“Yeah, I’m the Tax Man”[i]
Last week, several media outlets reported that Mr. Biden will soon propose that Congress increase the federal income tax rate applicable to long-term capital gains recognized by individual taxpayers.[ii]
The time and place at which this and other changes to the Code are expected to be proposed is this Wednesday, April 28, when the President, at the invitation of House Speaker Pelosi, will appear before a Joint Session of Congress[iii] to advocate for his $2.3 trillion American Jobs Plan.[iv]
These reports should not have surprised anyone. After all, candidate Biden ran on a platform that called for increases to the individual federal income tax rates applicable to items of both ordinary income and long-term capital gain.[v] As President, Mr. Biden has not wavered from this position.
Let me tell you how it will be
There’s one for you, nineteen for me
‘Cause I’m the taxman
Yeah, I’m the taxman
In accordance with campaign promises, Mr. Biden will seek to increase the maximum tax rate on the ordinary income of individual taxpayers from 37 percent to 39.6 percent;[vi] he is also likely to adjust the taxable income brackets – i.e., reduce the threshold – at which the higher rate will apply.[vii]
Although these increases will be of great interest to the owners of an ongoing business, they will also have to be accounted for by any business owners who are considering the near-term sale of their business. For example, the ordinary income realized on the sale of inventory or receivables, and the interest paid or accrued on the deferred receipt of purchase price – whether paid pursuant to a promissory note or an earnout, or out of escrowed funds securing an indemnity obligation – are items of ordinary income to which this increased tax rate would apply. Also subject to these new rates will be any compensation paid to a former owner of the business for services rendered to the buyer after the sale, whether as an employee or consultant, or in exchange for a non-compete. If the former owner retains possession of the real property on which the business will be conducted by the buyer, the rental received for the use of such property will be affected by the rate hike.
Less obvious to many owners who are selling their business is the treatment of the gain realized from the sale of certain depreciable or amortizable assets as ordinary income. For example, when a taxpayer sells tangible personal property – manufacturing equipment, for example – with respect to which the taxpayer has claimed depreciation deductions in determining their taxable income, at least some of the gain realized on the sale will be taxed as ordinary income because the Code requires the “recapture” of the tax benefit arising from the earlier depreciation deductions.[viii]
Should five percent appear too small
Be thankful I don’t take it all
‘Cause I’m the taxman
Yeah, I’m the taxman
Long-Term Capital Gain
It appears that most business owners are resigned to accept the proposed increase in the tax rate applicable to the ordinary income of individual taxpayers. That is not to say they are welcoming the rate hike; they realize, however, that the increase is not that significant (about 7 percent), and its enactment now would merely represent the acceleration of an already scheduled event.
The same cannot be said of the business community’s reaction to the President’s proposed increase of the federal tax rate on the long-term capital gain recognized by an individual taxpayer during a taxable year in which the taxpayer has more than $1 million of gross income.[ix]
If the President and his allies in Congress succeed,[x] the long-term capital gain rate will nearly double, jumping from 20 percent to 39.6 percent of such gain. The prospect of such a change has set the teeth of many business owners on edge.[xi]
To better understand the concerns of these owners – and why we, in turn, should be concerned – one must appreciate that about 95 percent of all businesses in the U.S. are pass-through entities (including sole proprietorships,[xii] tax partnerships[xiii] and S corporations[xiv]) the income of which is taxed directly to their owners.[xv] According to the U.S. Census, more than 50 percent of American businesses are owned by baby boomers.[xvi] One must also consider that, prior to the pandemic, “baby boomer business owners”[xvii] were retiring in record numbers.[xviii] However, as a result of the uncertainty caused by the pandemic, many of these owners are reevaluating their exit plans, with some having decided to accelerate the sale of their business, and others having decided to delay their exit in the hope of “recovering lost business value.”
