President-elect Joe Biden made it clear that corporate tax rates and taxes on high net worth individuals, would increase under his administration. Just how many plans will come to fruition, and how quickly, is unknown.
Executive orders, bipartisan compromises, and more modest tax increases most likely lie ahead. Although the immediate priority remains focused on COVID recovery, few doubt that new taxes will go into effect, with best guesses focused on 2022.
Right now, investment firms and business owners are looking at the possibilities and examining their exit strategies under different tax outcomes.
The critical focus has been on the proposed increase of long-term capital gains tax and taxes on dividends to 39.6% on income above $1 million a year, nearly double the current rate of 20%.
How does this impact an owner? For example, a fictional business generating $20 million in revenue and growing at 5% every year with a consistent 20% EBITDA margin received 6x EBITDA multiple at sale. To simplify calculations, assume a basis of $0 and no transaction costs and no other pre-planning tax mitigation strategies applied.
In 2021, the business has an EBITDA of $4 million. At a 6x multiple, that’s an enterprise value of $24 million. At a 20% capital gains tax rate, the tax liability would be $4.8 million for net proceeds of $19.2 million.
Instead, the owner decides to grow the business and sell in 2023. With a 5% annual growth rate, revenue is now $22,050,000 and the EBITDA is $4,410,000. At a 6x multiple, that’s an enterprise value of nearly $26.5 million. At a 39.6% capital gains tax rate, the tax liability would be nearly $10.5 million, for net proceeds of $16 million – a significant loss.
Although very simplified calculations (and exclusion of many other factors), these basic scenarios show that an owner projecting 5% annual growth would need to run the business for an additional five years to reach a breakeven point if the capital gains rate increases.
In addition, it takes an average of nine months to sell a business, on average, that is prepared and ready for market. If you’re a business owner and you were thinking about exiting in the next couple of years, start talking to your advisors now.
Begin with an M&A advisor to get a valuation and see if it even makes sense to take your business to market. Then talk to your CPA and run the tax scenarios to understand the best- and worst-case possibilities ahead.