“Typically, tax cost is merely one item on a long list of regulatory considerations business owners and investors must analyze,” Hall and Hermiller write. “However, the magnitude of the proposed rate increases is likely to push tax issues to the top of that list in 2021.”

Business owners will need to carefully weigh decisions like when to sell, their choice of entity, and tax deferral and tax elimination structures. For example, Hall and Hermiller explain, “The near doubling of the capital gains tax rate would have a large impact on net profit from any M&A transaction.” And for those not ready to sell, they will need to also consider the increased tax burden of operating a business. “Regardless of entity type, available operating cash flow will likely be materially diminished under the proposed rates, and business owners may need to consider additional avenues for operating liquidity such as increased debt financing or cost cutting,” write Hall and Hermiller.

They add that the availability of certain tax-favored investment structures is likely to take on additional importance if the proposed rates become law. Yet, while the enactment of these proposed tax rate increases are far from certain, Hall and Hermiller encourage business owners and investors to be proactive and consider the effects now.

Tax changes proposed by the Biden administration give rise to a number of considerations for business owners. C. Wells Hall III and Drew Hermiller of Nelson Mullins walk through how higher tax rates impact the decisions of if and when to sell, choice of entity, and tax deferral and tax elimination structures.

The specter of increases in the corporate, capital gains, and individual tax rates continues to spur M&A activity as business owners and private equity firms and their advisors attempt to plan for the possible enactment of tax changes proposed by the Biden administration. Chief among those proposed changes are:

an increase in the tax rate applicable to C corporations from the current 21% to 28%; an increase in the tax rate applicable to capital gains and qualified dividends realized by taxpayers with income above $1 million from the current 20% to 39.6%; an increase in the top individual tax rate from the current 37% up to 39.6%; the phase-out of the 20% qualified business income deduction available to partnerships and S corporations; and the addition of a new 12.4% payroll tax on gross income above $400,000.

White House summaries of the foregoing can be found here and here.

Typically, tax cost is merely one item on a long list of regulatory considerations business owners and investors must analyze when starting, operating, owning or selling a business. However, the magnitude of the proposed rate increases is likely to push tax issues to the top of that list in 2021. What follows is a brief summary of how the proposed tax rate increases may influence a few high-level business decisions.

When to Sell

The near doubling of the capital gains tax rate would have a large impact on net profit from any M&A transaction. For instance, to pocket the same after-tax proceeds from a transaction, a company that sold at 10 times EBITDA under the current rates would have to be sold for 13.2 times EBITDA under the proposed rates. Business owners and investors, therefore, must consider the possibility of accelerating their exit/sale timelines. It is widely anticipated that the proposed rate changes are unlikely to be enacted quickly enough to take effect in the current year or apply retroactively. Consequently, 2021 may continue to be a very busy year for M&A activity. Whether that increased activity results in an over-supply and undervaluation scenario for a potential seller will likely need to be determined on a case-by-case basis.

Choice of Entity

If a business owner or investor is not ready to sell, they will need to consider the increased tax burden of operating a business. While a number of factors will impact overall operating tax cost, the proposed rate increases are likely to have an effect on both corporations (via the increased corporate tax rate) and pass-throughs (via the phase-out of the 20% qualified business income deduction). Consequently, the choice of entity type for starting or operating a business remains highly dependent on individual circumstances. However, regardless of entity type, available operating cashflow will likely be materially diminished under the proposed rates and business owners may need to consider additional avenues for operating liquidity such as increased debt financing or cost cutting.

In the event the proposed rate increases result in a pass-through entity structure becoming clearly advantageous for a currently operating corporate entity, a business owner may want to consider conversion of a C corporation to S corporation status, or even conversion to partnership status. The increased tax rates, once effective, will make a conversion to partnership status significantly more expensive.

Tax Deferral and Tax Elimination Structures

The availability of certain tax-favored investment structures is likely to take on additional importance if the proposed rates become law. In particular, structuring a new venture as a C corporation with the intention of meeting the requirements of a “qualified small business” should be considered by nearly anyone starting a new business. If the qualified small business requirements are met and the stock of such business is held for five years, a business founder or early investor can eliminate up to $10 million in capital gains upon an exit. As the capital gains tax rate nearly doubles, the value of that gain elimination also nearly doubles for the first $10 million of capital gain.

Similarly, investors realizing capital gains currently, may want to consider reinvesting those gains in a “qualified opportunity fund.” If structured properly, payment of tax on those capital gains can be deferred until 2026. In addition, if the investor holds their interests in the “qualified opportunity fund” for 10 years, all of the appreciation in the value of that investment can be realized without paying capital gains tax. While the ability to exit an investment tax-free has already generated a great deal of interest in qualified opportunity funds, the possibility of an increased capital gains tax rate is likely to make this investment structure even more popular.

The enactment of the proposed tax rate increases is far from certain and the details of any tax changes may well be significantly different from the current Biden administration proposals. Nevertheless, we strongly encourage all current and potential clients to consider the effects of the proposed tax rate increases.