If you’re a business owner at or near retirement, it is in your best interests to accelerate the sale of your business to the 2012 calendar year.
The Bush-era tax cuts enacted in 2001 and 2003 which reduced the capital gains tax rate from 20% to 15% were set to expire at December 31, 2010. However, in the midst of tough economic times and extreme pressure from Congress, President Obama extended the capital gains tax cut until December 31, 2012.
Capital gains are set to increase back to 20% in the next 12 months! In addition, a new tax of 3.8% will be layered on top of the 20% capital gains rate for single taxpayers with income over $200,000 and income over $250,000 for married taxpayers. This additional 3.8% tax is the result of the Medicare tax being extended beyond wages to investment income per the National Healthcare Reform Act of 2010.
The end result is an effective capital gains rate of up to 23.8%. The magnitude of this impact on the sale of your business can be seen in the following example:
Let’s assume you either purchased or invested $500,000 to start your business. Annual revenues are now approximately $1.5M with cash flow of approximately $300,000. Let’s also assume the business is valued and can be sold for $1.2M. Subtracting the purchase price from your initial investment means you now have a total gain on the sale of $700,000 that is subject to capital gains tax and $500,000 ($700,000 – $200,000 threshold) that is subject to the additional Medicare tax.
In all likelihood some of this $700,000 gain will be allocated to asset classes taxed at ordinary income rates (rates higher than the capital gains rate)! However, for simplicity purposes, in this example we assume that 100% of the gain is attributed to asset classes receiving capital gains treatment. If the sale is consummated during 2012 you will pay $105,000 in capital gains tax to the federal government ($700,000 *.15). If you wait until after 2012 to sell the business you will pay $159,000 in taxes (($700,000 * .20) + ($500,000 * .038)). The result is an after-tax take home amount of either $1,095,000 ($700,000 – $105,000 + $500,000 basis) in 2012 or $1,041,000 ($700,000 – 159,000 + $500,000 basis) after 2012.
* Note: The numbers above assume the taxpayer files individually and the business has no outstanding debt subject to repayment. Debt repayments must be subtracted dollar-for-dollar from the “take-home” amounts.
In this simple example your after-tax take home decreases $54,000 by not selling before the end of 2012. Your effective tax rate on the $700,000 gain after 2012 increases to 22.7% compared to 15% in 2012. That’s a tax increase of 51.4%!
This is just one simple example. As your gain on the sale of the business increases, so do the taxes!
Using the same scenario outlined above:
Assume your basis in the business is $300,000 instead of $500,000. Your gain on the sale of the business is now $900,000 instead of $700,000. So, you would pay $135,000 ($900,000 * .15) in tax by selling the business in 2012 and $206,600 (($900,000 *.20) + ($700,000 * .038)) if you wait and sell the business after 2012.
Your difference is take home cash is $71,600! That’s an effective tax rate of approximately 23% on your $900,000 gain when selling after 2012 compared to a 15% effective rate in 2012. That’s a 53% tax increase!
The math is simple. Selling your business is not. If you want to exit your business before the higher tax rates take effect, you need to begin the process now. It will take about 9 – 12 months to successfully complete a sale and 2012 will be gone before you know it!