If you’re a business owner nearing retirement or considering a business sale for other reasons, you may want to put that idea into high gear and sell before the end of this year.
Starting next year, the federal capital gains tax is expected to increase sharply, by 59 percent, which will significantly reduce the amount of money you will ultimately earn from your sale.
Here’s why: Beginning Jan. 1 the federal capital gains tax jumps from 15 percent to 20 percent. Combined with a new Medicare tax of 3.8 percent, that’s a whopping 23.8 percent that you will have to pay from your sale for federal capital gains taxes.
The existing long-term capital gains tax rate of 15 percent has been in place since 2003, when it was reduced from the former rate of 20 percent after the passage of The Jobs and Growth Tax Relief Act. The rate was extended to Dec. 31, 2012, by The Tax Relief, Unemployment Insurance Reauthorization and Jobs Creation Act of 2010. Consequently, the 15 percent rate is scheduled to expire and return to the former 20 percent rate at the end of this year. In addition, capital gains will be subject to an additional new 3.8 percent Medicare tax under national healthcare reform legislation passed in 2010.
The new capital gains taxes scheduled to take effect at the beginning of next year will result in significantly lower after-tax net proceeds for a selling business owner. To break even, a business owner would need to increase the business sales price by 11.5 percent to have the same net profit if the business is sold after 2012. That would be difficult to achieve in a business transaction environment where private equity groups and large corporate buyers are shopping for values in a buyer’s market and baby boomers are increasingly looking to sell, adding to the supply of businesses for sale.
To illustrate the difference in selling a business this year and next year, let’s look at an example contrasting the net after-tax sales proceeds to an owner from the same business sale.
This year: Assuming the business sale resulted in $10 million in capital gains, $1.5 million of federal capital gains taxes would be due under the 2012 federal capital gains tax of 15 percent. That would result in net proceeds to the seller of $8.5 million after federal capital gains tax.
Next year: Given the same $10 million in capital gains from a sale in 2013, an additional 5 percent would be due for the 2013 capital gains tax increase and an additional 3.8 percent would be due for the new Medicare tax. The business owner’s federal capital gains tax liability would increase to $2.38 million. In the end, the business owner would only take away net proceeds of $7.62 million. That’s $880,000 less in net proceeds compared to a sale in 2012.
Note that the above example only accounts for federal capital gains tax differences and does not include state and local taxes.
Keep in mind that substantial time may be required to properly structure, position and market your business for a sale in 2012. If you are considering a sale, you should meet with your financial advisor, accountant and an experienced business transactional attorney as soon as possible.
Business sales can be complex and may take several months to a year to complete. Prompt action may make the difference between closing before the end of 2012 or being delayed until after the beginning of 2013 and having to incur the coming increases in federal capital gains tax.
George M. Reyes is a partner in the business services practice group at Best Best & Krieger LLP in Riverside. His practice specializes in mergers and acquisitions and includes general counsel work for privately owned businesses and non-profits. He can be reached at firstname.lastname@example.org.