Today, all owners face three significant headwinds that increase the difficulty of a successful business exit. One is our flat economy—today and for the foreseeable future. The second is the substantially higher tax bill that’s due upon the sale of a business. And last, but not least, is the long-term mediocre investment climate that depresses the amount of income owners can expect from their sale proceeds and other investments. Combined, these three headwinds wreak havoc on an owner’s ability to cross the finish line at all, let alone as they originally planned.
Today, let’s look at how the first of these headwinds affects your efforts to leave your business in style and what actions you can take today to minimize their effect.
Headwind Two: The Tax Bite Just Got Bigger
We turn now to tax rates and how the U.S. Government’s increasing appetite for more revenue affects our ability to grow and reap business value.
Let’s leave shouting matches about the need to or folly of increasing taxes on “the wealthy” to others while we examine how increased federal taxes: 1) hinder owners’ ability to grow their companies and 2) reduce net sales proceeds when owners exit.
Capital Gains Tax
On New Year’s Day, 2013 the federal capital gains tax rate increased from 15 percent to 20 percent on income in excess of $450,000 for joint filers. This is imposed on the sale of stock of either a C or an S corporation.
Investment Income Tax
Also effective January 1, 2013, the Affordable Health Care Act (Obamacare) imposes a 3.8 percent tax on investment income (including capital gains on the sale of C corporation stock, but not (yet at least) on the sale of S corporation stock) for taxpayers earning above $250,000 per year. Had you sold your business during 2012, the government would have taken 15 percent of the gain. Today it can collect 20 to 23.8 percent (if you sell the stock of a C corporation). That is an increase of 33 percent to 59 percent.
Creep in Marginal Income Tax Brackets
Also on New Year’s Day of 2013 the marginal income tax brackets for individuals increased. The new top tax bracket for joint taxpayers earning over $450,000 is 39.6 percent. Taxpayers in this bracket potentially face a combined 43.4% (39.6% + 3.8%(AHCA)) marginal tax rate on their income. Because owners of S corporations, sole proprietorships, LLCs and partnerships are taxed on business income directly this additional tax affects not only their personal income, but also the amount of after-tax income available to their businesses for research, innovation, expansion, acquisition of other companies, etc.
The point the government seems to have missed is that much of the income taxable to the business owner must be kept at the company level if the business is to expand. The money retained in S corporations is taxed, in effect, at the highest marginal tax rate of the owner. Raising income tax rates reduces the amount of capital available to fuel growth.
It is difficult to quantify how much this increased tax burden inhibits growth, but it surely is not an insignificant drag, perhaps five to eight percent.
Taxes For Business Owners
Higher taxes affect you as an owner in a number of ways. First, if you had sold your business before 2013 and, after taxes, had exactly enough cash to achieve financial security, you’d have to sell that same business today by five-plus percent more to cover the higher capital gains taxes to end up with the same amount of cash in your pocket.
If the cash flow of your business is projected to grow at five or six percent a year, tack on another year or so of growth to the end of your journey. Second, the increased tax bite will likely reduce the amount of capital available to the business, slowing the rate of cash flow growth. Third, increased income taxes reduce the amount of money available to you to invest in assets outside the business.
Taxation has always been a headwind in the face of business growth, but the Feds have increased its velocity.
Mitigating Headwind 2
As owners we are not helpless. In fact, there are several tax strategies and concepts we can use to sidestep higher taxes—but most must be implemented long (at least five years) before an ownership transfer to be fully effective.
In fact, it is most effective to implement tax strategies before your value building activities take full effect. We encourage you to seek out an experienced business tax advisor who is familiar with exit planning concepts.
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