Wait or Sell? Capital Gains are Your Answer.
I thought I would share a recent conversation I had with a CEO who was contemplating whether to wait another year for revenues to go up and sell in 2022, or to begin the process now and push for a 2021 December transaction close.
If you are in the “Do I wait, or Do I sell” mode, this post may help you make an informed decision. Hint….it’s all about capital gains. And yes, we need to get into the weeds and look at some calculations to arrive at an informed decision, so stay with me here!
Currently, Biden’s proposal for taxing capital gains as ordinary income has the potential to have a huge impact on investors, especially those with a relatively big investment in the stock or bond markets. We don’t know yet what will happen, but most people do not think he will make it retroactive to January 1, 2021. While this is purely speculative and none of us know for sure, let’s assume for this article it is true; this analysis that might help you make an informed decision.
Increasing Capital Gain Rates
Right now, capital gains are taxed differently from ordinary income at a rate of either 0%, 15% or 20%, depending on your tax bracket. Biden wants to treat these gains just like normal income, meaning any capital gains a person makes in a year will be added to other forms of income such as salary and bonuses, and taxpayers will pay a single stepped tax bill at a rate based on their total income. We don’t know yet how this will play out in the House or Senate, nor do I want to speculate here, but……
At a minimum, I think we can all agree that capital gains rates will increase, so let’s be conservative and say that rates go from the current 20% to a new 28% (1). Let’s see what that really looks like and how much more revenue you need to produce if you decide NOT to sell this year.
Below are two examples for two companies, of which both are pass-thru taxable entities, so the income on the sales of a company passes through to the individual return of the owners.
One column shows the current capital gains rate and the second show the proposed 28% rate. That 8% increase in our example shows as $400,000 and $800,000 respectively in INCREASED capital gain tax.
Examples: $5M Sale and $10M Sale
But we need to take it a step further to determine how much more revenue (income) you would need to produce to be ahead of the game if you want to wait to sell.
In our first $5M example, the owners would need to make $662,252 (circled in red) more in taxable income (taxed at 39.6%) in 2022 to cover the potential increase in capital gains tax of $400,000. Which also comes out to about 13.2% of an increase in net income (bottom line profits). Then I would add another 5% on top of that–so say about $36,000 for the investment income for one year of investing that money (conservatively), and now you are looking at about $700,000 (or 14%) in extra taxable income.
Now that you know how this works, the answer becomes a lot clearer. If you feel your 2022 net income will increase by more than 13.2% – 14%, then the answer is: don’t sell just yet. And remember, that is just the breakeven number, you really need to be increasing net income by at least 20% to make it worthwhile. If you feel that might be a challenge, then selling this year is really the more advantageous decision.
Of course, this example assumes an increase in capital gain rates and an increase in the top personal income tax rate to 39.6% (yes, you most likely will be in the top rate if you sell your company for more than $500,000, net). There are other plans that Biden is considering which may treat all capital gains beyond $1M as ordinary income. That would hurt even more because only the first $1M would be taxed as capital gains, the rest would be ordinary income and taxed at 39.6% – assuming you are at the top rate.
Our example above only takes into account federal tax rates. If you live in a state like California as I do, well then you can add another 13% on top of that (highest CA tax rate). Clearly there is a lot to consider here and a good tax accountant will be needed.
Please don’t commit to any decision based upon my thoughts above before you check with your own tax accountant. I only play tax accountant for my own family.