Post Election Tax Considerations for Business Owners
There’s now a plethora of media coverage about the Fiscal Cliff and its implications and potential effects. This essay strives to distill the discussion into selected tax policy aspects that are directly pertinent to owners/shareholders of smaller to mid-sized companies, and possible actions you may consider taking, after discussion with your business’s qualified tax counsel.
For brevity, the focus is on capital gains aspects, and the potential for an extension of the current cap gains tax rates, thus extending the opportunity to sell assets, such as a business, at the tax-advantaged 2012 rate.
I have written various posts about the expiring “Bush Era” tax cuts (enacted 2001, 2003) over the past few years and it seems appropriate now to revisit the topic.
Inputs to this article have come from attending several law firm conference call panel discussions over the past few months, including two conferences since the election, plus extracts from news reports. I thank the highly regarded firms of Chadbourne & Parke LLP and Venable LLP, each of which has Washington, DC offices and significant “Beltway insider” contacts and insights.
This discussion confers no political slant or judgments on my part.
The Fiscal Cliff
The confluence of fiscal policy changes scheduled to occur at the end of 2012 is sometimes referred to as the “fiscal cliff.” Ben Bernanke has been in the news a lot recently warning of the Fed’s concern about what it may do to the economy. Highlights of the fiscal cliff include:
- $1.2 Trillion in spending cuts take effect Jan. 2nd, over 9 years (the so-called budget “sequestration”). These cuts are across the board, not targeted selections.
- Tax law changes, some of which are discussed in more depth below
- The Federal Debt Ceiling must be raised to keep the government solvent (the date moves, but is somewhere in February-March). The last time this issue was before Congress, the US debt rating was downgraded a notch because Congress couldn’t reach agreement. They “kicked the can down the road” until the end of 2012, by creating this “Sequestration” (spending cuts) mandate, taking effect in January.
There is tremendous pressure from the business community on Congress to delay the immediate tax increases and spending cuts that take effect in January. Most economists say these changes could tip the economy back into recession. Many CEOs, including the Business Roundtable, are pressuring Congress to fix the debt, cut spending, and increase tax revenues, and in any case, move swiftly to reduce uncertainty.
One major area of Congressional disagreement is the increase in tax rates for high-income taxpayers, resulting in part from the sunset of elements of the 2001 and 2003 tax cuts. Four things that will increase the top tax rates are:
Description |
Current Rates |
Scheduled 2013 Rates |
Other Additions |
Individual tax rates |
33%, 35% (top 2 brackets) |
36%, 39.6% (top 2 brackets). It’s important to remember that this is a marginal rate; it doesn’t apply to the first dollars made, these rates only apply to those dollars above a threshold. However, the more one makes above that threshold, the more dollars that will be taxed at the highest marginal rate. |
For joint income >$250 K or individual over $200 K, Medicare tax increase: · 0.9% on wages over threshold and · 3.8% on lesser of net investment income or excess of modified adjusted gross income amounts over the threshold |
Qualified Dividends |
0%; 15% |
= individual income tax rate, up to 39.6% |
|
Long Term Capital Gains Tax |
0%; 15% |
20% |
|
Estate Tax |
35% top rate; $5 M exemption |
55% top rate; $1 M exemption |
Chart Source: Venable LLP
For selling a business, stock, real estate or other long term assets qualifying for capital gains treatment, the combination of these tax changes results in a top tax rate on capital gains rising from 15% to 24.7% (20% capital gains + 0.9% Medicare + 3.8% Medicare). This created a significant incentive for those considering such divestments to do so in 2012, and not wait until 2013.
Unless Congress agrees to do otherwise, every one of the tax changes listed above will take effect January 2nd.
The Politics
Congress returned to Washington, D.C. Tuesday, November 13thfor a lame duck session that will last through the end of year with the existing members of Congress, a number of whom will be leaving at the start of 2013. Between Monday, November 19 and the year’s end there are only effectively only 3 weeks, considering the holidays. Few expect The President, the Democrat-controlled Senate and the Republican-controlled House to resolve much in such a short time, though most feel that there is a genuine desire among all to move ahead and work through the issues.
According to resultsof a National Journal poll of Congressional insiders discussed in a recent law firm panel discussion conference call (link to my blog post Industry Focus: Renewable Energy – What The Election Results Mean), 79% believe that Congress will kick the can down the road so that sequestration (the spending cuts) will not take effect on January 2 as scheduled. This sentiment reflects bi-partisan agreement that across the board, indiscriminate cuts make no sense.
