 million in revenues. Our team combines decades of transaction-related expertise in the areas of business transactions, valuations and equity recapitalizations.   Securities offered through Alpha Omega Capital Securities a FINRA – SIPC member firm.