From a tax, estate and gift planning perspective, January 1, 2013 is like seeing a very scary, giant, thick fog bank on the horizon. We don’t know for sure what is on the other side. One of the great challenges of managing a business transition is the complexity that accompanies the transaction.
One of the greatest hurdles to overcome for your transition may be navigating the tricky and ever-changing landscape of transfer tax, specifically your ‘investment income’ and how (we think) the government plans to tax your transition proceeds in 2013.
Now, there is an old saying that ‘you don’t want the tax tail to wag the dog.’ This simply means that you should not base a large decision, such as the timing of a business transition, on tax matters alone. However, there is not a lot of time left in 2012, so it is important to highlight some areas where your ‘investment income’ taxes are probably going to increase next year and why transitioning your business in 2012 may prove to be a more tax-efficient strategy (assuming that this possibility is still open to you).
History of Tax Rates
For nearly 100 years, the government has taxed the income and investment income of Americans. It is worthwhile to gain some perspective on past tax rates as a potential indicator of the future.
• The highest tax on income was in 1944 when the highest rate was 94%.
• If we measure the time that you need to work on an annual scale before you got to keep any of your income, in 1944 you would have had to have worked for 328 days in the year before you could keep any of your income.
• It is worthwhile to note that the average highest tax rate over all of our 100 years of income taxation was 55%.
• Using our tax calendar again, you got some tax relief in time to enjoy the end of summer, keeping your fall and winter income.
The highest income tax bracket today is 35%. That rate is also set to revert to the old rate of 39.6% in 2013 if the Bush Tax Cuts expire without any further action from Congress. In this regard, you may want to think through the strategy of accepting deferred and contingent payments for the sale of your business, recognizing that if you accept payment for certain sale proceeds into future years, you may keep significantly less of what you bargain for today.
History of Capital Gains Taxes
Like the United States income tax, capital gains taxes have been in place since 1913. At that time, realized gains were taxed the same as other income at a maximum rate of 15%. Since then these rates have fluctuated greatly, with the highest rates coming in 1936-37 and 1976-77 at rates of 39% and 39.9%, respectively.
More recently, the maximum capital gains rate has been steadily decreasing from the 1993 rate of 29.2%. This rate decreased to 21.2% with the Tax Payer Relief Act of 1997. The Economic Growth and Tax Relief Reconciliation Act of 2001 and Jobs and Growth Tax Relief Reconciliation Act of 2003 under George Bush led to further decreases in the maximum rate to 15.7% in 2006, 15.4% in 2008 and our current rate, 15%, which began in 2010. However, with the expiration of the Bush Tax Cuts, these rates will change.
On January 1st, 2013, the capital gains tax rate is set to return to 20%, a 5% increase overall but a 33.3% increase from where it currently resides at 15%. It is helpful to think of taxes in relative, percentage-based terms – do you want to pay an extra 33.3% in capital gains taxes if you can avoid doing so?
Healthcare Legislation Mandates an Additional 3.8% Tax on Investment Income
If you sell your business in 2013, your sale transaction is also likely subject to an additional 3.8% tax that was put in place with the 2010 passage of President Obama’s Healthcare legislation. When we add the 3.8% to the new capital gains tax rate, we see that the taxes that you will pay on a sale of your business could go from 15% to 23.8%. On a relative basis, this means that the additional 8.8% increase in the taxes that you pay for your business sale equals an additional 58.67% increase over the 15% capital gains tax that exists today (without the healthcare tax).
National Debts will Compel Higher Taxes
The public debt has increased by over $500 billion each year since fiscal year 2003, with increases of $1 trillion in 2008, $1.9 trillion in 2009, and $1.7 trillion in 2010. As of September 20, 2012 the gross debt was $16.245 trillion. The annual gross domestic product (GDP) at the end of 2011 was $15.087 trillion with total public debt outstanding at a ratio of 103.3% of GDP. This growing level of national deficit has led many legislators to look at tax increases to help reverse this trend.
Increase in Capital Gains Taxes from 15% to 20%
Let’s take a look at a simple example to make my overall point clearer. If you sold your business for $10 million in December of 2012 and received capital gains tax treatment for the sale proceeds, you would pay 15% capital gains tax (plus state and other taxes). You would pay $1,500,000 in federal capital gains tax assuming a $0 cost basis.
Now, assuming that you sold the same business for the same amount the following week, in January of 2013, you would be paying $2,000,000 in federal capital gains taxes as well as an additional $380,000 in tax for the healthcare tax. The taxes at the federal level for a sale in 2013 amount to $880,000 in additional taxation over a simple difference in timing.
The Bigger Picture
Given the history of tax rates in the United States as well as our current fiscal position, as a business owner you really need to consider whether you think that the rates are going to trend higher or lower. Once you have clearly thought through this issue, you then need to ask yourself when and how you plan to turn your illiquid business into cash. When you make that calculation, you finally need to ask ‘how much of my exit proceeds will I be able to keep?’ What you will find is that taxes play the largest part and that timing can make a large difference. Forewarned is forearmed.
Talk With Your Tax Advisor
Owner’s Edge is not a substitute for your relationship with your tax advisor, nor are we tax experts or tax planners. Careful tax planning is always an important consideration when planning your transition from your business.
As trained transition planning professionals, Owner’s Edge relies on tax experts, usually your own CPA, to help us estimate the tax implications of the various options you need to consider when evaluating your desired transition options. Tax considerations are not the only driver you need to consider, but given the fiscal cliff and uncertainty of the 2013 tax laws, it certainly needs to be high on your list right now.
Sep 1, 2012 Download PDF