Capital Gains Tax Rate Increase and Its Impact on the Sale of a Business

We are surprised that we are just now beginning to hear discussions of increased taxes and actions individuals should consider taking to address that possibility. The prospect of the capital gains tax rate increasing from 15% to at least 20% in 2011 is real. There is also talk of personal federal tax rates increasing, particularly for the more affluent. And with mounting deficits and the government’s seeming inability to make meaningful reductions in expenses, California and many other states may have few options but to increase state tax rates—on both ordinary income and capital gains. Consequently, more and more accountants and financial planners are beginning to advise their clients to consider accelerating tax payments, as today’s tax rates may never again be this low. This advice is particularly relevant for business owners who may have delayed considering selling their companies in hopes that the economy will soon improve. (If you have read some of our earlier blogs, we do not think that the economy, as it impacts middle-market companies, particularly in California, will improve meaningfully in the foreseeable future.) Business owners should consider what effect an increase in tax rates will have on the net after-tax proceeds resulting from the sale of their business. Or put differently, they should look at the increased EBITDA (earnings before interest, taxes, depreciation, and amortization) that the business would have to achieve in order to obtain the same after-tax proceeds of a sale completed before pending increases in take rates. Here is an example:

Assume the following:

• The federal capital gains tax rate is increased from 15% to 20% beginning in 2011
• The maximum personal federal tax rate is increased from 35% to 39.6%
• The company EBITDA is $10,000,000
• The sales price multiple is 5.50 times , resulting in the sale price and taxable gain of $55,000,000 (ignoring any basis issues for example purposes)

 As a result, the federal capital gains tax on a $55,000,000 gain would increase from $8,250,000 (15% of $55,000,000) if the sale were completed in 2010 to $11,000,000 (20% of $55,000,000) if the sale were completed in 2011—an increase of $2,750,000.

After the additional charges for personal federal and state taxes, the net proceeds to shareholders would be reduced from $22,833,031 if the sale were completed in 2010 to $19,542,109 if the sale were completed in 2011—a reduction of $3,290,922 or 14.4%! Put differently, to achieve the same net after-tax proceeds if the sale were made in 2011 as opposed to 2010, EBITDA would have to increase by 17%!   The message is that business owners who are considering selling their company in the next several years should think about doing so in 2010 rather than wait and potentially realize lower net after-tax proceeds as a result of increased taxes that seem to be inevitable. Additionally, as a thoughtful sale process can take six months or longer, we encourage business owners to act sooner rather than later. We at Barnard/Montague Capital Advisors welcome the opportunity to explore a sale transaction with you or your business owner clients.   (If you would like to see the model we developed to analyze the tax impact on a business sale, please notify us and we would be happy to email it to you.)