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Insight Newsletter
Tax Rates Affect Returns to Business Owners
Due to a changing tax environment, businesses earnings and value must increase just to stay even.
by Frank S. Buhler
Barring legislative action this year, the
tax environment will become more punitive
in 2013. To remain even, owners
will need to earn more profits to offset higher
taxes, and values of businesses will have to increase
to yield the same after-tax proceeds in
a sale. While no business owner should make
a decision on the sale of a business solely as
a function of tax policy, these significant
changes merit a review of ownership transition
plans with an eye toward maximizing
after-tax proceeds. Owners who have established
a time "window" during which they are
considering ownership transition should evaluate
their specific situation and determine if
the impending changes matter to them. The
old axiom, "it's not what you make, it's what
you keep," remains relevant.
THE LIST OF CHANGES INCLUDES:
- Higher tax rates on capital gains, qualified
dividends, and ordinary income;
- New Medicare taxes on net investment
income, including capital gains, as part of the
funding for the Patient Protection and Affordable
Care Act ("ObamaCare"); and
- Higher tax rates on estate transfers and a
reduction in the exemption from estate tax.
The chart below compares the current tax
rate structure to the framework scheduled to
go into effect on January 1, 2013.
..........
It appears likely that the
17-year run of declining capital
gains rates will end in 2012,
thereby decreasing the after-tax
value of businesses. The scheduled
upwards adjustment of
ordinary income tax rates will
also have a significant impact
on the cash flow retained for
business operations owned in
pass-through entities (Sub-S,
LLC, and partnerships).
..........
Three meaningful changes will impact
the after-tax proceeds from the sale of a Company,
or dividends received from C-Corporations,
starting in 2013.
- Capital Gains The effective tax rates on
capital gains will increase from 15% to 23.8%
(a combined federal rate of 20% capital gains
+ 3.8% Medicare tax), representing a 58.7%
increase relative to 2012.
- Depreciation Recapture The typical
transaction structure for the sale of a business
organized as an S corporation, a limited liability
company, or a partnership, is the sale
of assets or, in the case of an S corporation, of
stock with an election (338(h)10, for those
tax aficionados) that treats the sale of stock
as an asset sale for tax purposes.With either
of these structures, buyers gain the ability to
amortize goodwill for tax purposes and re-depreciate
fixed assets over the assets’ assigned
life. The sale may result in the recapture of
depreciation, which occurs when the tax
basis of assets is below market value. Such recapture,
up to the original cost of the asset, is
treated as ordinary income and will be taxable
at ordinary income rates. In 2013, the highest
marginal ordinary income rate will jump to
39.6%. The various investment tax incentives
available over the last few years have allowed
for immediate write-off or rapid depreciation
of new capital expenditures. As a result, many
companies now have a large gap between the
tax basis and current fair market value of fixed
assets, thereby exacerbating the effect of the
increase in ordinary income tax rates.
- Qualified Dividends Owners of C-Corporations
currently pay tax at a rate of 15%
on dividends. In 2013, the qualified dividend
rate will expand to a combined rate of 43.4%
(39.6% ordinary income rate + 3.8% Medicare
tax), representing an increase of 189% over
tax rates in 2012.
The above chart illustrates the effect on a
seller in a sale transaction with a $25 million
capital gain and depreciation recapture of $2.5
million. Higher tax rates in 2013 will reduce
the net sale proceeds by $2.1 million. All else
being the same, the purchase price for a transaction
completed in 2013 would have to be
approximately $2.8 million greater than the
same transaction completed in 2012 to result
in the same after-tax proceeds.
In addition to higher effective income
tax rates, the tax and exemption structure for
estates will also change. The chart below provides
an overview of changes to federal estate
tax exemptions and rates.
The most significant changes to the estate
tax include the simultaneous tax rate boost
to 55% and the lowering of the exemption
from $5 million to $1 million. Business owners
should investigate ways to use up their maximum exemption this year regardless of their
ownership transition schedule.
It appears likely that the 17-year run of
declining capital gains rates will end in 2012,
thereby decreasing the after-tax value of businesses.
The scheduled upwards adjustment
of ordinary income tax rates will also have a
significant impact on the cash flow retained
for business operations owned in pass-through
entities (Sub-S, LLC, and partnerships). Business
owners should continuously be evaluating
their ownership transition plans based upon
changes to the operating environment, including
the tax environment. In that light, we
recommend that owners request their tax advisors
to assess the impact of the pending tax rate
changes on their business and on the amount
of after-tax proceeds realizable in a sale.
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