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Business Sellers - Beware of Potential Changes in the Capital Gains Tax

Nov 20, 2007
Thinking of selling your business? If you have planned it correctly, most of your transaction proceeds should be long term capital gains. Given the current political climate and the upcoming change in the White House, capital gains taxes will come under attack. If you are a business owner and are thinking of selling your business within the next 5 years, you may want to move up your exit timeframe says Dave Kauppi, President of MidMarket Capital, a Merger and Acquisition Advisor.

The reduced 15% tax rate on capital gains, previously scheduled to expire in 2008, has been extended through 2010 as a result of the Tax Reconciliation Act signed into law by President Bush on May 17, 2006. In 2011 these reduced tax rates will revert to the rates in effect before 2003, which were generally 20%.

Kauppi believes that with the AMT currently targeted for elimination, the $23 billion will be made up by raising taxes elsewhere, and I believe this "owner of capital" tax is the most vunerable for increase. I expect that the long term capital gain tax rate will be moved to an upper limit of 25% by mid 2009 for the high end income bracket.

Translation, the business seller is going to take a big hit on his after tax proceeds if his business sale is concluded after July 1, 2009. Let's look at a quick example. A 63 year old man started his business 25 years ago and he sells it for $5 million. All his equipment has depreciated so his basis is approximately $0. Under current tax laws he would have a $5 million capital gain from the sale of his business. His after tax proceeds would total $4,250,000.

If he sells after July 1, 2009, and the tax laws change as I am predicting. The same sale would net him $3,750,000. He lost $500,000 because of this change. If you wait until the actual change is voted into law, there will be a rush to the exits causing an unusually high number of business to be for sale. That would further reduce proceeds for the seller because of supply and demand pressures.

The most important tax issue, however, for the business seller continues to be the corporate structure (C Corp, S Corp, or LLC) and whether the business sale is an asset sale or a stock sale. First, unless you are planning on going public or have hundreds of stockholders do not form a C Corp to begin with. Use an S Corp or an LLC. If you currently are a C Corp ask your attorney or tax advisor about converting to an S Corp. If you sell your company within a 10-year period of converting to an S Corp the sale can be taxed as if you were still a C Corp.

Here is what happens when there is an asset sale of a C Corp. The assets that are sold are compared to their depreciated basis and the difference is treated as ordinary income to the C Corp. Any good will is a 100% gain and again is treated as ordinary income. This new found income drives up your corporate tax rate, often to the maximum rate of around 34%. You are not done yet. The corporation pays this tax bill and then there is a distribution of the remaining funds to the shareholders. They are taxed a second time at their long term capital gains rate.

Compare this to a C Corp stock sale. The stock is sold and there is no tax to the corporation. The distribution is made to the shareholders and they pay only their long term capital gain on the change in value over their basis. The difference can be hundreds of thousands of dollars.

This anticipated change to the capital gains tax rates will certainly add to the complexity of selling a business. I can not stress how important a factor taxes will be in your successful business exit. Here is my summary checklist:

Tax Consideration Checklist
Get Good Advice on Original Corporate Structure
If C Corp - Retain Ownership of all Appreciating Assets Outside Corporation - ie Real Estate, Patents, Franchise Rights: avoid double taxation
Look at Deal Economics First, Taxes Second
Make Sure Your Transaction Support Team has Deal Experience
Before You Go To Market, Work With Your Team to Understand Deal Structure vs After Tax Proceeds
You Have the Right to Pursue the Minimum Payment of Taxes - Exercise Your Rights
It Is Never as Effective as an Afterthought
The Pros Can Match Your Desired Outcomes With the Right Tools

Be agressive in your tax positioning of your sale, both with the buyer in your negotiations and with your filing with the IRS. The give and take on deal structure with the buyer is just one of the many factors that you will negotiate along with total purchase price and cash at close.
About the Author
Dave Kauppi (davekauppi@midmarkcap.com) is a Merger and Acquisition Advisor and President of MidMarket Capital, representing owners in the sale of privately held businesses. We provide Wall Street style investment banking services to lower mid market companies at a size appropriate fee structure.
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