Over the last twenty to forty years, the typical baby boomer owner of one of these closely held businesses has been investing almost all their time, efforts, and resources into establishing the business. They have borrowed funds and guaranteed loans that the business needed for operations; they have often under-compensated themselves for the services they rendered to the business, and they have rarely taken distributions from the business at a level comparable to what an outsider would have expected for the same investment, choosing instead to plow the earnings back into the business.[xix] At some point in time, the business may have grown enough to become an attractive target for an unrelated buyer.[xx]
The successful sale of the business is the goal toward which the owner has been working, and the after-tax proceeds from the sale represent both the owner’s return on their investment and their retirement fund.[xxi]
I’ll tax the street
If you try to sit, I’ll tax your seat
If you get too cold, I’ll tax the heat
If you take a walk, I’ll tax your feet
‘Cause I’m the taxman
Yeah, I’m the taxman
Sale of the Business
In general, the sale of a business may be accomplished either as a sale by the owners of their stock or partnership interests in the legal entity that owns and operates the business, or as a sale by the corporation or partnership of its assets.[xxii]
The gain realized by an individual taxpayer from their sale of stock in a corporation[xxiii] which they have held for more than one year represents long-term capital gain.[xxiv] The same is true for the gain from the sale of a partnership interest held for more than one year, except to the extent the gain is attributable to hot assets.[xxv]
When the S corporation or partnership sells its assets, the character of the gain realized – as ordinary income or capital gain – will depend upon the nature of the assets sold; for example, the gain from the sale of assets that constitute accounts receivable or inventory, or that are subject to depreciation recapture, will be treated and taxed to the shareholders or partners as ordinary income.[xxvi] If the property sold has been held for more than one year and (a) constitutes a capital asset, or (b)(i) is used in the business and (ii) is of a character which is subject to depreciation, or (c) is real property used in the business, then the gain from the sale of such property will be treated as capital gain.[xxvii]
In many, if not most, cases, it is likely that much, if not most, of the gain realized from the sale of the closely held business will be attributable to the goodwill and going concern value of the business,[xxviii] both of which generate long-term capital gain which, during the adult lives of most boomers, has been taxed more favorably than ordinary income.
Prior to the Tax Reform Act of 1986,[xxix] individual taxpayers who satisfied certain holding period requirements could exclude from gross income a percentage of their gain from the sale of a qualifying asset, and the remaining gain was taxed at a maximum rate of 20 percent. The 1986 Act repealed the exclusion of long-term capital gain and raised the maximum rate to 28 percent; it also reduced the maximum rate on ordinary income from 50 percent[xxx] to 28 percent, thereby temporarily eliminating the distinction between the two classes of income.
In 1990, the Omnibus Budget Reconciliation Act[xxxi] increased the top marginal rate on ordinary income to 31 percent. In 1993, the Omnibus Budget Reconciliation Act[xxxii] added a 36 percent and a 39.6 percent rate bracket for ordinary income. It also provided for the partial exclusion of gain from the sale by non-corporate taxpayers of “qualified small business stock” (issued by a domestic C corporation) that was held for more than five years.[xxxiii]
The maximum rate on an individual’s long-term capital gain, however, remained at 28 percent until the Taxpayer Relief Act of 1997,[xxxiv] when the maximum rate on capital gain was reduced from 28 percent to 20 percent.[xxxv]
The Jobs and Growth Tax Relief Reconciliation Act of 2003[xxxvi] cut the maximum rate on ordinary income to 35 percent. It also reduced the maximum capital gain rate to 15 percent,[xxxvii] and it remained there through 2012.[xxxviii]
The American Taxpayer Relief Act of 2012[xxxix] increased the rate on capital gain to its current level of 20 percent, while also restoring the maximum rate on ordinary income to 39.6 percent.[xl] It also provided for a 100 percent exclusion of the gain from the sale by non-corporate taxpayers of qualified small business stock.[xli]
In 2013, the Affordable Care Act imposed a surtax of 3.8 percent on the “net investment income,” including capital gain, of certain higher-income taxpayers,[xlii] thereby raising to 23.8 percent the maximum federal tax rate that may be applied to the capital gain realized by certain owners of a closely held business on the sale of the business.[xliii]
Which brings us to 2021, and to Mr. Biden’s proposal to raise the tax rate on long-term capital gain to 39.6 percent.
