Warning: Tax Risk for Entrepreneurs Who Do Not Sell their Businesses in 2020

Dec 17, 2019

The phrase “A Day Late and a Dollar Short” has an unknown origin during the Great Depression in the United States between 1929 and 1939.  The good news is that a significant majority of economists believe 2020 will be a good economic year in the United States with 1.50 – 2.50% growth in the Gross Domestic Product (GDP) and continued high employment.  Regionally in the Pacific Northwest economic conditions are expected to outperform national numbers.

The bad news is that potential increased tax liability exists for entrepreneurs in 2021 if they do not sell their businesses in 2020.  The reason tax risk exists in 2021 is that 2020 is a Presidential election year and divergent thought exists between our political parties related to the tax rate that is most relevant to the sale of a business, the long-term capital gain tax rate.  One party believes encouraging investment and entrepreneurship through lower tax rates will increase GDP and result in increased tax revenue for safety social net programs for the nation by increasing the size of the economy.  The other party believes in income redistribution for the common good of the population and that people earning income in the top 5% should pay a larger share of their income in taxes than people earning less.  As a reference point, the current average income of the top 5% of households in the United States is $376,587 according to the most recent data published by the United States Census Bureau.  2021 offers a prime opportunity for tax reform depending on the results of the election and the political philosophy of the party in power.

The problem for entrepreneurs thinking about selling their businesses in the next couple of years is that they have no control of what the long-term gain capital gain tax rate will be in a given year.  Presently, the long-term capital gain tax rate is 20% for individuals earning $434,551 or more and married couples filing together earning $488,851 or more.  The rate drops to 15% for individuals earning $39,276 to $434,550 and married couples filing together earning $78,751 to $488,850.  It is not anticipated that these rates will change in 2020.  All bets are off regarding what takes place in 2021.  Historically during the last 50 years the top long-term capital gain tax rate has ranged from 15 – 35%.   It also should be noted that up until December 31, Congress has the ability to change individual tax rates for a specific year. This is possible, because individual taxes are not due until April 15 of the next year, over a 100 days after the end of the year that created the relevant tax liability.  Tax reform by Congress has often come late in the calendar year historically.

The reason I am sharing this information is threefold:

  1. I believe the best decisions are made from a position of knowledge.   As a twenty-five year mergers & acquisitions intermediary who has personally facilitated over 300 transactions involving privately held companies and family businesses, I believe it is my responsibility and the responsibility of the team of knowledgeable, experienced, highly skilled business brokers who work for me at IBA to educate the entrepreneurial community to enhance their ability to assess situations and make decisions in their “best interest” that facilitate achievement of their goals.  We do this through direct engagement as a resource for business owners, accountants, attorneys, bankers, and other consultants; writing articles for trade journals and publications; and participating as experts in seminars.
  2. Time is of the essence. It traditionally takes IBA three to nine months to sell a privately held company or family business from the time the business is first brought to market.  This time range for successfully completing transactions consistently ranks as one of the market leaders in the Pacific Northwest, as does our 80 – 90% rate of successfully completing our representation projects.  If a sale is desired in the next 18 months, I would hate to see someone sell a business a few months after the tax rate changes to their financial detriment.
  3. The Baby Boomer Generation is Retiring. 70% of IBA’s clients are selling businesses created through expenditure of significant time, energy, and resources as entrepreneurs to facilitate retirement.   These individuals deserve to receive the fruits of their labor.  It is also a fact that people are living longer on average than at any time in American history and that the cost of living continues to climb.  Many of IBA’s clients were born between 1944 and 1964, the Baby Boomer Generation, having ages in 2020 between 56 – 76.  It greatly troubles me that an act of Congress has the ability to reduce their proceeds from the sale of their privately held companies and family businesses and the amounts in their retirement accounts by hundreds of thousands of dollars.

A simple example will help illustrate this fact.

John & Jane Evergreen own a manufacturing company. They are the founders of the business having opened their doors in 1995.  The business had gross revenues of $5,000,000 and an EBITDA of $750,000 (15%) in 2019.   The business was brought to market for $3,000,000 and through the creation of competitive market conditions by the intermediary firm sold for $3,100,000 in a cash transaction.  The buyer & seller negotiated an asset sale with a tax allocation of $350,000 to furniture, fixtures, equipment, and vehicles, $250,000 for inventory & work in progress, and the remaining $2,500,000 to goodwill.   The goodwill component of the sale is taxed at the long-term capital gain tax rate.

In this transaction with present tax rates, the tax on the sale of the goodwill of the business would be $500,000.  If in 2021 the long-term capital gains tax rate increased from 20% to 30%, both figures within the 15% to 35% range that has occurred for the long-term capital gain tax rate during the last 50 years, the amount of tax due on the goodwill portion of the business would increase $250,000 to a total amount of $750,000.

The tax rate increase would also be relevant in a stock sale, as the long-term capital gain tax rate is the relevant tax rate for that type of the transaction.

IBA clients traditionally do not need to sell their businesses.   Most of our clients are very similar to John & Jane Evergreen, entrepreneurs who run profitable, successful companies who enjoy and are professionally fulfilled by what they do as business owners.  However, “father time” does not stop for anyone and retirement via business sale on a selected timetable is always preferred to one created by health issues or out of urgency.   2020 presents an opportunity to sell a business with a likely known long-term capital gain rate.  A sale in 2021 does not offer the same certainty of a known tax rate.   The outcome of the 2020 Presidential election is unknown.  I share this information with the goal to assist entrepreneurs with their strategic planning.  It will pain me in 2021 if I hear stories of entrepreneurs who are a dollar short because they are a day late for a favorable tax rate.   As Thomas Edison famously said, “Good fortune is what happens when opportunity meets with planning”.  I encourage all entrepreneurs thinking about retirement to seek information and plan from a position of knowledge.  My firm is available for a complimentary consultation.  100% of our fees are payable on performance at the completion of a transaction.

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”.