Monday, June 7, 2010

Capital Gains Tax Rate to Increase in 2011 – Should you Sell your Business Now?

The current capital gain rates are scheduled to expire effective December 31, 2010 and will probably increase from 15% to 20% in 2011. The federal government will have little choice given the mounting deficits and soaring debt. In fact, most accountants and wealth mangers have been advising their clients to consider accelerating any tax liabilities as we may never see today’s tax rates again.

This tax increase will have a particularly devastating impact on business owners who are considering the sale of their business. Unfortunately, the recent recession has had a significant impact on the health and bottom lines of many small businesses and many of these business owners are waiting for the economy to turn around before considering a sale. The good news is that many small businesses appear to be getting healthy again. The bad news is that it will be just in time to realize these tax increases. If you have considered selling your business the below analysis of how much an owner would need to increase their bottom line (EBITDA) to stay even should cause you to think twice about the timing.

Assume the following:
• The federal capital gains tax rate is increased from 15% to 20% beginning in 2011
• The maximum personal federal tax rate is increased from 35% to 39.6%
• The company EBITDA is $500,000
• The sales price multiple is 4 times , resulting in the sale price and taxable gain of $2,000,000 (ignoring any basis issues for example purposes)

As a result, the federal capital gains tax on a $2,000,000 gain would increase from $300,000 (15% of $2,000,000) if the sale were completed in 2010 to $400,000 (20% of $2,000,000) if the sale were completed in 2011—an increase of $100,000. This is simply the capital gains tax calculation and does not include any federal or state income taxes which will be increasing and take an even larger chunk of your sale proceeds. When you consider all the proposed tax increases (Capital Gains, Federal and State) the net effect on your sale proceeds will probably be a decrease between 11% and 15%.

To mitigate the effect of these tax increases a business owner would need to grow their bottom line by a considerable amount. So, the question becomes should you consider a sale in 2010 or resolve to grow the business beyond its current levels and know a larger portion will go to cover the increases in the tax rates.

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