21% and up: What business owners should consider when considering higher tax rates
The specter of rising corporate, capital gains and personal tax rates continues to boost M&A activity as business owners and private equity firms and their advisers attempt plan for the eventual adoption of the tax changes proposed by the Biden administration. The main among the 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 eligible dividends realized by taxpayers with income over $ 1 million, from the current 20% to 39.6%;
- an increase in the maximum personal income tax rate from the current 37% to 39.6%;
- phase-out of the 20% deduction from qualifying business income available to partnerships and S corporations; and
- the addition of a new payroll tax of 12.4% on gross income over $ 400,000.
Typically, tax cost is just one part of a long list of regulatory considerations that business owners and investors should analyze when starting, operating, owning or selling a business. However, the magnitude of the proposed rate hikes is likely to put tax issues at the top of the list in 2021. The following is a brief summary of how the proposed tax rate hikes may influence a few top business decisions. level.
When to sell
The near doubling of the capital gains tax rate would have a significant impact on the net income of any merger and acquisition transaction. For example, to pocket the same after-tax proceeds from a transaction, a company that would sell 10 times EBITDA at current rates would have to sell 13.2 times EBITDA at offered rates. Business owners and investors should therefore consider the possibility of speeding up their exit / sale times. It is generally expected that the proposed tariff changes are unlikely to be enacted quickly enough to take effect within the current year or apply retroactively. Therefore, 2021 could continue to be a very busy year for M&A activity. Whether this increased activity results in an oversupply and underpricing scenario for a potential seller will likely need to be determined on a case-by-case basis.
Choice of entity
If a business owner or investor is not prepared to sell, they will need to consider the increased tax burden associated with operating a business. While a number of factors will affect the overall fiscal cost of operation, the proposed rate increases are likely to have an effect on both corporations (via increasing the corporate tax rate). ) and transfers (via the phase-out of the 20% of eligible business income deduction). Therefore, the choice of the type of entity to start or operate a business remains highly dependent on individual circumstances. However, regardless of the type of entity, free operating cash flow is likely to be significantly reduced below the proposed rates and business owners may need to consider other means of having operating cash flow, such as ” increased debt financing or reduced costs.
In the event that the proposed rate increases result in a flow-through entity structure becoming clearly advantageous for a currently operating legal person, a business owner may consider converting from a C corporation to an S corporation, or even converting to an S corporation. partnership status. The increase in tax rates, once effective, will make the conversion to partnership status much more expensive.
Tax deferral and tax elimination structures
The availability of certain tax-advantaged investment structures is likely to take on additional importance if the proposed rates become law. In particular, structuring a new business as a C corporation with the intention of meeting the requirements of a “skilled small business” should be considered by almost anyone starting a new business. If the requirements of a qualified small business are met and that company’s stock is held for five years, a business founder or early investor can wipe out up to $ 10 million in capital gains on an exit. As the capital gains tax rate nearly doubles, the value of this gain elimination also nearly doubles for the first $ 10 million of capital gain.
Likewise, investors currently realizing capital gains may consider reinvesting those gains in a “qualifying opportunity fund”. If properly structured, the payment of tax on these capital gains may be deferred until 2026. Additionally, if the investor holds his interest in the “qualified opportunity fund” for 10 years , any appreciation in the value of this investment can be made without paying capital gains tax. While the possibility of exiting an investment tax-free has already generated a lot of interest in qualifying opportunity funds, the possibility of a higher capital gains tax rate is likely to make this possible. even more popular investment structure.
The enactment of the proposed tax rate increases is far from certain, and the details of any tax changes may well be very different from the Biden administration’s current proposals. Nonetheless, we strongly encourage all current and potential clients to consider the effects of the proposed tax rate increases.
This column does not necessarily reflect the opinion of the Bureau of National Affairs, Inc. or its owners.
C. Wells Hall, III is a partner at Nelson Mullins in Charlotte, North Carolina. Hall advises clients on federal, state and multi-tax aspects of acquisitions, reorganizations, business entity restructurings and private equity transactions and estate and gift tax planning. in the context of such transactions. He can be contacted at [email protected] or (704) 417-3206.
Drew Hermiller is a partner at Nelson Mullins in Charleston, SC Hermiller practices in the Tax and Benefits group and has experience advising clients on complex domestic and cross-border transactional tax matters. He can be contacted at [email protected] or (843) 534-4125.
Bloomberg Tax Insights articles are written by seasoned practitioners, academics, and policy experts who discuss current tax developments and issues. To contribute, please contact us at [email protected].