M&A Challenges with New Tax Proposals Looming
Business owners often approach their CPAs, attorneys and advisors to develop exit strategies to maximize their financial well-being. One such strategy is the ultimate sale of a business to a third party. Often times, the value generated from the sale of a business to a large competitor or private equity firm can be the most lucrative for the business owner.
Important factors to consider when selling a business include fair market value, deal structure, as well as income tax rates. With the release of the Biden Administration’s Green Book, a large monkey wrench has been thrown into the equation as substantial retroactive capital gains rate increases have been proposed. These proposals could have the potential to squash deals in progress.
Tax Strategies
Business sales are frequently structured in a tax efficient manner with two goals in mind: create long-term capital gain income for the seller while allowing the buyer to amortize the value of the purchase over time. This strategy allows buyers to generate ordinary income tax deductions while the seller maximizes the amount of gain taxed at preferential rates. In this scenario, both parties tend to walk away from the deal satisfied.
Currently, long-term capital gains on assets held over one year are taxed at a maximum federal rate of 20% with the sale of a business typically excluded from the 3.8% Net Investment Income tax (NII). Under the current proposal, long-term capital gains would be subject to a 43.4% (i.e., 39.6% + 3.8%) federal tax rate to the extent that a person’s gross income exceeds $1M ($500K for taxpayers filing separate returns) each year.
WM Wisdom:
While $1M may seem like a large threshold to exceed, taxpayers experiencing one-time life events such as the sale of a business are likely to meet that threshold and be taxed at a 43.4% rate. Since many business owners often have low basis in their business asset (perhaps as a result of annual income tax planning), a substantial portion of the sales proceeds received may be subject to a much higher capitals gains rate.
The Green Book also contemplates that the capital gains rate increase would be retroactively applied to April 2021 to allow the Administration to balance their proposed budget. Any retroactive application would have a significant impact on deals currently in a due-diligence phase; or worse, deals that have already closed after the prospective effective date.
WM Wisdom:
The sale of a business is a process that takes a considerable amount of time and effort. M&A deals require careful negotiations, due diligence studies, and financing considerations which often lead to a process that can take many months. Sellers will typically involve their financial advisors who have the ability to analyze whether the sales transaction can fulfill their lifetime financial goals. Deals that started with simple discussions in late 2020 could conceivably be finalized during the summer of 2021. A retroactive 117% capital gains rate increase (20%/43.4%) would have a significant impact on the seller; to the point that they may opt to not finalize the deal. Buyers, on the other hand, will remain largely unaffected against retroactive tax rate increases.
Contemplating a Sale
Let’s look at a simple illustration to quantify the impact of a capital gains tax increase on the after-tax proceeds from the sale of a family owned business structured as a pass through-entity (i.e. S-corporation or Partnership). For simplicity’s sake, we will assume that 100% of the gain is classified as long-term capital gain.
The proposed law would see an additional $2.1M of taxes generated reducing the seller’s after-tax proceeds from 2M to nearly $6M.
WM Wisdom:
Sellers in the midst of an M&A negotiation are urged to prepare “what if” scenarios to determine the range of after-tax proceeds should the proposed changes in capital gains rate become effective during 2021. One alternative is to insert gross-up language within the sales agreement to compensate the seller for any retroactive changes to the tax code. This issue should be on the forefront of any due diligence process with the tax rates no longer being a known quantity. In the illustration above, the seller would simply lose $2.1M of value with the buyer being unaffected. This $2.1M shortfall may interfere with seller’s financial plan.
Considerations
- Sell before year-end: Many experts believe that retroactive gains will not become law. However, many do believe that there will be rate increases effective 2022. If contemplating a business sale, time is of the essence. With M&A deals routinely taking six months to finalize, business owners looking to sell during 2021 should begin the process ASAP in order to close by year-end.
- Fair Market Value: The importance of understanding FMV is more important than ever. An increased tax rate environment will typically impact the valuation of a business.
- Negotiations: Sellers should not be afraid to walk away from a deal. Higher tax rates equate to less after-tax proceeds. Less after-tax proceeds make it difficult to satisfy your financial goals. Tax gross-ups can be a great way to protect against retroactive rate hikes. However, many buyers may not be willing to absorb the entire tax cost so this should be a careful negotiation.
- Tax Strategies:
- Consideration should be given to installment sales. These can be an effective tool to keep annual income under the $1M threshold and thus avoid the increased capital gain tax rates. Alternatively, if the law is not applied retroactively, sellers may consider opting out of installment sale treatment in order to maximize the best tax rates possible during 2021. Please keep in mind that there are risks to each strategy and careful analysis should be taken when evaluating the best path forward.
- Taxpayers with C-corporations may qualify for 1202 stock treatment. In these unique situations, the seller may be able to exclude 100% of the gain on the sale of their business. Moving forward, many start-ups should consider the C-corporation vehicle as a possibility to avoid 43.4% capital gains rates.
Ready for an Exit Strategy?
If you’re contemplating an exit strategy, the Wouch Maloney team is ready to assist with the goal of protecting your wealth in order to meet your lifetime financial goals. Contact us to discuss your needs today.
Suzanne Feldman, CPA, MT and Sweta Joshi, CPA contributed to this article.
DISCLAIMER: The WM Update, WM Wednesday Wisdom, WM Daily Update COVID-19, COVID-19 Business Resources, COVID-19 Client News Alerts and other related communications are intended to provide general information, including information regarding legislative COVID-19 relief measures, as of the date of this communication and may reference information from reputable sources. Although our firm has made every reasonable effort to ensure that the information provided is accurate, we make no warranties, expressed or implied, on the information provided. As legislative efforts are still ongoing, we expect that there may be additional guidance and clarification from regulators that may modify some of the provisions in this communication. Some of those modifications may be significant. As such, be aware that this is not a comprehensive analysis of the subject matter covered and is not intended to provide specific recommendations to you or your business with respect to the matters addressed.
