Taxes and Small Business Owners: Followup

Two weeks ago, we published an overview of the implications of state and federal tax proposals (Taxes: Bad News and Good News for Business Owners). Judging from the response, this is forefront in a lot of business leaders' minds right now.

We received valuable insights and feedback from some of our trusted referral partners who are equally concerned with how these tax proposals would impact business owners — especially those owners who have been thinking about exiting and retiring in the next few years. Two of these partners gave us permission to share their valuable information.

Exit Now or in 14 Years

John Dimmer owns FIRS Management, LLC. He told us:

The current administration is poised to implement a significant increase to the capital gains tax, taking the top rate from 20 percent to 40 percent. In addition, many states are implementing or increasing their capital gains tax. Here in Washington, the government has passed legislation that was signed into law by the governor that will impose a capital gains tax of as much as 7 percent. Furthermore, the Affordable Care Act included a net investment tax of 3.8 percent that took effect in 2013. All told, capital gains in excess of the $1 million threshold are poised to be taxed at their highest rates in years, reaching 50.3 percent in the state of Washington.

As my business partners and I were examining the impact of these new taxes, the critical question that arose was how long it would take for us to get back to even. In other words, taking the net after-tax profit if we sold our business today, how many more years in the future would we have to operate our business in order to net the same amount of money? This is a bit of a complex calculation as it requires a number of assumptions on net after-tax earnings from future operations, estimating future partner distributions and discounting everything back to present value, but for us the number was 14 years. We would need to run the company for another 14 years, at which time a sale would yield net after-tax proceeds equal to a sale of the company this year.  Our operational partner was very clear that he was not interested in running the business until he was in his mid-70s. Accordingly, our decision was made, and we are exploring our exit options.

I would recommend every business owner run this calculation so they know exactly where they stand. While some may find that the time horizon to equality is very reasonable, others may find it exceeds the owner’s estimated life span. It is best to plan now for an appropriate and well-managed exit.

Don't Forget the Qualified Small Business Stock Exemption

Mark Mitchell, founder and principal consultant at Creekside Consulting Company added:

Another item to consider is the qualified small business stock (QSBS) exemption which allows business owners to exclude federal capital gains tax incurred when selling their business. There are some limitations. The company must be a C corporation, stock held for more than 5 years, assets of less than $50 million, and the exclusion has a cap of $10 million. The exclusion only applies to individuals, not to corporations. Gains above $10 million are subject to a capital gains tax. QSBS is a complicated subject and should be reviewed with a qualified financial advisor. 

Also, based on my experience, private equity firms were pretty active during 2020. They have funds to invest and are comfortable working remotely on due diligence and disclosures. They use cloud-based solutions like SharePoint and Dropbox for data room document sharing, allowing them to close deals faster than a data room located at a seller or an attorney site.

As a side note, another area that deserves attention when considering a sale is contingent liabilities, like forgiveness on the Payroll Protection Program (PPP). It's important to file for forgiveness as soon as possible. Buyers will require the PPP loan balance to be set aside in escrow until the forgiveness is approved.

Doing the Math

Dr. Kevin K. Boeh is an associate teaching professor of finance at the University of Washington's Foster School of Business. He shared the following:

Some math to illustrate the realities of these implications:

1. 1. WA SB 5096 (the 7 percent capital gains tax bill for Washington State) excludes the first $250,000 per person or per couple (spouse or domestic partner). This means two things:
      1. Each owner (if there is more than one) may receive this deduction
      2. If a couple jointly owns the business but separates, the exclusion appears to double to $500,000 (see Section 7.1 of the bill)
   2. The 7 percent does not apply to qualified family-owned small businesses.
   3. The 3.8 percent net investment income tax instituted by the IRS in 2013 might also apply if this is passive C-corp stock, making the tax even higher. Imagine: 39.6% + 3.8% + 7%