March 5, 2009

Beware of potential changes in the capital gains tax

Do you have clients who are thinking of selling their businesses? If you have planned it correctly, most of the transaction proceeds should be long term capital gains. Given the current political climate and the change in the White House, capital gains taxes will come under attack. If you have business owner clients who are thinking of selling their businesses within the next five years, you may want to move up the exit timeframe.

The reduced 15 percent tax rate on capital gains, previously scheduled to expire in 2008, has been extended through 2010 as a result of the Tax Reconciliation Act signed into law by President Bush on May 17, 2006. In 2011 these reduced tax rates will revert to the rates in effect before 2003, which were generally 20 percent.

With the AMT currently targeted for elimination, the $800 billion will be made up by raising taxes elsewhere, and I believe this "owner of capital" tax is the most vulnerable for increase. I expect that the long term capital gain tax rate will be moved to an upper limit of 25 percent by mid-2009 for the high-end income bracket.

Translation? The business seller is going to take a big hit on his after-tax proceeds if his business sale is concluded after July 1, 2009. Let's look at a quick example. A 63 year old man started his business 25 years ago and sells it for $5 million. All his equipment has depreciated so his basis is approximately $0. Under current tax laws he would have a $5 million capital gain from the sale of his business. His after-tax proceeds would total $4,250,000.

If he sells after July 1, 2009, and the tax laws change as I am predicting, the same sale would net him $3,750,000. He lost $500,000 because of this change. If you wait until the actual change is voted into law, there will be a rush to the exits causing an unusually high number of business to be for sale. That would further reduce proceeds for the seller because of supply and demand pressures.

The most important tax issue for the business seller, however, continues to be the corporate structure and whether the business sale is an asset sale or a stock sale. First, unless your client is planning on going public or has hundreds of stockholders, do not form a C Corp. If the business is already C Corp ask your attorney or tax advisor about converting to an S Corp. If you sell the company within a 10-year period of converting to an S Corp, the sale can be taxed as if it were still a C Corp.

In an asset sale of a C Corp, the assets that are sold are compared to their depreciated basis and the difference is treated as ordinary income to the C Corp. Any good will is a 100 percent gain and again is treated as ordinary income. This new found income drives up the corporate tax rate, often to the maximum rate of around 34 percent. You are not done yet. The corporation pays this tax bill and then there is a distribution of the remaining funds to the shareholders. They are taxed a second time at their long term capital gains rate.

Compare this to a C Corp stock sale. The stock is sold and there is no tax to the corporation. The distribution is made to the shareholders and they pay only their long term capital gain on the change in value over their basis. The difference can be hundreds of thousands of dollars.

This anticipated change to the capital gains tax rates will certainly add to the complexity of selling a business. I cannot stress how important a factor taxes will be in your successful business exit.

Here is my Tax Consideration Checklist:

  • If you're selling a C Corp, retain ownership of all appreciating assets outside the corporation, i.e. real estate, patents, and franchise rights to avoid double taxation.
  • Look at the deal economics first, and taxes second.
  • Make sure your transaction support team has deal experience.
  • Before you go to market, work with your team to understand deal structure vs after-tax proceeds.
  • You have the right to pursue the minimum payment of taxes - exercise your rights.
  • It is never as effective as an efterthought.

Be aggressive in tax positioning the sale, both with the buyer during negotiations and in filing with the IRS. The various deal structure options are very important issues that need to be understood from a tax impact perspective. Remember, a deal term that is favorable to the buyer for tax treatment is correspondingly unfavorable to the seller. You can bet that the buyer's team of advisors is well-versed on this topic. Make sure your team of advisors is equally well-versed or your client could end up with much less than you thought in after-tax proceeds.

Dave Kauppi is a Merger and Acquisition Advisor with Mid Market Capital Inc. MMC is a private investment banking and business broker firm specializing in providing corporate finance and business intermediary services to entrepreneurs and middle market corporate clients in a variety of industries. The firm counsels clients in the areas of M&A and divestiture, family business succession planning, valuations, minority interest shareholder sales, business sales and business acquisition. Dave is a Certified Business Intermediary (CBI), a licensed business broker, and a member of IBBA (International Business Brokers Association) and the MBBI (Midwest Business Brokers and Intermediaries). Contact Dave Kauppi at (630) 325-0123, email davekauppi@midmarkcap.com or visit www.midmarkcap.com.

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