Dan Reiter, CFP®, CPA
The goal to pay less tax is a universal goal shared by all. In all the conversations I have had with clients in all the years I have been offering financial and tax advice, I have yet to meet one person that desires to pay more in tax than they are legally obligated to owe. It may surprise some to know that the Supreme Court has held that it is one’s right to pay as little tax as (legally) possible! In a landmark 1935 Supreme Court Case Gregory v Helvering, Justice Learned Hand famously wrote the following :
“A transaction ... does not lose its immunity, because it is actuated by a desire to avoid, or, if one chose, to evade, taxation. Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.”
It is every individual person’s right to structure their transactions in such a way that they minimize their tax burden. Four general strategies to plan for, and reduce, taxes include the following :
Deduct expenses to reduce taxable income.
Take tax credits to reduce taxes due.
Realize income in a form that is taxed at a lower rate (i.e. shift character of income from ordinary to capital), or
Change the timing of when income or expenses are recognized for maximum benefit.
With some legislative changes likely forthcoming after the recent change in administration, our firm has been receiving a lot of questions about strategies to help minimize one’s tax expense in the wake of such proposed changes. For the purposes of this writing, I will focus on the question on the final bullet point noted above, the question of timing. One of the specific questions asked is if one should consider selling their business sooner to avoid potential tax increases in the future. The biggest catalyst at the time of this writing is the proposed changes to increase both ordinary income and capital gains tax rates. Fear of paying more taxes in the future have left many wondering if now is the right time to sell. My answer to the question of timing, usually (and still today in light of the proposals!) is the same. It depends..
The decision to sell one’s business is a significant one - one that involves far more factors than just taxes. Many quantitative and qualitative variables other than taxes are part of making the right decision for your personal situation. First, I will begin by describing as it stands today the current legislative changes that have been recently outlined by the House Ways & Means Committee. The contents of this report outline what provisions we might see as part of the push for tax reforms. Next, I will describe some other key questions to address by business owners considering a sale and the relative importance of each. Finally, I’ll outline what factors must be present for it to make sense potentially giving more weight to possible future tax increases in one’s decision for when to list their business for sale.
Proposed Tax Law Changes
As part of the American Families Plan first announced by President Biden in April, there has recently been released a summary by the House Ways & Means Committee of the proposed changes to the tax code included in the plan. In the interest of space, I will not cover all of them in this writing. However, below I have listed several that I view may have the greatest potential impact on owners of businesses:
Increase in the top corporate tax rate to 26.5%
Increase in the top ordinary income tax rate to 39.6%
Increase the top capital gains tax rate from 20 to 25% (for taxable income that exceeds $441,450 if single, or $496,600 if married)
New expansion of the 3.8% net investment income tax to net investment income derived in the ordinary course of business for taxpayers with income above certain thresholds ($400,000 single, $500,000 married)
New “surcharge” of 3% of modified adjusted gross income in excess of $5 million
The lowering of the estate and gift tax unified credit back to pre-2018 levels (about $6 million per person)
When a business is sold, the structure of how the transaction is taxed is largely dependent upon whether the business is sold as an asset sale or a stock sale. The main difference is the character of the income that is realized. Typically, in an asset sale, more of the gains to the selling owner will be taxed at higher ordinary income tax rates. In a stock sale, however, lower capital gains rates are primarily used. Assuming we’re dealing with a gain from a sale and income higher than approximately $500,000, selling owners will be impacted largely by the increase in the ordinary income tax rate by 2.6%, and capital gains rate by 5%. For those with businesses worth more than five million, you may also separately be impacted by the new 3% surcharge as well.
For the sake of discussion, let’s say when you sell your business you are one of those most dramatically impacted by the proposed legislation and you pay somewhere between 5-10% more in taxes. If you sell a $10 million business, for example, you pay $500,000 to $1,000,000 more to Uncle Sam. That’s a lot of money! At first blush, that price tag might make anyone panic and go running for the hills. Is that motivation enough to rush to the nearest M&A professional or business broker to find you a buyer as soon as possible, though? Not so fast.
First, unfortunately, the long-term capital gains rate increases are already set to take effect after the date the legislation was introduced, or September 14th, 2021. If any portion of your gain is related to capital assets (it probably is) and you have not yet signed a contractually binding agreement that will close by the end of 2021, that ship is sailed. No need to fret, however! The truth is, there are many other key questions that must be answered that likely have a far more significant impact on the ultimate value and success of your business sale. Although we love to help lower client’s tax bills, we also love to follow this adage: thou shalt not let the “tax tail” wag your “financial security dog”. Let’s discuss some of the non-tax key questions all owners should answer looking to maximize long-term success.
Is Your Business Ready to Sell for Top Dollar?
