Increase in Capital Gains Taxes Will Affect Your Business in Many Ways

Thursday, December 02, 2021

By Susan Kaplan

The White House has proposed a plan that will essentially double the capital gains tax for investors making over $1,000,000 to fund trillion dollar initiatives like the American Families Plan, American Jobs Plan, and The Infrastructure Investment Act. The goal of the Administration is to eliminate the loopholes that allow taxpayers making $1 million a year or more to pay a lower rate on their capital gains than ordinary working Americans pay.

The current top capital gains rate is 20%, but could increase to a tax more in line with the top income tax rate of 37%, for those making $1 million or more. The White House is also entertaining the idea of increasing the top income tax bracket to 39.6%. The proposal has left many business owners worrying how an overall 19.6% increase in the tax investors will face will affect their businesses.

The increase in capital gains taxes will not only affect big businesses, but smaller ones as well. Significantly increasing the capital gains tax results in less capital investment, so for smaller businesses the increase creates a hurdle to raising capital from outside investors that is needed to start businesses and support growth. The proposal has negative implications on new investment, but also on the future sales of investments, resulting in less revenue. It will also have an impact on the creation of jobs and growth of the economy.

What happens when you decide to exit your business? Raising the capital gains tax will come into play as business owners liquidate their life’s work. Selling a $10 million business after the proposal goes into effect, they will end up paying 39.6% in taxes on the proceeds from the sale, leaving them with a little over $6 million, a number far below the appraised value. It could be wise to sell before the tax law comes into effect, or to have a plan to minimize tax liabilities in the event the sale occurs after the tax law has come into effect.

Here are some strategies clients can use to minimize this liability:

  1. Set up a trust fund from which to take distributions on a monthly, quarterly or yearly basis. Putting the proceeds from the sale of a company in the trust prevents being taxed initially, since the proceeds have not been received yet. The trust holds the proceeds and invests them in real estate, securities or other business ventures to generate a return to pay you back over time. They are taxed at the applicable tax rate associated with the amount taken out each year. If a distribution of interest is taken the trust has earned, then ordinary income tax is paid on said amount. If principal is taken after the interest has been paid, then capital gains tax would be paid on that amount.
  2. Seller financing is a scenario in which the owner acts as a bank, allowing the buyer to make payments over time. Therefore, the owner is not taxed immediately on the overall value of the company. They will be taxed in the applicable bracket based on the payment received each year. They will also earn interest utilizing seller financing.
  3. Earn outs are a method of payment in which the proceeds from the business are tied directly to the performance of the company. Specific financial goals are set that determine the payment received each year. This is an option that will minimize tax liability, but carries significant risk as the payment is tied to performance. If the financial goals set in place are not met, you may not receive the proceeds initially agreed upon.
  4. A 1031 exchange can be useful to avoid paying capital gains tax on the real estate component of a company. The client sells an investment property and reinvests the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value. The proceeds from the sale are transferred to a qualified intermediary, rather than the seller of the property, and the qualified intermediary transfers them to the seller of the replacement property or properties. Capital gains tax is deferred, freeing up more capital for investment, and allowing the client to reap the benefits of the rental income that will be produced. This method could be used alongside one of the strategies above, allowing business owners to avoid and defer capital gains on not only the real estate, but the business as well.

Reach Out to Us: The recent change in the White House is set to bring about substantial adjustment to the way high-net worth individuals are taxed in relation to capital gains. It’s important to look at the bigger picture and plan ahead so you can be prepared once the proposals become reality. Consulting a tax strategist could be beneficial in reducing capital gains tax liability when it comes time to sell a business. We have a team of Business Exit Planners to help you! They can help with the allocation of the purchase price, as well as facilitating the strategies mentioned above. We are also great intermediaries to engage in order to help minimize tax liabilities when it comes time to sell.