By: Sherri Sorbello, CPA
Among President Biden’s tax proposals is an increase in the long-term capital gain tax rate from 20% to the top ordinary tax rate (37% for 2021 or 39.6% for 2022) for taxpayers with adjusted gross income (AGI) over $1 million. At the time of the publication of this blog, it is unclear if this change, if enacted, will be retroactive to a yet-to-be determined date in 2021 or if it will take effect as of January 1, 2022. For those looking to sell a family business, planning for the potential higher tax rate is essential to ensure you net the greatest cash flow from the sale of a business.
The below chart illustrates the significant differences in net cash proceeds received from the sale of a business for $20 million based on the current and proposed 2021 and 2022 capital gains tax rates. The tax from the sale is nearly doubled under the proposed 2022 rate of 39.6%.
Planning Strategies and Considerations for Sale of a Business
Given the significant reduction to net cash flow from a sale with the increased capital gains tax rate, there are planning strategies to consider when selling a family business.
When a business is sold in exchange for an installment note, the gain is realized on the seller’s tax return over the term of the note as sales proceeds are received each year. There is an option to elect out of the installment sale method, which must be done by the extended due date of the tax return for the year of the sale. The benefit of electing out of the installment sale method is the gain may be taxed at a lower rate if the sale occurs before the capital gains tax rate increase. The downside is there may need to be available cash outside of the sale to pay the tax on the entire gain in the year of sale, as the entire proceeds will not be received in the year of sale.
Asset vs. Stock Sale
A sale of a business can be structured as an asset or stock sale. Sellers typically prefer that the sale be structured as a stock sale so the gain is treated as capital gain. Some or all the gain from an asset sale may be treated as ordinary income depending on the assets sold. If the capital gains rate does increase to the ordinary income tax rate, the asset vs. stock sale consideration may be irrelevant since gains from both types of sales would be taxed at the same rate. However, if the capital gains rate remains at its current level or is increased to a rate below the ordinary income tax rate, we expect sellers would continue to prefer those sales of businesses be structured as stock sales.
Investment of Sales Proceeds into a Qualified Opportunity Zone Fund
The capital gain from a sale of a business to an unrelated party can be deferred until 2026 to the extent the seller invests the proceeds into a Qualified Opportunity Zone Fund (QOZ) within 180 days after the sale. There are other benefits for investors in QOZs such as 10% forgiveness of capital gain if invested in QOZ funds by 12/31/2021 and exclusion of the QOZ’s appreciation from tax if the investment is held 10 years of more. See our previous blog about QOZ investments here.
Acceleration of Deductions to Offset Gain
Consider accelerating deductions into the year of the sale to offset the gain from the sale of the business. Using charitable planning strategies such as a donor-advised fund, private foundation, or charitable trust may provide a significant tax deduction to offset the gain.
Transfer of Business by Gift Instead of Sale
For those contemplating a sale of their business to family members, an alternative to a sale may be the transfer of the business by gift. One proposal included in the Biden Administration’s Green Book is for capital gain to be realized upon gift transfers, with an important exception for certain family businesses that remain family owned and operated. The capital gains tax on the appreciation of the business would be deferred until the business is sold to a third party or no longer family owned and operated.
The Tax Warriors® at Drucker & Scaccetti are keeping a watchful eye on developments in Washington and will post future updates once more information is available. The sale of a business is a complex transaction in which you should have a tax advisor to assist in structuring the deal in the most tax-efficient manner for your family. Call on our experts to help.