As a primary step, you must determine whether your business is ready to sell, and for maximum value. In short, what is your businesses transferrable value? Transferable value is defined as what your business is worth, to someone else, without you. In other words, if you remove yourself from the business, what impact does this have? Would customers or employees leave? Would growth sputter? It is critical that you thoroughly review these questions and others like it through the lens of a prospective buyer. This occurs by a systematic review of your business value drivers. Value drivers include things like a solid strategic business plan, strong leadership team, documented organizational processes, convincing growth plan, among many others.
The reason value drivers are so important is this: high-quality value drivers create a best-in-class business result in buyers paying top dollar. To illustrate the impact of this concept, assume that businesses in your industry typically sell for anywhere between two- and four-times earnings. The reason for the range in this multiple is the range in the quality of value drivers!
Let’s illustrate further. You know and believe that your business is a high-quality business. From the perspective of a buyer, however, let’s say it falls somewhere in the middle of the pack of comparable companies in your industry. Perhaps in the due diligence of the buying process they uncover a couple of risks that are of concern (and believe me, they try!). As a result, your business may get a multiple of three times earnings. Through an intentional focus on building your company’s value drivers, therefore, your opportunity for increased value is moving from a three multiple to a four. This is equivalent of a 33% increase in company value! Is it worth delaying a sale paying 5-10% more in taxes in the future to create 33% more value in your business? Absolutely!
Does Selling Today Meet Other Values Based Goals?
In many business sale negotiations, the ultimate deal killers have little to do with the negotiated selling price or dollars involved in a transaction. Often, what causes the seller to walk away is discovery of things late in the selling process like a buyer’s plans to change a key benefit package, lay off employees, close a plant, or change the cultural identity of the business. Or an owner simply realizes that they are not mentally ready to leave the business they have poured their heart and soul into for years. Abruptly, this causes owners to put the brakes on the sale.
Values goals are those goals that reflect your personal values. These are the goals that are important but often not clear to an owner until they are made readily apparent. When they are uncovered, though, in many cases these goals are given a higher level of importance than the total dollars involved. As such, it is an essential part of the process that owners consider the impact of a potential sale on these values. Values based goals can often be uncovered by asking the right questions. A rush to market to avoid taxes may result in consideration of only those sale opportunities currently available, and higher risks of these questions not being fully considered. Examples of such questions include:
How ready do you feel to move on from your business?
How will a sale impact your customers, employees, community, and other key stakeholders?
Can a buyer maintain the company culture? Is that their goal?
How does the sale of your business impact your family harmony?
Are You Financially Independent?
Have you specifically quantified all your financial goals for the future? If so, have you translated this amount into what you need to sell your business for? One of the most common issues that I see with business owners is not properly answering these questions before they sell. By not doing so, their lifestyle ends up being defined by the price they receive for their business, not chosen based upon what they desire it to be.
The foundational goal for all owners is financial independence, defined as the accumulation of enough resources before or through the sale of your business to sustain and live the lifestyle and future you envision. The goal is foundational as it is critical that you retain control of your business until you have reached your definition of financial independence. If you believe selling your business sooner will save you in taxes but the sale amount is still not enough to meet your financial goals, you may save taxes but still not have enough to meet your lifestyle expectations. You may be forced to continue working and not have the ability to ride off into the sunset or compelled to reduce your lifestyle.
Proactive and intentional tax planning with a professional may certainly help increase the after-tax dollars that are available following the sale. However, if you have not accumulated the necessary funds outside of the business, or developed the value within the business necessary, paying a reduced amount of taxes will not be enough to meet your goals. It is imperative that you quantify and determine what you need for financial independence as a primary goal, then determine how you can get there with tax planning begin a factor in that decision, not the primary catalyst itself.
Conclusion
Paying less in tax should always be a means to an end, not the end itself. Exploring general tax planning strategies, I focused on one in particular—timing. Should business owners consider selling their business sooner to avoid potentially higher ordinary income and capital gains taxes? I reviewed legislative changes that have been proposed, and how (if they pass) those may impact business owners.
Unfortunately, it is likely too late for owners to take advantage of selling their businesses to avoid potential tax increases recently proposed as of the time of this writing. Regardless, for many owners, primary attention should be placed elsewhere. First, you should quantify the current value of your business and determine if you have taken the necessary actions to maximize its value and transferability. Actions taken to proactively increase the “multiple” that values your business can result in substantial wealth creation, often more so than a 5-10% tax increase erodes. Second, you should consider your values, and whether selling today meets your values-based qualitative goals. Rushing to market without consideration of whether a sale aligns with your values may result in a significant amount of time (and money!) lost. Finally, as a primary step, you should identify in specific terms your financial independence need based upon your specific future goals. Otherwise, your future lifestyle is defined by the sales price of your business today, not proactively decided by you.
Our Prosperity Business Blueprint™ process systematically answers these questions and provides the roadmap for business owners looking to eventually exit their business for maximum value. In the way of timing, it is never too early to start planning for your eventual exit. However, exiting too early without proper planning, even in pursuit of the goal of paying less tax, may result in a loss of a significant wealth creation opportunity.