Biden’s proposed tax hikes speed up trade deals
The potential tax rate increases proposed by the Biden administration and its allies in Congress could be a factor in accelerating the realization of business sales.
Depending on the amount of the increase ultimately agreed, sellers will walk away with much less of a deal if they wait for the new rates to take effect, observed Michael De Prima, tax director of Top 10 Firm CliftonLarsonAllen in Denver.
“The proposed changes have injected uncertainty into the world of mergers and acquisitions,” he said. “The rate for individuals would drop from its current 37% to 39.6%. And the rate on eligible dividends and capital gains for those earning over $ 1 million, currently at 20%, will likely drop to 25%. The House reversed the rate increase originally proposed by Biden, initially set to reflect the individual rate of 39.6%, to 25%. Regardless of the final figure agreed upon, the chances of an increase in tariffs are very high. “
“These increases will have a major impact on business owners considering a potential sale,” De Prima said. “And the additional net investment income tax of 3.8% will still apply to the gain on certain sales.”
De Prima and his team at CLA’s Federal Tax Strategies Group modeled the various transaction outcomes for potential buyers and sellers. “We’re really trying to figure out how rates might affect potential transactions,” he said. “The effective date, and whether it is retroactive or prospective, is a wild card. Originally, Biden proposed an effective date of April 28, 2021, when they announced the proposed increases. “
De Prima illustrated the effect of rate increases on the sales of an S corporation and a C corporation with these examples:
Example 1: A shareholder of an S corporation sells 100% of their stock, with $ 5 million in long-term capital appreciation resulting from the sale. If that stock were sold today at the current 20% capital gain rate, it would pay $ 1 million in tax on the sale. That same sale as part of Biden’s plan would trigger $ 1.98 million in taxes – a difference of nearly $ 1 million.
The Biden plan would also increase the corporate tax rate. Although the original proposal was to increase the rate from its current 21% to 28%, once the dust settles it will likely drop to 25%, De Prima predicted. “Either way, the increase will leave owners of C corporations with even less after-tax proceeds from an asset sale,” he said.
Example 2: XYZ Corp. is a C corporation with a shareholder who sells all assets in liquidation, resulting in a taxable gain of $ 10 million. Suppose the shareholder has zero stock base, a long-term holding period, and is not eligible for exclusion from section 1202. The after-tax proceeds are then distributed to the shareholder. At the current tax rate of 21%, the tax owed at the corporate level is $ 2,100,000. At the probable rate of 25%, the tax owed at the corporate level would be $ 2,500,000, a difference of $ 400,000 in the after-tax product available for distribution. The after-tax total at current rates would be $ 6,320,000 over the total at the proposed rates of $ 5,400,000, a difference of $ 920,000.
“Another consideration is that a higher effective tax rate at the company level and a corresponding decrease in cash flow can have a negative impact on company valuations,” said De Prima. “This will be particularly important in private equity, where cash flow can be a critical metric in valuing transactions, financial modeling and benchmarking investor distributions.”
The potential rate hike has been a factor, not the only motivator, in sales planning, according to De Prima. “It played into conversations with customers as a reason to close deals before the changes took effect, especially from a salesperson’s perspective,” he said. “The bill has yet to return to the Senate before we know the final numbers.”