In December of last year, Congress passed the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010. Essentially this act extended the Bush era tax cuts through the end of 2012.
A significant number of taxes and rates were affected by this extension, the most important being the extension of the capital gains rate at 15 percent. This means that you have until December 31, 2012, to sell your business and pay all or at least part of it in cap gains tax at 15 percent.
Unless Congress passes new legislation, on January 1, 2013, the cap gains tax rate will increase to at least 20 percent. Some analysts are predicting that that the new rate will probably be even higher than 20 percent given our growing budget deficit and need for new revenues.
Keep in mind that on top of this likely increase, 2013 will also introduce increased Medicare taxes that could add 3.8 percent tax to all investment income. So ultimately, unless Congress moves to change this, the combined tax bite will be closer to 24 percent from the 15 percent of today. That may not sound like much but it represents nearly a 60 percent increase in the cap gains tax rate.
To illustrate this, I thought we would look at a few likely scenarios. First, let’s assume that you are married and that you and your spouse’s Adjusted Gross Income (AGI) is $250,000. Let’s also assume that your business sells for $1 million.
Scenario One: If you sell your business before the end of 2012, the federal income taxes owed from the sale will be $150,000, allowing you to keep $850,000.
Scenario Two: OK, now you sell your business after January 1, 2013. Assuming that long-term capital gains rates increase to 20 percent in 2013, you will owe $200,000 in capital gains taxes, an increase in federal taxes of 33 percent. However, since your 2013 AGI remains at $250,000, the $1 million income from the sale of your business will be fully subject to the 3.8 percent Medicare tax, providing an additional $38,000 in federal taxes owed. Selling your business in 2013, instead of 2012, will add a minimum of $88,000 to your federal tax bill, which is an increase of 59 percent over what you would owe under scenario number one.
Scenario Three: However, what if some analysts are correct and cap gains rates are increased even higher? For example, manybelieve that the capital gains rates could increase to the 1996 level of 28 percent in 2013. Under this scenario, your total tax bite would increase to $318,000 (31.8% = 28% cap gains tax plus the 3.8% Medicare tax). This would leave you with only $682,000.
To help us visualize this, here are the net after tax proceeds to you under these three scenarios:
Scenario One, sell before Dec. 31, 2012 (15% cap gains tax) = $850,000 net after tax proceeds
Scenario Two, sell after Jan. 1, 2013 (23.8% combined tax rate) = $762,000 net
Scenario Three, sell after Jan. 13, 2013 (31.8% combined tax rate) = $682,000 net
As you can see, delaying the sale of your company past this two-year window could significantly impact the amount of money you retain. In fact, if scenario three turns out to be accurate, delaying the sale of your company would more than double the amount of taxes you would pay ($150,000 vs. $318,000).
On a weekly basis we encounter middle-market business owners who are not fully aware of the ramifications of what taxes will look like after Dec. 31, 2012. Of course tax rates are not the only factor you need to consider in the sale of your business. However, if you are considering the sale of your company, it could be critical for estate-planning purposes that you move up the target transition date so that you can take advantage of these low cap gains rates. If you don’t, as illustrated above, you will be paying a significant portion of your proceeds to Uncle Sam.
Keep in mind that it typically takes nine to 18 months to close most deals. Getting the process started now is critical if you are interested in selling before Dec. 31, 2012. One thing we know for sure: Taxes will only be going up!
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