COVID-19 and the Washington state government’s response to the pandemic impacted all businesses operating in the state in 2020. Many business owners, especially in the hospitality, retail, and education sectors, saw the equity value of their small business assets greatly diminished or taken to zero by policies that largely ignored the economic health of family owned businesses and privately held companies. In addition to damaging the small business sector, the pandemic and government policies greatly diminished tax revenue collected through sales, business & occupational, and labor & industries taxes in Washington negatively impacting the state’s ability to fund schools, parks, and social safety net infrastructure. Pre pandemic approximately 99.5% of the businesses operating in Washington were of the small business variety with over 51% of the jobs in the state economy being created by private sector entrepreneurs according to the United States Small Business Administration (Washington Small Business Economic Profile (sba.gov)).
Many small business entrepreneurs have a significant percentage of their personal wealth housed in their companies, electing to invest in employees, equipment, marketing, technology, and facilities rather than pull dollars out for personal use. This investment is done in pursuit of excellence, to gain market share, improve product quality and service, and with a goal of a future liquidity event when the business would be sold to facilitate retirement, estate creation for family members, and philanthropy in the community. As an interesting side note, a recent study found that entrepreneurs were 50% more philanthropic than their nonentrepreneurial peers (Entrepreneurs are more successful philanthropists — what you can learn (cnbc.com)), so dollars in the hands of entrepreneurs has been shown to have direct societal benefit for nonprofit organizations.
Approximately, 1/6 of the population of Washington is presently 65 years of age or older (https://www.ofm.wa.gov/washington-data-research/statewide-data/washington-trends/population-changes/population-age-mapped-county#:~:text=Median%20Age%2C%202019,County%20had%20reached%2058.9%20years). Many of these individuals are Baby Boomers born between 1946 – 1964, a large generation in terms of population size, and business owners. Unfortunately, Governor Inslee has put forward a tax proposal in the form of the creation of a state capital gains tax for FY 2021 (Capital gains tax Q&A | Office of Financial Management (wa.gov)) for addressing the budget shortfall that will be specifically harsh on these individuals as they try to transition to retirement with enough to live out their golden years in comfort and dignity.
Governor Inslee’s 9% state long term capital gains tax is in addition to the federal long term capital gains tax in place. For those unfamiliar with the tax implications of selling a business, I will provide two examples demonstrating the impact on the owners of a family owned business and privately held company.
Family Owned Business
Sale Price: $750,000
Tax Allocation:
Furniture, Fixtures, & Equipment: $100,000
Inventory/Work in Process: $50,000
Goodwill: $600,000
In a transaction facilitated as an asset sale and assuming the furniture, fixtures, and equipment sell close to their book value on the balance sheet, the significant tax implications from the sale to an owner of a business operating as a LLC, S Corporation, Partnership, or Sole Proprietorship would be calculated on the goodwill value. The 2021 rate applicable in the example would be 23.8% (The 2021 Capital Gains Tax Rate Thresholds Are Out – What Rate Will You Pay? | Kiplinger), so in the example, the tax liability created by a sale of goodwill would be $142,800 meaning the seller would net $607,200 before retiring company debt, other taxes, and paying the professional advisors who supported them in the sale. $600,000 in savings for retirement equals $50,000 a year for twelve years without calculating the impact of prudent investment of the asset with a knowledgeable, experienced wealth advisor. Governor Inslee’s proposal would result in an additional 9% state long term gain capital gains tax on $550,000 of the goodwill value reported to the IRS (The first $50,000 would be exempt for a couple filing a joint return, or $25,000 for an individual filer under the referenced proposal) resulting in an additional tax liability of $49,500 or the loss of a year of saved living expenses for retirement. Looked at from another perspective, is it right for a small business owner who created employment opportunities and supplied valued products and/or services in their community for decades to only walk away with roughly 2/3 of the value of their life work? How many of us found our first job and personal income working for a community entrepreneur? I am personally eternally grateful for the opportunity provided to me at 15 by the Beef & Brew on Canyon Road in Beaverton, Oregon.
Privately Held Company
Sale Price: $10,000,000
In a transaction facilitated as a stock sale, assuming 3 partners as equal shareholders who were founders of the company, and that the company operated as an S Corporation this transaction would result in a total federal long term capital gains tax liability of approximately $2,380,000 or $793,333 per partner. Adding the new Governor Inslee proposed long term capital gains tax and assuming each partner is married, an additional amount of $750,000 in total or $250,000 per partner would be payable to the state. The net result being that each partner would start with $3,333,333 as a reward for their vision, execution, and risk taken in starting a company, experiencing years of stress and working for free in its infancy, and weathering the economic storms caused by the mortgage market and COVID-19 this century. The amount would be reduced by $1,043,333 from federal and state long term capital gains taxes resulting in net dollars to each of the partners and their families of $2,290,000. This may seem like a lot of money, but given the opportunity costs associated with leaving good paying jobs at companies like Microsoft, Boeing, or Amazon to take the risk of creating a new company from a kitchen table or garage while funding the enterprise with hard earned, personal dollars saved over multiple years, taxes of this nature can create a negative incentive for innovation and investment in the unknown. Where would Seattle be today, if Howard Schultz had not taken a trip to Italy and enjoyed its coffee culture or Bill Gates & Paul Allen hadn’t been willing to get up in the middle of the night to experiment at the University of Washington computer lab. How many people do you know that presently or in the past worked for Starbucks or Microsoft? How many owe their roof over their heads or children’s college education partially to these men and their willingness to take risk as entrepreneurs? Before a company can go public and offer top tier paying jobs to its employees, it needs to start and prosper as a privately held company.
The good news is that many new businesses have been created during the pandemic (https://www.wsj.com/articles/is-it-insane-to-start-a-business-during-coronavirus-millions-of-americans-dont-think-so-11601092841) in extra bedrooms, kitchens, and garages while people have had forced time to think with fewer social engagement and travel opportunities. Washington has historically been home to more entrepreneurs than many other states because it has no state income or capital gains tax. It is not happenstance that fast growing publicly traded companies Smartsheet (smartsheet.com), Biolife Solutions (biolifesolutions.com), and Aptevo Therapeutics (aptevotherapeutics.com) are located in Washington. A Washington state long term capital gains tax is bad public policy from damaging the retirement savings of our seniors to diminishing our state’s quality environment for entrepreneurship. Opposition to the idea is encouraged by anyone who cares about the state and quality employment opportunities for its citizens.
The above said, there is an old saying, “Those that fail to plan, plan to fail”, a state capital gains tax is a possibility in the foreseeable future. Providing a warning to the small business community about the gestation of the idea in Washington was the motivation for this blog article. If retirement is planned in the next couple of years by an entrepreneur, it may be prudent to start planning for and complete the transaction before the tax environment potentially changes. IBA, as the oldest business brokerage firm in the Pacific Northwest, would welcome the opportunity to help with that business sale. We offer complimentary first meeting consultations and professional opinions of the market value of businesses to potential clients. We are confident that after a meeting with an IBA professional it will be easy to identify why IBA has sold more businesses (Over 4200) than any other firm in the region.
IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, mergers & acquisitions, and real estate communities on subjects relevant to the purchase & sale of privately held companies and family owned businesses. IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.