The individual income tax rules and regulations have had a lot of changes in the last few years, and it appears we might see more changes by year-end.
One hot topic is a potential change in the capital gains tax rates. Long-term capital gains have enjoyed lower tax rates during the last several years, ranging from a minimum of zero percent to a maximum of 23.8 percent, which includes the 3.8 percent net investment income tax (NIIT) rate. Under current rules, NIIT does not apply to business income where an owner materially participates producing a maximum capital gains rate of 20 percent with respect to the sale of certain business assets.
Under President Biden’s proposed tax plan, long-term capital gains for married filing joint tax filers making more than $1 million would be raised to the maximum income tax rate of 39.6 percent. NIIT also would apply to business income of high-income individuals. These changes would result in a combined tax rate of 43.4 percent (39.6 percent + 3.8 percent NIIT).
The House Ways and Means Committee recently issued its proposed changes, which would increase the long-term capital gains rates to 25 percent. NIIT also would apply to business income of high-income individuals. In addition, there is the introduction of a surcharge tax of 3 percent for taxpayers who have modified adjusted gross income greater than $5 million for married filing joint filers. This creates a potential combined tax rate of 31.8 percent (25 percent + 3.8 percent NIIT + 3 percent surcharge).
While changes in the tax rates will affect all individuals, those considering selling a business may be more adversely affected than others. In a business sale, there is usually both an ordinary income and capital gain tax component. A sales price for a successful business that has been in operation for many years could easily produce income that exceeds the high-income threshold under either proposed tax plan.
Let’s explore a quick example focusing on the current capital gains tax rates and the potential changes to capital gains tax rates. A business owner who materially participated in the business sells the business for $15 million with $5 million in basis resulting in a net long-term capital gain of $10 million.
The business owner nets less cash if the political winds raise the effective rate to 31.8 percent or 43.4 percent.
A seller facing such a difference in net cash might consider the following:
- Delaying the transaction and holding out for lower tax rates
- Working with the seller to possibly share the tax burden by increasing the sales price
- Continuing to operate the business for a few years until net after tax cash profits can make up the difference in net cash proceeds reduced by the potential change in tax law
The tax analysis becomes even more complex if the potential capital gains tax rate is retroactive (the House Ways and Means Committee targeted September 13, 2021). Then buyers and sellers may be looking to unwind transactions or adjust terms and conditions to try and alleviate the unexpected tax increases reducing net cash proceeds.
Each potential sale/transaction has its uniqueness without involving the tax law. Now, the tax law may drive a multitude of cash flow considerations and multiyear modeling to weigh the different outcomes and derive a decision that works for the business, seller, and buyer.
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