Paying the Piper – The Impact of an Increased Capital Gains Tax Rate When Selling Their Business

The question of who will lead America for the next four years is no longer a mystery however there are questions regarding changes to the tax code. President Biden has publicly and repeatedly stated his desire to increase the long-term capital gains tax rate. Make no mistake, the increase is coming, and the unknowns are how much the rate will increase, when the rate increase will take effect, and how large a bite of your hard-earned equity will be gifted to the Treasury. Business owners must understand the impact of an increased capital gains tax rate when selling their business.

Every business owner contemplating the sale of their business in the next 2 to 5 years needs to understand the impact of the increased long-term capital gains tax rate on the after-tax proceeds of the sale of their business.

President Biden has proposed increasing the long-term capital gains tax and taxes on dividends from the current 20% to 39.6% on income over $1 million a year. Even if the rate is ‘only’ raised to 30% the impact will be painful. How painful? Let’s do the math on the sale of a business with annual 2020 revenues of $10 million with a growth rate of 6% per year. Assuming a steady 20% EBITDA margin, and a 6x EBITDA multiple at the time of sale the firm’s enterprise value, if sold in 2021 would be $12 million. ($10 million x 20% = $2 million in EBITDA x 6 = $12 million). For the sake of simplicity, we will assume a basis of $0 and no sale transaction costs. At a 20% tax rate the Seller will walk from the Closing with a cool $9.6 million after paying the $2.4 million tax bill. Not bad at all.

But hold on a moment, let’s assume you don’t plan to sell until 2024 after you close out 2023. Business is good, so it makes total sense to ride the wave for 3 more years and benefit from this growth to increase the sale price and walk away with even more money at closing. In fact, with an annual growth rate of 6%, revenues will grow from $10 million to just shy of $12 million ($11.91 actually). This will raise EBITDA to $2.38 million and with that 6x multiple the enterprise value will increase to $14.29 million – or $2.38 million more for 3 years of work. Not too shabby at all! After tax proceeds at a 20% long-term capital gains rate will net the Seller $11.43 million. Riding the wave for 3 years increased your net post-closing proceeds by a little more than $1.83 million – this is on top of the compensation you have earned over the same period. Well done!

This was the simple math for business owners selling in the past few decades (from 2004 to 2012 the rate was even lower, at 15%).

How much will an increased long-term capital gains tax rate cost me when I sell my business?

Let’s get back the math to understand the impact of an increased long-term capital gains tax rate. We determined that waiting just 3 more years to sell will increase your net proceeds to $11.43 million. However, if the rate is increased to the 39.6 % rate that President Biden has proposed your net proceeds will not be $11.43 million but $8.63 million! That is just shy of $1 million LESS in your pocket, or your family’s pocket for 3 more years of hard work.

While these calculations are rather basic and there will be other costs associated with the sale transaction the numbers do not lie.  If the long-term capital gains rate increases to 39.6% you will need to work at least 4 more years to net the same post-transaction proceeds as if you had sold in 2021.

If 2020 taught us anything, the future is uncertain, and that life can change without warning. What we are certain of is that the long-term capital gains tax rate is going to increase, and this will determine how many more years we will need to work to offset this increase just to get back to where we are today. If you cannot meet the 6% annual growth rate or revenues remain flat or take a downturn (the pandemic lasting another 12 months for example), you will probably look back and say ‘I should have sold before the long-term capital gains tax rate increased’. This is why one must understand the long term capital gains rate impact when selling a business.

How long does it take to sell a business?

On average it takes a little more than 8 months to sell a ‘good or great’ business.  It would be prudent for a business owner contemplating a sale in the next few years to with their advisors without delay. Your advisors should include your CPA, attorney, investment or financial planner, and Business Broker. Business owners need to understand the impact of an increased capital gains tax rate when selling a business.

Rocky Mountain Business Advisors is a business brokerage focused 100% on selling our clients’ business. As Business Brokers, we fathom it as our responsibility to apply a proven process to educate, prepare, and guide our clients through the sales process so that they can focus on managing their business while we focus on a successful sale. We bring a strong sense of urgency and tenacity to every engagement to realize the highest sales price in the shortest period of time. We bring buyers and sellers together. Contact us at 303-474-5582 , or schedule a free 15-minute consultation to learn more about the services that makes us one of the best business brokers in Denver.