- President Biden’s proposed tax increases for individuals and corporations would have far-reaching impacts.
- Business owners considering a sale may be taxed at the pre-TCJA rate of 39.6%, and Biden has proposed moving the corporate tax rate up to 28%.
- Retroactive and prospective rate applications may complicate a potential sale.
- A higher effective tax rate at the corporate level may have a negative impact on company valuations.
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President Biden’s proposed tax increases — which have been highly publicized since the campaign trail — would have far-reaching impacts for taxpayers who are still struggling to navigate the sweeping changes introduced by the Tax Cuts and Jobs Act of 2017 (TCJA) and unprecedented COVID-19 legislation.
These proposed changes have injected uncertainty into the world of mergers and acquisitions. Sellers contemplating a transaction are seriously assessing whether a deal should be accelerated before tax rate increases go into effect, how after-tax proceeds will be diminished, and how the changes could impact their succession and estate plans.
Tax rate increases
The most significant changes under Biden’s proposal are tax rate increases for individuals and corporations. The proposal would revert the top rate for individuals back to the pre-TCJA rate of 39.6% (currently 37%). The rate on capital gains and qualified dividends would also increase to 39.6% (currently 20%) for those making over $1 million. This increase will have a major impact on business owners considering a potential sale. The proposals do not alter the additional 3.8% net investment income tax that applies to the gain from certain sales.
Example 1. S corporation shareholder sells 100% of her stock with $5 million of long-term capital gain resulting from the sale. If that stock were sold today at the current capital gains rate of 20%, the shareholder would pay $1 million in tax on the sale. That same sale under Biden’s plan would trigger $1.98 million in tax — nearly a $1 million dollar difference.
The Biden plan would also increase the corporate tax rate. The current rate of 21% was a result of the TCJA (previously the rate was 35%) and received strong support across the business community. Biden has proposed moving the rate up to 28%, although the administration has signaled that it would consider a lower rate of perhaps 25%. Either way, the increase—if enacted—will leave the owners of C corporations with even less after-tax proceeds in an asset sale.
Example 2. XYZ Corp. is a C corporation with one shareholder that sells all assets in liquidation, resulting in $10 million of taxable gain (assume shareholder has zero stock basis, a long-term holding period, and is not eligible for the Section 1202 exclusion). The after-tax proceeds are then distributed out to shareholder. Here’s a basic comparison of the federal taxes due and after-tax proceeds under current rates and Biden’s proposed rates:
|Currently||Under Biden Plan|
|Gain upon sale of assets||$10,000,000||$10,000,000|
|Corporate tax rate||21%||28%|
|Tax due at corporate level||$2,100,000||$2,800,000|
|After-tax proceeds available for distribution||$7,900,000||$7,200,000|
|Long-term capital gains rate upon distribution||20%||39.6%|
|Shareholder tax due upon distribution||$1,580,000||$2,851,200|
As can be seen from this simple example, shareholder would walk away with nearly $2 million less in cash under Biden’s proposed increases compared to current rates.
Evaluating the impacts
The prospect of a tax increase is causing business owners to closely analyze the implications of a sale under the current and proposed rates. Although Biden has proposed making the rate increase effective retroactively to April 28, 2021 (the date his plans were announced), some Democratic lawmakers have voiced their preference to have the increase applied prospectively. There could be a benefit in accelerating a transaction, but such an acceleration is not without risk. To enhance after-tax cash flows, evaluate the timing of income and deductions while considering the potential rate changes.
Another consideration is that a higher effective tax rate at the corporate level and corresponding decrease to cash flows may have a negative impact on company valuations. This will be of particular importance within private equity — where cash flow can be a critical metric in valuing transactions, financial modeling, and benchmarking investor distributions.
With the razor-thin Democratic majority in Congress, Biden’s tax plans will face negotiations and compromise amongst GOP and Democratic lawmakers. However, a tax rate increase is very possible in the near future. Work with a team of professionals to assess how your business will be impacted by these changes and plan accordingly.
How we can help
CLA uses a thoughtful, objective, industry-focused approach to help you discover opportunities — and we can provide the necessary tools to guide you every step of the way. We take the time to understand you so we can provide information that can facilitate sound financial management decisions. At CLA, our team can help business owners navigate the current conditions and ultimately help to preserve value.