A New Tax Plan Creates Urgency for Entrepreneurs to Sell Their Business Today
There’s a common saying that the two constants of life are death and taxes.
Well, the latter one has begun to rear its head in new ways that could lead to far less profit for entrepreneurs looking to sell their successful startups, at least if you’re an American.
The Biden Administration recently announced its plan to do a massive tax overhaul that primarily focuses on taxing the wealthy and high-net worth individuals. For most Americans, the tax policy is much to do about nothing in the sense that they won’t be affected, at least not in direct ways.
But, the person most directly affected by this new tax plan could be you.
If you’re an entrepreneur who is running a successful and profitable online business valued at over $1 million dollars, then you’re in dangerous territory. You could lose close to half of your business value to taxes when you go to sell the business.
Depending on where you live in the USA, you could pay as much as 38.3% in taxes when you sell your business under the new plan.
This tax hike is one of the highest in the history of the United States, with it only being beaten out by the capital gains taxes of the 1920s, where capital gains were taxed at 77% in the highest bracket.
This could also have far-reaching implications for business sellers in terms of liquidity and just how much they can exit for.
In this blog post, we’re going to talk about the least boring thing in the world … taxes.
Specifically, capital gains tax.
Just to be clear, what you’re going to read isn’t perfect tax advice for your business. The proposed tax plan we’ll discuss has yet to pass and the rates have changed a couple of times over the past year. If you’re unsure whether you’re filing your taxes correctly, make sure you speak to a tax advisor.
With that said, pull up a chair and a cup of coffee, and let’s dive in if you want to learn how to not lose close to half of your business’s value to taxation.
First Off, What’s the Tax Proposal Plan?
Investors around the world love holding high-conviction investments for at least a year so they can save a significant amount on taxes by holding long-term investments. Instead of paying income taxes as high as 39% on their investments, depending on income bracket, they instead will pay only 20% taxes on any investment sold that was held longer than a year.
This is the difference between short-term and long-term capital gains.
Long-term capital gains do a wonderful job of incentivizing investors to invest on value fundamentals rather than the wily short-term winds of market speculation. The vast majority of entrepreneurs who sell their businesses have owned them for longer than a year. The youngest businesses we sell on our marketplace tend to be 24–32 months old.
That’s well beyond the limit of short-term capital gains and can lead to preferential tax treatment since the value of the sale will not be taxed as an income tax.
This will largely stay true for the majority of entrepreneurs.
The problem comes for entrepreneurs with 7- and 8-figure businesses.
Under the new rules, there will be no advantage to selling the business after a year of ownership. No advantage after two years or really any length of time.
However, you could be taxed at a higher rate if you make over $1 million dollars on the sale of your business within a calendar year. That money will be taxed by the IRS as taxable income instead of capital gains regardless of how long you’ve owned the business.
Despite the potential capital gains tax increase, how much you’ll pay in capital gains taxes if and when the proposal passes legislation might not be as bad as you expect.
Capital Gains Tax to Increase to 25%
Earlier this year, Biden proposed a capital gains tax rate of 39.6%, which equaled the proposed individual tax rate hike for income at the time.
The individual top tax rate is looking to stay at 39.6%, but a recent House proposal lowered the capital gains tax rate to 25% for profits made on investments over $ 1million. What’s more, a potential retroactive date has been set for September 13, 2021. If this date stays in place after the proposal is passed, businesses sold after September 13, 2021, will be subject to the higher capital gains tax rate.
The federal income bracket a 7- or 8-figure entrepreneur finds themselves in is the highest taxed bracket. As mentioned, you will pay 25% taxes on the sale of your business if it is over a 7-figure valuation.
There’s a tax known as the Net Investment Income Tax (NIIT) that we should mention, but it’s highly unlikely to affect the majority of deals on our marketplace. NIIT is a tax for individual earners with an ordinary income of over $200,000 and married couples that file jointly earning over $250,000.
The name is a bit misleading as it sounds like this is only a tax on investment income, but it is actually a tax that combines both your regular active income with your investment income. Your active and investment income is combined into what is called MAGI—Modified Adjusted Gross Income.
