Potential Tax Changes Pressure Business Owners to Make Big Decisions

Owning a business and navigating the twists and turns that come along with it is like following a map that is constantly rewriting itself. Depending on any number of factors, pathways that seemed clear are suddenly closed off while new routes regularly open — and sometimes, a fork in the road that appeared far away is unexpectedly near at hand.

Few entities can rewrite the map like the government can. Even the barest suggestion of a change to the tax code or new regulations can shake the market or jolt a business owner into making a decision that might greatly affect their organization.

We’re seeing that today with the introduction of the Biden administration’s new proposals investing on infrastructure and helping families with education, child care and paid family leave. Both are funded by tax increases that could have major impacts on business owners as they relate to income tax rates, capital gains tax rates and estate and gift tax exemptions. Such proposals, if they come to pass, will create another new tax environment for business owners to navigate.

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So, for owners who have been mulling major decisions, such as selling their business, perhaps a fork in the road that appeared to be five years away is looming much closer. Here are just a handful of the decisions and items up for consideration:

Selling a business

Let’s imagine a business owner in their late 50s is planning on selling their company in three years. The question suddenly is, should they sell now at a lower capital gains rate, or in the future, when the business could be worth more, but potentially higher taxes could undercut the extra gains?

Using a broad example (and not counting other fees and taxes for simplicity’s sake), if the business sold for $10 million today and the business owner had to pay today’s 20% capital gains tax, they’d be left with $8 million. If, however, they waited to sell for another three years, when the business is worth $12 million, they should expect to take home more from the sale, right? It depends on what happens to taxes between now and then.

If the tax rate doubles to 40%, the owner would be left with $7.2 million. In fact, under this tax rate, the business would have to sell for about $13.5 million for the same $8 million payout. I realize in the example above I did not account for the additional 3.8% surtax on net investment income as part of the Affordable Care Act, and I took some liberty with rounding the highest rate, but you get the picture.

In this scenario, the owner must ask, “If I’m going to wait to sell, will my business grow 35% in the next few years?” Even if the business is thriving and growing year after year, it may be a risk to wait to sell. As the past year proved, circumstances can change quickly. With that context, the increased potential for a tax increase forces a business owner to confront these questions and decisions.

Transitioning the business

Instead of selling their company, many business owners plan on transitioning it to the next generation. Even with a different exit strategy, the potential for tax changes that could impact estate planning and common transfer techniques should prompt a fresh look at succession plans.

For instance, owners commonly gift stock in the business to heirs. With the proposal from the Biden administration aiming to dramatically lower the federal lifetime exemption amounts on estates (from $11.7 million per couple currently to a proposed $7 million per couple), it would make this type of planning tough. In addition, with the annual gift-tax exemption set at $15,000 for individuals or $30,000 for married couples, an owner likely won’t completely transfer their business this way.

Even for an owner who plans on transitioning their business to the next generation but is still young and successful, now is a good time to consider succession planning. It always is, of course, but particularly when the tax environment changes, the proper strategy can ensure wealth is protected in the years to come. This may include getting the jump on shifting ownership to long-term estate planning vehicles, such as trusts.

Restructuring the business

Business owners should ask, what is the best way to own a business right now? Or rather, what’s the best way to structure a business?

For C corps, not only do they pay federal, state and sometimes local taxes, but also tax on profits, a rate that could increase (from 21% currently to a possible 28%) under the proposed legislation. Distributions to shareholders also have potential to be taxed at a higher rate, should that rate increase via new legislation. An S corporation, meanwhile, allows profits and losses to be passed through to personal tax returns.

Structures such as LLCs and sole proprietorships also avoid C corps’ double taxation issue, but it’s important to remember that an individual’s income tax rate may be higher than the corporate rate, adding another factor that may influence how an owner organizes their business. Even if tax rates don’t change notably in the coming years, there still may be an advantage to changing a business structure.

Choosing a path

Business owners constantly face decisions that affect their company’s lifecycle and its fortunes, whether that is a sale or transition to a new generation. We all want to be masters of our own fates, but often it is our environment that drives decision-making.

Nevertheless, owners don’t want to be too hasty in making a decision that could have a significant impact on their future, even if it appears the tax environment may be changing. It is always best to meet with advisers, break down the available options and their pros and cons.

While the fork in the road can arrive quickly, pausing before going left or right is the best decision.