In my last article, I compared hockey sticks with trying to time the sale of your business. In this article, I look at a factor that can have a major impact on your decision to sell now or later: taxes.
Our clients often ask us to assist them in determining the best time to sell their businesses. While our crystal ball is no clearer than yours, there are certain elements to consider when determining the best time to sell your business.
Morley Zipursky (the founder of CFA, my business mentor, and my father) likes to say, “The best time to sell a business is when you are ready to sell and [are] emotionally committed to the process. Of course, it helps if the company is doing well, and the economy is in good shape—as it is today. Furthermore, buyers want to have a little fuel in the tank when they acquire the business, so waiting until your company is on the precipice of disaster (or seeing a downward trend in revenues) is not a wise decision.”
Beside the health of your business and your mental preparedness, there is another factor looming today regarding how to determine if now is the time to consider a sale of your business. Today, we enjoy long-term capital gains tax rates, which are close to historic lows. The current rate of 20% for long-term capital gain taxes is not as low as the 15% rates we saw during the Bush administration, but are certainly lower than rates of 25% and 30% seen in years past.
We also know lower capital gains tax rates are always a boon to the economy. However, we also know when Democrats control the White House and Congress, capital gains rates have a tendency to increase. Look no further than President Obama allowing long-term capital gains rates to increase from 15% to 20% during his term in office.
With a presidential election coming in November, it’s anyone’s guess whether or not Ms. Clinton will win. If she is elected, you can safely bet that increases in capital gains rates will be back on the table, and they will potentially impact anyone trying to sell a business.
What does this mean to a business owner? Consider the following example. Assume you sell your business for $5,000,000 today, and the entire transaction is taxed at the current long-term capital gains rate of 20%. The tax you would pay Uncle Sam for this transaction is $1,000,000.
But what if Ms. Clinton is elected, and a Democratic Congress increases the long-term capital gains tax rate to 25%? On that $5 million deal, you would now pay Uncle Sam $1.25 million in taxes, which means a bonus payment of $250,000 to your fellow taxpayers.
Let’s take this example one step farther, and assume you know your business is going to grow. So you wait until 2017 to sell your business. Ms. Clinton is elected, the Dems control Congress, and they increase capital gains taxes to 25%—retroactive to January 1, 2017. (Remember, when Bill Clinton was President, he set the precedent for retroactive tax increases.) You did a nice job of growing your business, and now it’s worth $6,000,000—a 20% increase in value from 2016. You sell the business and receive a tax bill for $1.5 million (assuming the entire transaction is taxed at long-term capital gains rates of 25%).
Thus, in this example, you increased the value of your business by $1,000,000, but you increased your tax bill by $500,000—because you waited to sell, and taxes were increased. Consequently, you only kept 50% of your gain, and gave Uncle Sam a 50% incremental gain as well. Hardly just deserts for your efforts.
Of course, if capital gains rates are increased to the 28% rate that President Obama, Mrs. Clinton, and the Dems have been hinting at for the last year, the math looks even worse for business owners.
We all know tax rates change with frequency and sometimes they go down, too. While we at CFA never, ever advise our clients to sell because they fear a threatened or pending tax rate change, we are not so naïve as to underestimate the value of maximizing our clients’ after-tax sale proceeds by taking advantage of today’s more favorable economy and comparatively modest long-term capital gains tax rates. After all, in our business, it isn’t necessarily what you get but what you keep that is most important when you sell your business.
In my next article, we will examine how the proverbial “alignment of the moons” impacts the timing of the sale of your business.