Don’t ask me what I want it for
If you don’t want to pay some more
‘Cause I’m the taxman
Yeah, I’m the taxman
Although the Administration has provided few details to date, the increased rate will be targeted at an individual taxpayer who realizes more than $1 million of income during a taxable year. Any long-term capital gain recognized by this individual during that taxable year will be subject to the increased rate.
On its face, this rule seems straightforward, but is it? For example, what if the taxpayer’s income includes their share of pass-through income from an S corporation that has been allocated, but not distributed, to the taxpayer? Should a capital-intensive business be treated differently than a service-oriented business?
In the case of our baby boomer business owner, should the capital gain from the sale of their business be counted toward the $1 million threshold? Should a portion of such gain be excluded? Should an owner who is active in the business be treated differently for purposes of the proposed rate change than one who is merely a passive investor?[xliv]
For that matter, should the rate hike apply only to individual taxpayers who report investment income and gain from the sale of property that generates such income,[xlv] and not to those taxpayers who report business income and gain from the sale of assets used or held for use in the business?
The preceding “history”[xlvi] of the capital gains tax (if I may call it that) begins at the time that I became a student of taxes and tax policy and parallels my career to date as an adviser to closely held businesses and their owners.[xlvii] I cannot recall a time when the owners of a closely held business did not seek to structure the sale of their business in a way that minimized the amount of ordinary income realized on the sale. Stated differently, to the extent that income was expected to be realized on the sale, the owner’s preference was to achieve capital gain treatment, and for good reason. The difference in capital versus ordinary tax rates resulted in a significant difference in the net proceeds retained by the sellers.
The last few years have not been an exception as baby boomer business owners have sold, or have begun to plan for the sale of, their business. Many who are in the planning stage have decided (or are close to doing so), for reasons independent of taxes, that their business is ready for sale. They have also determined – relying, in no small part, upon the historical rate preference for long-term capital gain over ordinary income – that a sale will leave them with sufficient after-tax proceeds for their retirement.
Now assume that Mr. Biden can hold the Democrats together;[xlviii] assume further that Congress – probably using the Senate’s reconciliation process, and Vice President Harris’s tiebreaker, again – enacts a substantial increase in the tax rate for capital gains.
Is it possible, following such an increase, that the planned-for sale of a business, that we previously assumed made sense from a business perspective, will not occur because a basic assumption on which the sale was predicated and the sale price determined – i.e., a preferred tax rate for long-term capital gains – has suddenly been upended? You bet.
On the one hand, the owner of the business may see a substantial part of their return on investment and retirement funds wiped out overnight because of the rate hike; on the other, the owner may also see the pool of potential acquirers shrink overnight as financial (as opposed to strategic) buyers, who planned to flip the business in a couple of years, bow out of the bidding because their own expected return on investment – i.e., their “compensation” for taking the risk of acquiring and improving the business before selling it themselves – has suddenly been reduced by the tax increase.
Now my advice for those who die
Declare the pennies on your eyes[xlix]
‘Cause I’m the taxman
Yeah, I’m the taxman
And you’re working for no one but me
I have spoken with plenty of business owners since the results of the general election last November, and especially after the Senate run-off elections in Georgia at the beginning of this year. The math is straightforward, and the outcome is not pretty: for every $100 of long-term capital gain recognized on the sale of a business in 2020, the active business owner would have paid $20 of federal tax, leaving $80 of proceeds; if the same gain is recognized after a rate hike in 2021, it may result in the payment of $39.6 of federal tax, leaving the owner with $60.4. Stated differently, for the owner to end up with $80 following a rate hike to 39.6 percent, they will have to receive $132.45 on the sale – not likely.
Of course, this outcome begs the question regarding the effective date of a rate hike that is enacted during 2021.
Will it be retroactive to January 1, 2021, to cover all sales occurring, and all installment or other deferred payments received in respect of earlier sales, on or after that date? The government would be within its rights to make it so. However, the uncertainty of the net economic result for any transaction[l] that is undertaken during that part of the year preceding the passage of legislation diminishes the likelihood of retroactive application the further into the year we get.
