We’ve all heard that the proverbial webs we weave in life and business are tangled. But as a business owner, the “psychological web” behind your financial and business decisions can be downright convoluted, especially in our current state of impending legislative change. Seller psychology is easily influenced by things like the power of suggestion, political commentary, and personal thoughts and beliefs. And that intricate combination, among other variants, is what has some of us feeling like prey trapped in that tangled web. In the business valuation world, potential changes ahead for capital gains rates are what’s keeping many business owners suspended there.
What are capital gains, and how are they taxed?
Let’s start with the basics. An investment is an asset that increases in value during your ownership. A capital gain is the profit you earn when you sell an investment, which is calculated by determining the difference between the original cost (basis) and the sales price. If the difference between the cost basis and sales price is negative, it’s a capital loss. Net short-term capital gains (those held less than a year) are generally taxed at ordinary income rates. Long-term capital gains (those held more than a year), on the other hand, are subject to a special capital gains tax rate, which determines how much of that profit stays with you, and how much will go to the IRS to satisfy the related tax obligation.
When the investment for sale is your business, things get a little trickier. A business is made up of multiple assets, so each asset is treated as a separate sale for the purpose of determining capital gain or loss. And inventory, stocks and investments, and physical, land, and equipment have their own tax calculation requirements, and each affects your ultimate tax liability.
How are proposed capital gains rate increases affecting seller psychology?
Currently, the top federal capital gains tax rate is 23.8% [20% federal capital gains plus 3.8% Net Investment Income Tax (NIIT)]. Whether and at what state capital gains tax rate you’re required to pay depends on the applicable state laws. Massachusetts imposes a 5% capital gains tax, which brings that top rate up to 35.8%. On a $10 million sale, a Massachusetts-based business owner stands to go home with around $6.4 million in profit after capital gains tax.
Changes in capital gains tax rates can have a significant effect on a business owner’s profit from the sale of their business. No one enjoys paying more taxes or making less money, but the potential for a multi-million dollar difference in your business’s price tag is enough to make anyone hesitate or start to second-guess. Let’s look at a simplified, representative example of the potential effects of recently proposed changes in capital gains rates on the same business owner’s profit.
In April, the Biden Administration proposed to change the top federal combined capital gains tax rate to 43.4% (39.6% federal, 3.8% NIIT) on those whose income exceeds $1 million. Under Biden’s initial plan, the same owner of a Massachusetts-based business could face a capital gains tax obligation as high as 48.4% (43.4% federal combined plus 5% Massachusetts). On a $10 million sale, that drops the business owner’s profit after capital gains tax down to around $4.5 million.
Under the latest plan placed into circulation by the House Committee on Ways and Means, the top federal combined capital gains rate would be 28.8% (25% federal capital gains, 3.8% NIIT) and would apply to gains realized after September 13, 2021 (not retroactively to April as previously proposed).
The House Democrats’ proposal would also lower the income thresholds at which the top capital gains rate applies starting in 2022 ($400,000 for single taxpayers, $425,000 for heads of household, and $450,000 for married couples filing jointly). However, for households making more than $5 million in a year, there would be an additional 3% surtax, which results in an effective capital gains rate of 31.8%. For that same Massachusetts-based business owner, the highest capital gains tax obligation would be 36.8% (28.8% federal combined capital gains, 3% surcharge, plus 5% Massachusetts). On a $10 million sale, you’re looking at about a $5.6 million profit.
How do the potential changes tie into succession planning and business valuations?
The main catalyst behind this particular brand of unrest is the fact that, at present, all we have to go on are vastly varying proposals and rhetoric. Ultimately, some unrest can be expected until we have legislative proof of the actual changes to the federal capital gains rates.
Psychology compels us to weave a decision-making process that’s more leaden than gossamer. History tells us that significantly increasing the capital gains tax can lead to less capital investment in general, which is a ripple that businesses of all shapes and sizes would feel. Additionally, investors with pre-existing gains may be more inclined to put off the sale of investments, and that behavior doesn’t exclude business owners and their plans to sell their businesses. The result? More than a few M&A deals and exit and succession plans will be interrupted, suspended in the same tangled web as their owners.
Whether the proposed increases mean now is the best time to sell or to wait and see can only be determined on a case-by-case basis. But exiting your business is inevitable, and doing it on your own terms or at the right time in life has value too. If your heart isn’t in your work any longer, hanging on to your business can lead to complacency… and that could have a significant effect on your business’s future value as well.
How is LGA uniquely qualified to help?
LGA’s Business Valuation, Succession Planning, Business Tax Teams help sellers break down each asset and price allocation appropriately, and ensure you are taking advantage of all the tax benefits and deductions available to you.
As a CPA and a certified valuation analyst (CVA), I can help you with tax, business valuation, and succession planning techniques that provide you with alternative means to break free from the web holding you and your plans hostage.
I help clients determine whether certain tax strategies, such as 1031 like-kind exchanges, trusts funds, or seller financing options, could help reduce their capital gains tax liability. And, if your plans for retirement or a family transfer are in limbo, I want to help you think outside the box as you rethink your succession plans. If you’re ready to untangle the web, contact me today.
Frank is a Partner at LGA and the head of the firm’s Business Valuations Group. He provides business valuation services to companies whose needs arise from issues such as business growth or disputes, M&A or shareholder transitions, and trust and estate matters or divorce. Clients also call on Frank to support their business growth through business advisory services such as budgeting and forecasting, benchmarking and KPIs, and tax consulting and compliance for privately-held businesses and their owners in an array of industries.