The 2020 election is behind us and a new president is about to take the helm in what has been one of the most tumultuous times in modern American history. With the Georgia run-off elections decided, the Democratic Party has control over both the Executive and Legislative branches of government. Changes to the tax code are surely coming, but what? Let me also be clear that this isn’t a political post – it’s simply a matter of fact. The election is over.
As stated by the Motley Fool, Biden’s tax plan is best summed up as “a tax increase to high-income households and corporations.” Anyone interested in all the nuances of Biden’s plan can view them here. What I’m going to focus on is the potential change to capital gains taxes because that is what is relevant to those seeking to sell their business in the next few years, and we could be looking down the barrel of the largest capital gains tax hike in US history.
In short, Biden proposes to treat any gain over $1M as ordinary income. Currently, the long term capital gains tax rate for gains over $1M is 20% plus a 3.8% surcharge (total of 23.8%) plus any state tax. If Congress goes along with Biden’s tax plan, which is very possible with a split Senate where VP Harris makes the deciding vote, the federal tax rate on gains over $1M will be over a whopping 43% (39.6% plus 3.8%). That increase equates to an additional $196k in taxes for every $1M of sale price above $1M. For residents in nearly half of the country, the combined federal and state capital gains taxes will exceed 50% on long term gains over $1M.
The proposal is insanely unfair to business owners looking to sell their business in the next few years. Certainly, $1M is a decent amount of money but most business owners work many years to get to a position to sell their business and depend on the net proceeds for their retirement. Can you imagine the government taxing retirement accounts at such an exorbitant rate?
The Unexpected Double Whammy
I’ve discussed before the “double whammy” agency owners were hit with back in the 2008 recession as a result of revenues declining from the recession and value multiples declining due to a tightening in capital markets (less money plus higher interest rates). If a potential 43.4%+ tax rate in and of itself is not enough pain, we can’t forget that this increased “exit tax” will also hit private equity (PE) investors, who are largely responsible for the great surge in agency values over the last half decade.
PE is return-driven and rate of return is proportional to after-tax investment gain. We can assume the effective tax increase will be approximately 20% since the PE funds gains will significantly exceed $1M. If private equity investors take an additional 20% hair cut compliments of the government, what impact do you think that will have on what they pay for agencies?
When to Expect a Tax Increase
Most M&A and tax professionals that I have been talking to are very confident that taxes are going up on higher income earners – if your business sells for more than $1M, then that includes you. Will a new tax bill pass in 2021 and be retroactive to the beginning of the year? That is hard to say but probably unlikely. Out of the last six tax bills, only one was effective retroactively. The rest went into effect after the date that the bill was signed into law. The American Taxpayer Relief Act of 2012 was the only one of those six bills that included a material tax increase. It was signed at the beginning of January of 2013 and effective for the same year. Time will tell but the longer the bill is delayed in the House and Senate, the better our odds are for a 2022 effective date. One thing is for certain, the window to sell your agency at a lower tax rate is closing fast.
The Bottom Line
In light of the current economic and political environment, we should expect to see a significant increase to the long term capital gains tax rate. The tax increase will not only impact net proceeds from the sale of a business, but could also drive down valuations as private equity investors adjust valuations to meet their expected rate of return on capital. A new tax bill could be retroactive to the beginning of 2021, but most likely would take effect in 2022. Any change to the tax law should be expected to last at least 4 years, if not longer, based on history (see the chart).
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