Will it be effective only for sales occurring, and for payments received, on or after January 1, 2022? Unlikely.
The most “reasonable” effective date would cover transactions occurring, and payments received, on or after the date of enactment of the tax hike, subject to an exception for sale transactions undertaken pursuant to an agreement entered prior to the date of enactment and not substantially modified thereafter.
Until the future of the proposed rate hike reveals itself, what is a boomer business owner to do if their goal is to minimize the taxes from the sale of their business in the face of a threatened tax increase?
Timing the Recognition of Gain
If the sale was completed in 2020, but included deferred payments, it may behoove the boomer to elect out of installment reporting on or prior to the due date for filing their tax return for the year of the sale (including extensions). If the boomer acts too slowly to take advantage of this option, they may want to “elect” out of the installment method by pledging the installment obligation as collateral for a loan, or “disposing” of the installment obligation, before the effective date of the rate increase.[li]
The boomer may consider deferring the receipt of any payment for a period beyond Mr. Biden’s first term in the hope that the rate increase will be reversed before the payments are due. Or they may defer the receipt of the purchase price for their business to limit their income for the year of the sale and for each subsequent year that payments will be made to stay below the $1 million threshold. That said, why assume the associated credit risk?[lii]
Similarly, the boomer may want to engage in a partially tax-free transaction in which a substantial part of the consideration received is equity in the acquiring company, the disposition of which may be timed by the boomer to coincide with the subsequent hoped-for rate reduction. Unfortunately, this could leave the boomer in a still-illiquid position if the acquiring entity is itself closely held, while at the same time relegating them to the status of a non-controlling owner. Not ideal.
An extreme option would be to defer the sale of the business until after the death of the owner, assuming Mr. Biden’s proposal to eliminate the basis step-up[liii] is not enacted. The step-up would eliminate much of the gain and offset the impact of a rate hike, but presents other issues; for example, what if there are several owners?
How About This?
The most sensible move may be to defer the sale of the business until the tax – and economic – environment improves. In the meantime, the boomer can work on strengthening the business. If appropriate, they may consider expansion plans, including perhaps the acquisition of another business. Alternatively, they may consider divesting themselves of a poorly performing line of business, or they may reorganize the business to facilitate a sale down the road (for example, by separating their real estate assets from their principal business). They should consider paying down or refinancing their debt. They should reconsider their real estate requirements, as well as their utilization of the internet. Poorly performing employees should be asked to leave, while the boomer should act to tie their key employees more closely to the business; although I rarely advocate for the grant of equity, an equity-flavored arrangement for these key individuals can work well as a retention vehicle, as may a profit-sharing plan for the loyal rank-and-file.
The President’s anticipated rate increase is not a welcome development for the owner of a closely held business, especially a baby boomer who is nearing a decision regarding the sale of their business, and especially coming on the heels of the pandemic and the resulting economic disruption.
That said, unless the boomer is in such an untenable position that a sale cannot be avoided or delayed, their best option may be to just wait, get some popcorn ready, and watch for the President’s address later this week.
[i] Apologies to the memory of George Harrison who wrote this song.
[ii] https://www.bloomberg.com/news/articles/2021-04-22/biden-to-propose-capital-gains-tax-as-high-as-43-4-for-wealthy .
It was also reported that the President will be asking for certain “enhancements” to the federal “estate tax for the wealthy.” When I hear the word “enhancement,” I think of improvements in quality. I am pretty sure that’s not what the President intends.
[iii] Joint Sessions are held at the Chamber of the House of Representatives. Query what the presumably COVID-compliant seating arrangements will be?
You may recall that, in early February, the Associated Press wrote that Mr. Biden was tentatively scheduled to appear before Congress on February 23, 2021 to give an “unofficial” State of the Union address, by which time, it was hoped, the American Rescue Plan would have been well on its way to enactment. Various other publications indicated that the President intended to use the occasion to unveil a large infrastructure package, including plans for tax increases to fund the package. Then, one week before the scheduled date, AXIOS reported that the White House press secretary had informed reporters that no such address was scheduled. Go figure.
