The American College of Financial Services, www.theamericancollege.edu
President Joe Biden has pledged that his sweeping American Families Plan will only target the nation’s wealthiest individuals, increasing taxes on those in the top 1.8% earning $400,000 annually or higher with the majority of new money coming from those bringing home $1 million a year.
But owners of small businesses who are planning to sell or transfer the business may end up as collateral damage.
That’s because the proposed combination of the increase in the capital gains tax rate and changes to the step-up basis rules could result in a significant tax hit to business owners whose businesses have appreciated in value. This could be a huge blow to owners who may have worked for decades to grow the value of their businesses, perhaps hoping to pass them on to their children.
And there are other pieces of pending legislation, such as the For the 99.5% Act and the STEP Act. Those could considerably impact planning for business transfers, such as business valuations and gifting strategies.
Capital gains changes
The biggest change under the proposed new rules would be the increase of the top marginal income tax rate to 39.6%, and the inclusion of capital gains in that top marginal bracket for individuals earning over $1 million in total income in the tax year. The increase of the top rate for capital gains to 39.6% is a significant jump from the previous maximum rate of 20%. This change would affect approximately 0.3% of all households.
At first glance, a business owner who doesn’t earn a million-dollar salary may believe this change does not impact them. What they may not realize is that the sale of their business could easily catapult their income above the million-dollar range in the year of the sale. Any gain in the value of the business of $1 million or more will be taxed at 39.6%. With the inclusion of the 3.8% Net Investment Income Tax on modified adjusted gross income, the rate becomes 43.4%. However, selling the business to family members may allow the tax to be deferred over an extended period of about 15 years.
Luckily, there are some options to salvage some of the profit from tax erosion. Although the current plan is for the changes to be enacted retroactively to April 2021, many experts speculate it is more likely that political considerations and logistical issues will result in a January 2022 effective date. So, there is a small window to take action.
Assuming a January 2022 date, a business owner can accelerate the sale of a business into 2021, taking advantage of the 20% top capital gains rate.
However, planning for a sale in such a short time frame is challenging at best. And even if they have already started planning for the sale of the business, the business owner’s entire retirement plan must be re-evaluated.
First, they will need new sources of income to replace lost income from the business. Two options would be to take a management position as a salaried employee in the business or for the owner’s spouse to delay retirement. Alternatively, if the business owner chooses to retire, their planned retirement income must be adjusted since the proceeds of the sale will need to stretch over a longer time horizon.
Second, the owner should consider whether successors are actually ready to take the helm. Ill-prepared successors can ruin the business, a consequence that far outweighs any tax savings.
Third, evaluate if the successors can locate the funding to complete the sale. If not, the owner may have to consider an installment sale rather than a lump-sum payment.
The installment sale can be structured in two ways. As long as the sale is effective in 2021, the owner can report all of the gain in that year and take advantage of the 2021 tax rates. However, the owner will need to ensure that they are liquid enough to pay the entire tax amount this year, while the remainder of the sale payments arrive in the years to come.
Alternatively, the installment contract can be structured so that the owner’s total annual income stays below $1 million each year, thus avoiding the top capital gains rate. This is also a good option if the client wants to hedge against the possibility of a retroactive April 2021 date.
Lastly, warn your client that accelerating a sale may require some compromises. For example, it may be necessary to accept a lower sale price in order to ensure the sale is completed this year.
Transfers by gift derailed by step-up basis changes
Say your client doesn’t need the income from the sale of the business. Is it possible to avoid the income tax mess by simply gifting the business to the next generation?
Unfortunately, proposed changes to the step-up basis rule could thwart this strategy. While many experts are referring to Biden’s changes as the “elimination” of step-up basis, the actual proposal is something quite different. Under the proposed changes, the appreciation would be taxed at the death of the decedent on the decedent’s final income tax return. Though the exact details are still forthcoming, appreciation of $1 million or more would be subject to income tax at the death of the owner, at the top capital gains rate.
There is some good news: some or all of that amount would be deferred as long as the business is passed to family members, and it appears that the heirs would inherit the business at the stepped-up value. Also, the income tax paid would be deductible on the estate tax return so that the estate would not be subject to double taxation on the appreciation.
The last bit of good news, and perhaps the most crucial, is that many industry analysts feel that this proposal is not likely to pass in its current form.
Even so, you should explore some options with your clients. The extremely high federal estate and gift tax exemption can be preserved by transferring the business interest by gift before 2026 before the exemption reverts back to its pre-Tax Cuts and Jobs Act amount of $5 million (adjusted for inflation, so the amount will likely be somewhere between $6 million to $6.5 million). Be aware that the business will be transferred at carryover basis, so this option may only be attractive if the family intends to continue to own and run the business instead of selling it. Again, you will need to evaluate other income sources for your client as well as the feasibility of transfer to the next generation.
These proposals are sure to cause major disruption in wealthier clients’ succession plans. To serve them, you should work with the appropriate team of attorneys, CPAs and other experts to create various options for your client, which can be executed according to which proposals pass Congress.
And although we didn’t touch on the For the 99.5% Act and the STEP Act, you should stay on top of those developments to refine and adjust your clients’ plans as needed.