How a rise in capital features tax can have an effect on your consumer’s enterprise

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How an increase in capital gains tax can affect your client's business

The recent change of presidency will lead to significant changes in the taxation of wealthy individuals on capital gains. The Biden administration has proposed a plan that will essentially double capital gains tax for investors earning over $ 1 million to fund the $ 1.8 trillion American family plan. The goal is to remove the loopholes that allow Americans who earn more than $ 1 million a year to pay a lower rate for their capital gains than working Americans for their jobs.

While the current peak capital gains are 20%, the proposal will subject investors above the aforementioned benchmark to a tax rate equivalent to the peak income tax rate of 37%. However, it’s worth noting that along with the capital gains tax hike, Biden also plans to raise the top income tax bracket to 39.6%. This results in an overall increase in taxes that investors face under the management of 19.6%. The proposal has left many business owners across the country wondering how this change will affect their businesses and the wider economy.

Many people may be led to believe that capital gains tax increases will only affect large companies, not smaller ones. However, economic models and the past show that a significant increase in capital gains tax translates into less capital investment, an outcome that affects businesses of all sizes. For smaller companies, the increase is a hurdle to raise capital from outside investors that is needed to start their businesses and grow. Without this raising of capital, they cannot hire workers. From a revenue perspective, too, the proposal is self-destructive. Not only does this have a negative impact on new investments, but investors with pre-existing profits will postpone selling their investments, resulting in lower income. In addition, the proposal is estimated to affect two-thirds of total capital investment and have a disastrous impact on job creation and economic growth.

Another impact that an increase in capital gains tax will have on entrepreneurs comes into play if they decide to leave their business and liquidate their life’s work, resulting in a lifelong growth tax in a single year. For example, if a customer decides to sell their $ 10 million business after the offer goes into effect, they’ll end up paying 39.6% tax on the proceeds of the sale, leaving them with just over $ 6 million, a number far from it is lower than the estimate.

However, if a customer is ready to sell and the company is able to maximize value now, it might be wise to sell before tax law goes into effect. Keep in mind, however, that it can take years to find the right buyer willing to pay the highest price for the business. Therefore, even if they decide to hire an M&A advisor to sell the company immediately, it is important to have a plan to minimize their tax liabilities in the event the sale occurs after the tax law goes into effect. Here are a few different strategies your customers can use to minimize this liability:

While many proponents say the proposal will only affect high-income investors, creating some kind of balance in taxing low-income Americans versus high-income Americans, many fail to see the trickle-down effects that will occur once capital gains taxes are levied are raised. It’s important to look at the bigger picture and plan ahead so that you can be prepared once the proposal goes into effect.

  • Trust Fund: Set up a trust fund where you can receive monthly, quarterly, or yearly distributions. Contributing the proceeds from the sale of a company to the trust prevents initial taxation as it has not yet received the proceeds. It’s similar to a 401 (k) or an IRA. The trust holds the proceeds and invests them in real estate, stocks, or other business ventures for a return that you can repay over time. They are taxed at the applicable tax rate associated with the amount they withdraw each year. If they make an interest distribution that the trust has earned, they pay ordinary income tax on that amount. If they take capital after they have been paid the interest, they would pay capital gains tax on that amount.
  • Seller Financing: Seller Financing is a scenario in which the owner acts as a bank, allowing the buyer to make payments over time. Therefore, the owner is not immediately taxed on the total value of your business. You will be taxed in the applicable tax class based on the annual payment received. You will also earn interest from the seller financing.
  • Earn Out: Earn Outs are a payment method where the proceeds from the deal are tied directly to the company’s performance. In general, specific financial goals are set that determine the receipt of payments each year. While this is an option that minimizes the tax burden, it also involves significant risk as the payment is linked to the benefit. If the financial goals set are not met, you may not receive the originally agreed proceeds.
  • 1031 exchange: A 1031 exchange can be useful in avoiding paying capital gains tax on a company’s real estate interest. The customer sells an investment property and reinvests the sales proceeds in one or more properties of the same or higher value within a certain period of time. The sale proceeds are to be transferred to a qualified agent, not the seller of the property, and the qualified agent transfers it to the seller of the replacement property or properties. The capital gains tax is then deferred, which frees up more capital for investments and the customer can benefit from the rental income generated. This method could be combined with any of the strategies mentioned earlier, which would allow business owners to avoid and defer capital gains not only for the property but also for the company.
  • Tax strategist: Consulting a tax strategist can be beneficial in reducing capital gains tax liability when selling a business. They can help with purchase price allocation and enable the strategies above as many will require a qualified third party intermediary. M&A advisors are also excellent intermediaries for minimizing tax liabilities on sales. Not only will you be helping to get the highest possible price, but many have networks of tax strategists, attorneys, etc. who can help with any of the previous strategies.

Michelle Seiler Tucker is the founder and CEO of Seiler Tucker Inc., a company that has sold over 1,000 companies and currently owns and operates several successful companies. She is the author of the books “Think & Grow Rich Today” and “Sell Your Business for More Than It’s Worth” and her latest book is “Exit Rich”.