The American Rescue Plan was enacted as Pub. L. 117-2 on March 11, 2021. The President announced his broadly defined infrastructure plan, coined the American Jobs Plan, on March 31, 2021. https://www.whitehouse.gov/briefing-room/statements-releases/2021/03/31/fact-sheet-the-american-jobs-plan/ .
[iv] The President announced this plan on March 31, 2021, along with his Made in America Tax Plan which calls for increased corporate income tax rates – for example, it would increase the rate from a flat 21% to 28% – and increased enforcement of the tax laws against corporations.
Interestingly, the week following the President’s announcement, Democratic Sen. Manchin indicated that he would not support a corporate tax rate increase beyond 25%. https://thehill.com/homenews/senate/546494-manchin-says-he-wont-support-corporate-tax-hike-to-28-percent .
[v] Please see my article online from the summer of 2020: https://www.taxlawforchb.com/2020/08/bidens-tax-proposals-for-capital-gain-like-kind-exchanges-basis-step-up-the-estate-tax-tough-times-ahead/ .
[vi] The Tax Cuts and Jobs Act (the “TCJA”; Pub. L. 115-97) reduced the maximum federal tax rate for an individual’s ordinary income from 39.6% to 37%. This reduction was drafted as a temporary measure, applicable to taxable years beginning after December 31, 2017, and before January 1, 2026. See Sec. 11001 of the TCJA.
[vii] To illustrate this point: in 2017, before the TCJA, the top rate of 39.6% applied to a single individual with taxable income of more than $418,400; in 2020, the top rate of 37% did not apply until the single individual’s taxable income exceeded $518,400.
[viii] IRC Sec. 1245.
The same rule applies when a partnership or an S corporation sells such property – each individual owner reports their share of the depreciation recapture (shown on their K-1) on their individual income tax return.
Speaking of partnerships, the disposition by a partner of an interest in a partnership may result in the recognition of some ordinary income notwithstanding the treatment of the partnership interest as a capital asset under IRC Sec. 741. Specifically, to the extent the value of the interest is attributable to so-called “hot assets” described in IRC Sec. 751, part of the gain will be treated as ordinary income. Depreciation recapture is one of these hot assets. IRC Sec. 751(c). There is no similar look-through rule for the sale of stock in an S corporation.
A type of recapture may also occur on the sale of depreciable real property (i.e., not land). In that case, that portion of the gain realized by the seller equal to the amount of depreciation claimed by the seller is taxed at a rate of 25%. The portion of the sale price that reflects the appreciation in the value of the property after its acquisition by the seller is treated as capital gain.
[ix] Thus far, the Administration has been stingy with providing details regarding the implementation of the increased rate. Hopefully, that will change this Wednesday.
[x] Their success may not be a foregone conclusion. There is some dissension among Democrats.
[xi] I may have mentioned in prior posts that I am idiom-challenged, though I think I got this one right.
By this point, you may have gathered that our focus here is on the business owner, and not on the individual who invests in the public markets. There are significant differences.
[xii] Including single member LLCs that have not elected to be treated as associations (i.e., corporations) for tax purposes. Reg. Sec. 301.7701-3.
[xiii] Including LLCs with at least two members that have not elected to be treated as associations for tax purposes.
[xiv] IRC Sec. 1361.
[xv] https://www.brookings.edu/research/9-facts-about-pass-through-businesses/ .
Our focus here is on these closely held pass-through business entities.
[xvi] https://www.census.gov/library/visualizations/2020/comm/business-owners-ages.html .
[xvii] Talk about alliteration.
[xviii] https://www.cnbc.com/2019/12/10/as-baby-boomers-retire-main-street-could-face-a-tsunami-of-change.html .
[xix] Another idiom. At least I’m not shirking the challenge.
[xx] Few of such businesses are passed down to the next generation.
[xxi] Eventually, what remains of these funds at the demise of the former owner will be included in their gross estate for purposes of the federal estate tax. Chapter 11 of the Code. We will discuss Mr. Biden’s plans for the estate tax in a later post.
