While relatively few details have been released about either presidential candidate’s tax plan, former Vice President and current Democratic Party nominee Joe Biden has made it clear that he would aim to eliminate tax breaks for long-term capital gains and qualified dividends for taxpayers with income exceeding $1 million, instead taxing them at ordinary rates.
In response, many entrepreneurial, family-owned or privately held companies may be left wondering whether now is the right time to sell to avoid having to pay a higher tax rate on long-term capital gains arising from the sale, should Biden take the White House.
Before making a decision, there are a number of important considerations for sellers to keep in mind, including:
The potential for widespread tax changes is still unclear.
No one knows what the outcome will be in November, or, given the unprecedented circumstances surrounding the election, exactly when a winner will be declared. It’s also crucial to remember that the future of tax reform isn’t simply a matter of who sits in the White House—which party controls the Senate and the House of Representatives also is relevant. For any tax increase to be enacted, the Democratic party would need to gain control of all three, i.e., the White House, the Senate and the House of Representatives. And, even if the Senate is flipped, the majority may not be large enough to break a potential minority filibuster.
While the 60-vote super majority generally is not required for revenue measures that are passed through the “reconciliation” process, changes made through reconciliation typically may expire after 10 years. Overall, multiple procedural factors are at play that could delay legislation, especially if control over Congress remains split. We’ve outlined several considerations that should be factored into any decision to dispose of a business.
Even if changes do occur, the timing is unknown.
Even if the long-term capital gains rate is increased, it’s too early to know when the increase would go into effect. While it is not impossible to effect tax changes in the first year of a new presidency, this has typically only been done to provide retroactive tax cuts, rather than tax increases.
Other factors could play a role in delaying a tax increase, including a decision to purposely keep rates low to allow the economy to rebound from the tough economic losses resulting from the coronavirus pandemic. Congress will also need to consider any changes that could affect the national deficit. Taxes would be one measure that would reduce the deficit, but a large tax increase could reduce employment (and employment taxes) in the near term.
Business strategy, not tax benefit, should drive a sale.
Whatever happens in November, ultimately business strategy—not tax strategy—should be the driving force behind a decision to sell a business. Whether a company has faced liquidity struggles due to the pandemic, or even if, in contrast, it has managed to perform well during this time, there should be an existing desire to exit the business regardless of what may happen with the long-term capital gains rate in the future. If there isn’t such a desire, business owners should avoid rushing to make a decision.
If you do decide to sell, make sure it’s tax efficient
If a business owner has decided it is time to sell, it is possible that doing so before the end of 2020 may be a tax-efficient strategy. However, accelerating a sale has consequences—sellers looking to close before the end of the year will need to be flexible around issues such as due diligence, for example, because there is limited time to devote to it. At the same time, buyers may push for a lower price to execute the deal quickly.
In many of these sale transactions, sellers receive a portion of the payment in cash at closing, as well as deferred payments in the form of seller-financed notes or other obligations, deferred escrows or earnouts to be received over the next few years or more, sometimes dependent on certain performance metrics for the acquired business in post-acquisition tax years.
While the cash element of these sales is taxable immediately, the deferred payments automatically qualify for installment sale treatment as they relate to capital assets (e.g., “stock” or other security interests in the case of a stock sale or a sale of another type of business interest, or “goodwill” and other intangible assets in the case of an asset sale).
This means that the seller has the option of using the installment method, which defers the taxation of the capital gain until the proceeds are received in the later years. When those proceeds are received, the seller will be subject to the capital gains tax rate in effect at the time the deferred gains are recognized, rather than the tax rate in effect for the year of the sale. While this usually helps lower a seller’s tax liability, the potential benefit depends on the capital gains rates remaining unchanged or being reduced. Should former Vice President Biden win the presidency and an increase to the long-term capital gains rate is enacted, it is possible using the installment method would result in increased tax payments.
However, since individual income tax returns for 2020 can be extended and filed as late as October 15, 2021, sellers have considerable time to make the decision on how these gains will be recognized. The hope for many taxpayers is that their effective tax rate for 2021 will be known well in advance of the deadline. If the tax rate is increased, an election out of the installment method should be considered.
While there many other potential considerations, the majority of business owners have been in wait-and-see mode pending the election results. Once there is more certainty and sellers can quantify the impact of potential changes, they may need to move quickly to execute their plans.
Learn about Trout CPA's Transaction Advisory Services.