This would only really affect you if your deal was over the $10 million mark. NIIT adds an extra 3.8% tax from your MAGI and would bring this proposed capital gains tax to 28.8%.
For most entrepreneurs, you’ll expect to be paying the proposed 25% capital gains tax rate.
And we’re not done yet.
This is just taxation at the federal level. You have to take into account your state-level and county-level tax, too.
State-Level Taxes Could Rise Total Capital Gains Tax to 38.3%
If you live in the following states:
- New Hampshire
- South Dakota
Then you’re all good.
None of these states currently imposes a capital gains tax. You’ll still have to pay at the federal level, but no additional tax will be added based on your location.
The winds in these individual states may change, but for now, there is no extra capital gains tax you’ll need to pay if you live in one of them when you sell your business.
However, this is not the case in other states.
The increased 25% capital gains tax jumps up further when you factor in the average local capital gains taxes across all the states in the USA. On average, you’ll see your 25% tax jump up to a 29.6% capital gains tax.
This is slightly higher compared to the average of 29% under the current law.
Keep in mind that 29.6% is taking into account an average of state-level capital gains taxation. Make sure to check with your professional tax person on what your state is charging.
You could pay close to 40% of the value of your business when you go to sell based on where you live. If you’re in California or New Jersey, you’re looking at close to the top capital gains tax rate of 38.3%.
So what can be done? How can you sell your business without paying such a huge amount in taxes?
After all, you probably had pretty good plans on what you wanted to do with that money. You worked hard for it.
Let’s look at what your options are.
The Easiest Way to Avoid Getting Taxed Close to 40%
With a retroactive date currently set, you might feel like your window of opportunity has closed. If you’ve already agreed to a deal but haven’t closed it, then it’s likely you’ll exit at the lower rate of 20% since there are supposed to be some grandfathering rules for things that are already signed.
Keep in mind the timing of when the new proposal passes is not a certainty since the legislation still needs to be voted in, and who knows when that will happen.
If you were planning to sell but sat on the fence, this is still a fantastic time to sell your business.
Over the course of this year at Empire Flippers, we’ve gauged record-breaking weeks of sellers wanting to sell their business with us. They want to get through vetting and load off their profitable asset onto another buyer to preserve the wealth generation they’ll get from an exit event.
From a non-tax perspective, this is literally the best time I’ve ever seen for someone to sell an online business. With multiples and valuations higher than ever, there has never been such a frothy amount of buyer demand.
And there are more well-funded aggregators snapping up quality brands by giving those entrepreneurs a premium offer.
You can still sell your business today to accelerate your wealth-building flywheel by generating the highest capital windfall you’ve likely ever seen in a single deal. The alternative is to hold on to your business and wait it out for a potentially lower capital gains tax rate in the future.
Hold or Sell: What Are the Implications of the New Capital Gains Tax?
If you decide to hold on to your 7-figure business, then this section is for you.
Keep in mind that these tax reforms may not even pass. It will have to go through both Congress and the Senate before implementation can begin. Also, keep in mind that many of the tax hikes are replacing tax policies already set to expire already in 2025; the sunset horizon has just moved up.
This means higher taxes are almost certainly coming in one form or another, whether this new plan passes or not.
The implications of these tax changes may not affect the average person directly but will likely impact the M&A online business space in a big way.
When the new plan does pass, it likely won’t be as far off from the new proposed rate as stated. Biden’s initial proposal of 39.6% was more likely the opening salvo to get negotiations started.
There is also a chance that if it does pass, as it stands right now, that the tax plan will be short lived.
The entire premise behind raising the income tax rate and capital gains taxes is to increase tax revenues. Typically, a capital gains tax hike leads to lower tax revenues as investors refuse to sell their assets. In the 1920s example, with 70% capital gains tax, investors simply passed their assets to their heirs instead, which decreased tax revenues as a result.
