Federal Capital Gains Rates – Where Are They Headed? – Implication for Selling a Business

Since 2003, the top tax rate on most capital gains has been 15% for people in the 25% or higher tax bracket. Although a lower level tax rate has also been in place since 2003 for people in the 15% or lower tax bracket, this lower rate seldom applies to people incurring a capital gain from selling a business.

The current capital gain rates are scheduled to expire effective December 31, 2010 due to a time lapse built into the regulations associated with the 2003 gain reductions. This time phase-in is known as a sunset provision. Thus, starting in 2011, the top 15% rate is scheduled to revert to its former pre-May 6, 2003 level of 20%.

The President was relatively safe making the campaign pledge that his administration would not raise taxes, because the sunset provision was already going to cause the rate to increase.

The big question now is; Will the top rate only rise to 20% or will Congress raise it higher?

Background
For the past 30 years, the top tax rate on long-term capital gains has been below 30%.

The top tax rate on most long-term capital gains was reduced from around 35 percent to 28 percent in 1978 and was further reduced to 20 percent in 1981. It was raised to 28 percent in 1987, reduced to 20 percent again in 1997, and further reduced to 15 percent in 2003.

The Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) extended the 15% rate through 2010. But, in 2011, the top long-term capital gain rate for most long-term capital gains is scheduled to revert back to the 20% rate that applied prior to the Jobs and Growth Tax Relief Reconciliation Act of 2003 (2003 Tax Act).

The pending tax change is well within the range of changes experienced in the last 30 years.

What To Expect

On September 25, 2009, in a letter to Representative Brian P. Bilbray (R-CA), the Congressional Budget Office (CBO) stated that when assessing the impact of the increased tax rates on economic growth, it is important to keep in mind that taxable capital gains account for a small portion of all capital income. Much capital income is paid as dividends, interest, rent, and proprietors’ profits. In addition, most capital gains are not taxable because they are held in tax-exempt accounts or are held until death. As a result, CBO does not anticipate that the pending increase in the capital gains tax rate alone will have a large enough impact on the rate of return to capital overall to change significantly the magnitude of saving and capital investment.

But the CBO did further state that higher capital gains taxes could have an additional effect by discouraging innovation and risk-taking, but there is insufficient evidence on which to base a quantitative estimate.

Congress depends on the CBO to help corroborate the financial and tax results of congressional decisions. In this case the CBO is uncertain as to the full impact to be realized by an increase in capital gain rates. This indecisiveness opens the door for Congress to support an increase in capital gain rates, saying that the CBO did not expect the increase to be harmful.

Observationally, It is notable that when Congress cut capital gains tax rates in 1978, 1981, 1997 and 2003, capital gains realizations and tax revenues increased.  When the cap gains rate was raised in 1987, the opposite occurred.

Also it is important to keep in mind that with the recent Health Care Reform, people classified as “wealthy” (earning over $200,000/year) will experience an additional 3.8% Medicare tax on unearned income (cap gains, dividends) beginning in 2013. Because the new tax on investment income won’t take effect for three years, that leaves more time for Congress and the IRS to tinker with it. So we can expect lots of refinements and “clarifications” between now and when the tax is actually rolled out in 2013.

When considering the financial impact resulting from the War on Terrorism and the overall increase in congressional spending, it is very reasonable speculation that the issue of raising capital gain rates even higher will be introduced by some member of Congress.

Furthermore, in 2011, the top Federal tax rate returns to 39.6%.

So, should a person trigger a capital gain in Year 2010, such as selling a business, if at all possible?

Since most business sales incur a blend of capital gain and ordinary income taxation, when considering the known capital gain rate increase, the potential for additional capital gain increases, the income surtax and the fact that the top federal tax rate returns to 39.6% in Year 2011, a clear answer certainly emerges.

If an entrepreneur wants to experience the lowest tax impact possible from selling the business, selling before the tax rates increase is the way to go.

Based on current regulations, 2011 capital gain tax rates will be at least 20% with the health care surtax likely causing some people to exceed a 25% aggregate rate. If congress decides to implement further increases, anyone who waited until 2011 to sell a business will wish they could go back in time to 2010.

This article was adapted from one written by Walker Advisory Associates, with minor additions and revisions, and used by permission.  Walker Advisory Associates is a national business transactions tax advisory and accounting firm.  As a specialist, they concentrate on the field of business transactions advisory work to minimize the taxable impact of the transaction and assist in tax-advantaged deal structuring.  Walker Advisory is a preferred partner of ABI-Tranzequity Advisors, and we will recommend that clients planning the sale or acquisition of a business engage their services early in the process.