I didn’t really establish this blog to talk about current affairs such as Taxmageddon. The need for exit planning is timeless and, for the most part, the need to plan for a business sale is not dependent on what’s happening currently. Current affairs do affect the details of exit planning, but not the necessity of exit planning. So, from a content standpoint, this will be an unusual posting and much longer than what you will see here in the future.
In my public accounting career, I learned the tax regulations have more exceptions to rules than rules themselves. I was not interested in being an attorney or providing tax advice because I found it to be so tedious and boring. So, I stuck to the audit side of the business.
In my career as a business broker, I’ve had to become generally aware of the tax regulations as it relates to business sales. I am not an expert by any means, far from it. I leave all that to the tax accountants and tax attorneys that spend their days learning all those monotonous rules (and exceptions). But, let me say this, those guys are worth their weight in gold for anyone that is considering selling their business.
The tax implications of a business sale are onerous at best and can be devastating. The fiscal cliff tax implications have the potential of being destructive to small business sales. Surely, the President and congressional leaders will take into consideration the tax implications of small business sales. (Won’t they?) After all, they always say that small businesses drive our economy.
I’m a little concerned about writing this because tax law is very complicated when it comes to business sales. Those guys that are worth their weight in gold (the tax accountants and tax attorneys) may be horrified by my understanding and summary. (If tax experts see this, please feel free to correct me through comments.) All I can do is the best I can do based on what I think I know and I’m going to try my best to keep it simple. (after drafting: I tried, but it’s not easy to do.) I’m pretty sure there will be some mistakes in this analysis, but it’s the overall thought that counts (and hopefully the mistakes will be immaterial to the overall theme).
For purposes of this posting, I’m going to ignore ordinary income tax implications of a business sale, such as depreciation recapture, consulting agreements, etc.
First, let’s look at the horrific tax implications of the sale of a C-Corporation (C-Corp) under today’s tax laws (as I understand them). C-Corps are subject to double taxation when a business is sold. Most small business owners don’t realize that there is no beneficial capital gains tax inside a C-Corp. All corporate income above $75,000 is taxed at rates between 34% and 39%. Depending on many factors outside the scope of this discussion, when an owner sells his C-Corp business (as an asset sale), the corporation will probably have to pay taxes of about 35% of the selling price (not necessarily true as much depends on the actual financial statements of the C-Corp). That’s bad, but it gets worse.
The proceeds of that sale are deposited into the bank accounts of the C-Corp. An owner really wants those funds in his personal bank account. But when those funds are withdrawn from the Corporation, the business owner is taxed again on his personal tax return at a 15-20% rate depending on whether the distribution from the C-Corp is a dividend or considered capital gains. Now the owner has paid the federal government an effective tax rate of about 45-48% in taxes (because the latter tax is really only on the distribution amount which is 35% less than the selling price because of the C-Corp tax). Let’s assume the owner lives in a state with 5% state income tax. Now the owner has paid 50%-53% in income taxes on the sale of the business.
So, what does the fiscal cliff do to the poor business owners if Congress fails to act? As I understand it, these two taxes are already “baked in”: 1st) it tacks on another 3.8% investment income tax to fund Medicare and Obamacare; 2nd) I believe there is also another .9% payroll tax on high-income earners to fund Medicare and Obamacare. As I understand it, under fiscal cliff taxation, dividends (the distribution of the after-tax proceeds from the C-Corp) will be taxed at ordinary income tax rates (i.e. 31% above $142,700, 36% above $217,450, 39.6% above $338, 450), more than twice as much as today’s 15% dividend tax rate. In addition, capital gains will rise to 20% from 15%.
Let’s get back to the poor business owner. If my math is right, under fiscal cliff taxation, his effective tax rate (including 5% state income taxes) might rise from an effective tax rate of 50-53% to 56% to 63% on the sale of the business. How many business owners are going to make the decision to sell if they only keep 40 cents of every dollar? In evaluating small businesses as a business broker, I ran across a LOT of C-Corp owners who couldn’t stomach the approximate 50% tax bite on a sale of their business. Now, they are facing 60%!!! Are they going to decide to sell their business or die in their chair?
Pass-through business entities such as sole proprietorships, S-Corporations and LLCs do obtain the benefits of the 15% capital gains rate when a business is sold (ignoring all the things that are taxed at ordinary rates such as depreciation recapture, consulting agreements, etc.). It seems to me, under Taxmageddon, they may be taxed at an additional 9.7% (the 3.8% and .9% Obamacare taxes, plus the 5% increase in capital gains tax.) If that is true, the effective tax rate on small business sales (pass-through entities) is increasing by about a whopping 65% (9.7%/15%)!!!
It is worse yet. Tax rate rises to 55% on estates over $1 million, up from 35% on estates
over $5 million. Don’t die in 2013! If only that was within our control.
What if business owners continue to hold on to their business because of the ugly tax implications of a business sale? I’ve seen it often – more common than not – business owners hold on too long, they lose enthusiasm (or die) and the business begins to degrade and is no longer saleable. The business ultimately shuts down. The employees are out of a job and families are devastated (often, including the business owner’s family).
Small business drives this economy. When burned-out or elderly business owners are able to sell their businesses, it is usually to a younger generation person who can supply the entrepreneurial spirit and drive necessary to revitalize (what is usually) a stagnant business. Those new owners create new jobs and help our national economy flourish. That’s why taxation of small business sales needs an exemption (or significant adjustment ) from the current and upcoming Taxmageddon regulations.