Step-Up Basis under Tax Law Changes
If the step-up basis where investors can pass their assets to their heirs continues, then it is likely tax revenue will decline under the new plan. The Tax Foundation Equilibrium study found that 39.6% capital gains tax on $1 million and above would reduce overall GDP by 0.1% and reduce the federal tax revenue by $124 billion over 10 years.
To close this potential loophole in tax-free capital gains, the new tax plan also talks about limiting the step-up basis that would force a taxable event at the moment of transferring an asset to an heir. If this is limited as proposed, then there is a solid chance the federal tax revenue could increase because a major tax shelter loophole is closed.
While no one knows what might happen, this is also unlikely to happen in my personal view. At least in its current format.
The current format could create a situation where young heirs of passing parents inherit large assets that come with tax bills they have no hope to actually pay, thus forcing the heirs to sell the asset and maybe even incur an additional tax for selling. It could pass as it is, but these kinds of scenarios will likely prevent much of the original plan of reducing the step-up basis tax.
The step-up basis has only slight relation to our industry, though, as most entrepreneurs are not passing down an Amazon FBA or SaaS business to their heirs in this manner.
What is relevant is the potential advantage a buyer might get from this new tax plan.
A New Era of Opportunity for Buyers as Sellers Fear the Tax Man?
First off, you should never plan your investment around taxes. If you’re paying taxes, it is a good sign you’ve made money. Reducing taxes is a sound strategy of course, but don’t penalize yourself from having a life-changing exit due to not wanting to pay a tax bill.
If the new tax plan does happen, then there is a chance that it’ll usher in a new era of opportunity for business buyers.
Business buyers will be in a better position to do extreme earn-out deal structures. Instead of buying a $2 million business with $1.5 million paid upfront and $500,000 paid over 12 months, a buyer could use the new tax plan to incentivize a seller to take a much longer earn-out.
In this same example, a buyer might offer $800,000 up front on a $2 million business to help the seller from paying the huge capital gains tax increase for anything above $1 million. Then the following year, the buyer pays another $800,000 to $1 million, and the final part of the earn-out is paid in the third year to help the seller on their taxes.
A buyer could minimize their capital exposure as they start investing into these larger assets in bigger volumes. If sellers start agreeing to varied deal structures, then it is likely buyers who do not have a long track record of success are going to be put on the backburner when a seller is considering an offer.
A seller is far more likely to sell their 7-figure Amazon FBA business to a brand aggregator with a rock-solid reputation at operating these assets.
If the seller is taking a greater risk by extending an earn-out, they will want to have massive confidence in their buyer to make sure they get the full exit amount that was promised.
This can be a great era for well-capitalized business buyers with that solid track record, but what about sellers?
Do Sellers Lose Out?
While the tax reforms are potentially a good thing for buyers, they could be not so good for sellers from a negotiation standpoint.
If you use a $10 million Amazon FBA business instead of a $2 million business in the above example, you can see what I mean. If the seller wanted to minimize their tax bill in the same method as above, it could take them over 10 years before they are fully paid out, which is obviously a highly unreasonable time frame.
The new capital gains tax may incentivize sellers to sell right now to avoid it and in the future cap businesses at a sub $1 million valuation to avoid the highest taxable bracket. There will likely be a few sellers here, though I wouldn’t recommend doing this even if the tax plan passes as it stands.
The reason why I wouldn’t recommend this is that even at a higher capital gains tax, you will likely have more money in your pocket even when you pay the tax by selling a 7-figure business. You’ll have cash in your account that you can immediately reinvest instead of trying to build a bunch of smaller businesses to sell at a later date and avoid the capital gains tax increase.
Also, as mentioned earlier, there is a strong chance that if the tax plan passes “as-is” that it could end up being a short-lived plan due to declining federal tax revenue and pressure on political representatives by the business community to adapt or iterate on the plan to be less aggressive.
Of course, no one has a crystal ball here, and anything could happen.
There is no telling whether the tax plan really will pass, if it will pass in its current incarnation, or if it will be a long-lived tax that we will have to deal with for the foreseeable future.
What we do know is that if you want to have the best chance to minimize your future tax burden as a 7-figure seller, then right now could be the best time to sell your business.