The specter of increases in the corporate, capital gains and individual tax rates continues to spur economic activity as business owners, investors, private equity firms and their tax advisors attempt to plan for the possible enactment of tax changes proposed by the Biden administration. Chief among those proposed changes are:
- An increase in the tax rate applicable to C corporations from the current 21% to 28%;
- An increase in the tax rate applicable to capital gains and qualified dividends realized by taxpayers with income above $1,000,000 from the current 20% to 39.6%;
- An increase in the top individual tax rate from the current 37% up to 39.6%;
- The phase-out of the 20% qualified business income deduction available to partnerships and S corporations; and,
- The addition of a new 12.4% payroll tax on gross income above $400,000.
White House summaries of the foregoing can be found
Typically, tax cost is merely one item on a long list of regulatory considerations that business advisors and investors must analyze when counseling clients who are starting, operating, owning or selling a business or buying or selling capital assets. However, the magnitude of the proposed rate increases is likely to push tax rate considerations to the top of that list in 2021. What follows is a brief summary of how the proposed tax rate increases may play into tax advisors’ analysis of a few common high-level client decisions.
When to sell
The near doubling of the capital gains tax rate would have a large impact on the net profit from any sale of any capital asset. For instance, in order for business owners to pocket the same after-tax proceeds from a sale of their business, the business would have to have a significantly larger EBITDA multiple (e.g., a company that sold at 10X EBITDA under the current capital gain rates would have to be sold for 13.2X EBITDA under the proposed capital gain rates to generate the same net profit). Tax advisors to business owners and investors therefore must explore with their clients the ramifications of accelerating their exit/sale timelines.
It is widely anticipated that the proposed rate changes are unlikely to be enacted quickly enough to take effect in the current year or apply retroactively. Consequently, 2021 may continue to be a very busy year for M&A activity and, more generally, sales of capital assets. Whether that increased activity results in an over-supply and undervaluation scenario for a potential seller will likely need to be determined on a case-by-case basis.
Choice of entity
If clients with an operating business are not ready to sell, their tax advisors will need to analyze the increased tax burden under the new rates and how it will affect the cash flow of the business. While a number of factors will impact overall operating tax cost, the proposed rate increases are likely to have an effect on both corporations (via the increased corporate tax rate) and pass-throughs (via the phase-out of the 20% qualified business income deduction). Consequently, the choice of entity type for starting or operating a business remains highly dependent on individual circumstances. However, regardless of entity type, the available operating cash flow will likely be materially diminished under the proposed rates. Tax advisors to business owners may need to consider additional avenues for operating liquidity, such as increased debt financing or cost cutting.
In the event the proposed rate increases result in a pass-through entity structure becoming clearly advantageous for a currently operating corporate entity, tax advisors may advise their clients to consider the conversion of a C corporation to S corporation status, or even conversion to partnership status. The increased tax rates, once effective, will make a conversion to partnership status significantly more expensive.
Tax deferral and tax elimination structures
The availability of certain tax-favored investment structures is likely to take on additional importance if the proposed rates become law. In particular, structuring a new venture as a C corporation with the intention of meeting the requirements of a “qualified small business” should be considered by tax advisors with clients who are starting a new business. If the qualified small business requirements under Code Section 1202 are met and the stock in the business is held for five years, a business founder or early investor can eliminate up to $10 million in capital gains upon an exit. As the capital gains tax rate nearly doubles, the value of that gain elimination also nearly doubles for the first $10 million of capital gain.
Similarly, tax advisors to investors currently realizing capital gains may want to consider reinvesting those gains in a “qualified opportunity fund.” If structured properly, payment of tax on those capital gains can be deferred until 2026. In addition, if investors hold their interests in the “qualified opportunity fund” for 10 years, all of the appreciation in the value of that investment can be realized without paying capital gains tax. While the ability to exit an investment tax-free has already generated a great deal of interest in qualified opportunity funds, the possibility of an increased capital gains tax rate is likely to make this investment structure even more popular.