Here is a Wall Street Journal short summary of the process:
The Fiscal Cliff is more hype than hazard. Politicians have created the fiscal cliff to pressure one another into a deal. It is theater. The most likely outcome is a combination of tax increases, spending cuts and kicking the can down the road.The Rational Outcome
As Yogi Berra once supposedly said, “making predictions is very difficult, especially about the future.” So, take these predictions with a grain of salt. They come from very knowledgeable people – but people who can be as wrong as anyone.
The reasonable outcome is to establish only a framework in December, 2012 for negotiating the details of a “Grand Bargain” throughout 2013, which would include long term tax reform, budget sequestration, the debt ceiling and entitlement reform. Meanwhile, they can raise the debt ceiling temporarily, but this must be done by February-March. The President has made it clear that he will not support delaying the comprehensive tax overhaul negotiation so that it coincides with the debt ceiling negotiation, as the U.S. cannot afford another debt rating downgrade.
The rational solution for Congress is to extend the existing tax code and planned budget cuts for an interim period to buy working time for them to tackle the planned overhaul of the entire tax code. It is a reasonable possibility that this extension of the current tax code will go through the Budget Reconciliation Process, at the end of 1st half, 2013, or perhaps even a year extension.
This temporary delay would provide Congress some breathing room before moving to the broader corporate tax reform debate. It is believed that comprehensive tax reform will be negotiated to become effective in the 2nd half of 2013, or early 2014, as there is now political will to do so.
Most people expect a short term delay in the January 2nd tax changes and budget cuts.
However, as suggested by Harvard University economist and Senior Fellow Robert Zoellick to the Wall Street Journal, if the President thinks that the two parties are not engaged in serious negotiation over the next few weeks, but merely pontificate about their respective positions (“what we see now,” he says), he may support immediate expiration of the tax cuts as a negotiating lever to force Congress to get serious. “Now that’s gutsy, given the state of the economy, but I think that people need to be prepared for it.”
In any case, negotiation to reach compromise on the “Grand Bargain” will be difficult, and several people indicate that it is more to tackle than what Reagan undertook in 1986.
One possible element of compromise may be to make $1 M in annual income, not $250 K, the trigger level of the highest tax personal income tax rate. Allegedly, both House Minority Leader Pelosi (D-CA) and Sen. Chuck Shumer (D-NY) want this. The East and West Coasts voted Obama back into office, and $250 K seems a low annual income threshold, relative to less expensive other states. It is considered reasonable to speculate that the $250 K level will be raised to $1 M.
The Irrational Outcome
An irrational, but also very possible outcome: the Sequestration and Tax Cut issues will not be resolved by the end of 2012; the 2001, 2003 tax cuts may expire, and then be put back in place during the Spring Budget Reconciliation process, to be effective retroactively to January. This outcome would provide no certainty whatsoever to the markets, though. It’s also possible that Congress will make no progress in 2012, and the budget cuts and tax increases will take effect January 2nd. This is probably the worst case of all imaginable scenarios.
Selling a Business, Stock, Real Estate, Assets Qualifying for Capital Gains Treatment
- The most direct influence on the sale of items above is the increase to the long term capital gains tax shareholders will pay. The net effect is to change the Federal tax rate that a seller of stock who is among the highest earners in the top tax bracket may pay from a potential rate of 15% to a potential rate of 24.7%, in addition to potential state tax rates which would increase these tax rates further.
- The tax burden for selling ownership will probably never be as low as in 2012. It will increase by 3.8% in 2013, even if Congress extends the 2001 and 2003 tax cuts.
- Owners of companies who may have waited to sell after 2012 because they “plan to do a few things to build the company’s value” would have had to improve the sale price by 10% to break even on that decision. Of course, the tax rate is only one of many reasons to sell an asset like those mentioned above.
It is far too late to initiate the sale of a company and expect to close the deal by year end. However, it is entirely feasible that this window of opportunity will re-open, if Congress does extend the 2001, 2003 tax cuts for some period of time. If that extension is at least six months, the transactions above may be feasible to accomplish at the lower tax rate. This process would need to be initiated immediately, however.
Please contact me if your company may contemplate the need for additional capital, and/or may consider merger and acquisition activity to divest or strengthen your market position.
Disclaimer: This article provides general information, and is not intended to constitute, and should not be construed as, legal, tax, accounting or business advice, nor does it constitute an offer to sell or to purchase securities. Rather, it is summary compilation of timely issues confronting your industry and as such does not purport to be a full recitation of the matters presented. Prior to acting upon any information set forth in this article or related to this article, you should consult independent counsel and/or more detail contained in the Source Information. The article reflects the opinion of the writer, and does not necessarily reflect the opinions of Mid-Market Securities, LLC, or its affiliates. IRS Circular 230 Disclosure: In order to comply with requirements imposed by the Internal Revenue Service, we inform you that any U.S. tax discussion contained in this communication is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
