Due to proposed legislative changes in capital gains taxes at both the federal and Washington State level, buyers and sellers of SMBs would likely save significant taxes if they get their deals done this year.
Thinking of buying or selling a business this year? Waiting to finalize your deals could increase costs to both buyers and sellers in the future. The capital gains tax, which is levied on sales of appreciated property or businesses, has become a hot topic among lawmakers. With a new federal administration and an active state legislature in Washington, the capital gains tax will likely increase. With sales of businesses expected to rise as the economy recovers from the pandemic, these changes could drastically affect the marketplace.
Proposed tax legislation favors the acceleration of deals to acquire or sell existing businesses
There are legislative proposals at the federal level and in Washington State that will impose higher taxes on acquisitions or sales of small to mid-size businesses. The Biden administration has proposed raising the tax on capital gains from selling a business to an effective maximum rate of 39.6% from the current maximum of 20%.
Governor Inslee has proposed a 9% long-term capital gains tax in Washington State that would be imposed on the sale and purchase of capital assets, including businesses. A similar 7% capital gains tax bill in the state legislature, SB 5096, was passed by the Washington State Senate.
What this means is that persons who are contemplating selling a business should act soon, preferably in 2021, to avoid the possibility that they will be subject to increased capital gains taxes that reduce the after-tax profitability of a sale. The following is an example of how the proposed federal changes would work at the maximum capital gains rate, which under the Biden proposals, is imposed on individual taxpayers with incomes of over $1 million.
This chart illustrates the increased taxes under the Biden proposal. In this example, the sale of a business generates a 20% tax on a gain of $7 million under current law. The capital gains tax under the Biden proposal is $1,372,000 higher than the sale under current law ($2,772,000-$1,400,000).
Q – Should buyers of businesses be motivated to finalize transactions before capital gains taxes are increased since capital gains taxes are imposed on the seller?
A – Yes. Assuming no other changes, the marketplace of businesses for sale will shrink, and/or the offering prices of sellers will increase after capital gains taxes are increased. The prospect of selling a business will be less attractive to potential sellers because their net proceeds will be reduced. In the example above, a potential seller might not be willing to sell their business knowing that their proceeds will be $1,372,000 lower after capital gains taxes are raised. Therefore, it is to the advantage of both buyers and sellers to accelerate their deals before the tax rates are increased.
Steven Rosenthal, JD, CPA, MBA, LLM, CFP®, has 30 years of experience providing tax research, planning, and audit defense for publicly traded companies such as AT&T, eBay, PayPal, Ericsson, and Expedia. Today, Steve serves as Senior Tax Expert at Fulcrum Wealth Advisors where he specializes in business valuation and tax strategies for small and mid-size businesses seeking to maximize their “after-tax” returns.
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