[xxii] Of course, this is an oversimplification. There are many permutations of these two basic forms of M&A transaction; one may be better suited for one set of circumstances than another. Moreover, there are times when they may be combined to achieve the desired business goal. Certain forms of transaction may be undertaken as a preliminary step to an M&A deal, and others may be implemented after the deal (for example, to remove unwanted assets). Some transaction structures may afford the seller tax-free (tax-deferred, really) treatment as to at least a portion of their gain realized.
[xxiii] Regardless of its status as a taxable C corporation or as an S corporation. IRC Sec. 1361(a).
We assume that no elections are made under either IRC Sec. 338(h)(10) or Sec. 336(e) to treat a qualifying sale of S corporation stock by a shareholder as a sale of assets by the corporation that is followed by the liquidation of the corporation.
[xxiv] IRC Sec. 1001, 1221, 1222, 1223.
[xxv] IRC Sec. 741 and 751.
[xxvi] IRC Sec. 702(a) and (b), and Sec. 1366(a) and (b). The character of the gain realized by the entity is preserved in the hands of the partners or shareholder.
[xxvii] IRC Sec. 1221 and 1231.
[xxviii] Described as Class VII Assets for purposes of IRC Sec. 338(h)(10), Sec. 336(e), and Sec. 1060. See the asset allocations in IRS Form 8883 and Form 8594.
This is what one would expect to find in the case of a successful, non-rental real estate, business.
[xxix] Pub. L. 99-514.
[xxx] It was 70% before the Economic Recovery Tax Act of 1981, Pub. L. 97-34.
[xxxi] Pub. L. 101-508.
[xxxii] Pub. L. 103-66.
[xxxiii] IRC Sec. 1202. Please see my article online at https://www.taxlawforchb.com/2019/05/is-timing-everything-only-time-will-tell-small-business-stock-and-the-reduced-corporate-tax-rate/ .
[xxxiv] Pub. L. 105-34.
This legislation also provided the current exclusion from gross income for the gain on the sale of a taxpayer’s principal residence. IRC Sec. 121.
[xxxv] According to the Blue Book, Congress believed that economic growth could not occur without saving, investment, and the willingness of individuals to take risks. To encourage such savings and risk-taking, and to avoid the so-called “lock-in effect,” Congress decided to reduce the effective tax rate on capital gains.
The 1997 Act was passed by Congress on a bipartisan basis, with 99.6% of the Republicans and 80% of the Democrats voting for it in the House, while 100% of the Republicans and 82.2% of the Democrats in the Senate voted for the measure. President Bill Clinton signed it into law.
[xxxvi] Pub. L. 108-27.
Prior to the 2003 Act, the Economic Growth and Tax Relief Reconciliation Act of 2001 (Pub. 107-16) called for the reduction, over time, of the ordinary income rate. The 2003 Act accelerated this change.
[xxxvii] The 2003 Act also extended the capital gain rate to qualified dividends. IRC Sec. 1(h)(11).
[xxxviii] The 2001 and 2003 rate cuts would have sunset in 2011 but for the passage in 2010 of Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (Pub. L. 111-312), which temporarily extended the cuts.
[xxxix] Pub. L. 112-240.
[xl] Of course, we know that the TCJA reduced this rate to 37%.
[xli] IRC Sec. 1202.
[xlii] IRC Sec. 1411.
[xliii] The 3.8% surtax is not deductible by the taxpayer for purposes of determining their income tax liability.
However, the tax does not apply to the gain recognized by a shareholder of an S corporation on the sale of their stock, or to the shareholder’s share of the gain realized on the sale by the corporation of its assets, if the shareholder materially participated in the business. Similar rules apply to individual partners in a tax partnership. IRC Sec. 1411(c); Reg. Sec. 1.1411-5.
[xliv] These are already treated differently for purposes of the surtax on net investment income under IRC Sec. 1411.
[xlv] See IRC Sec. 212.
[xlvi] I must confess, I was going to say “recent” history. Then I caught myself. It really sucks.
[xlvii] It has been a rollercoaster ride.
[xlviii] This will certainly require some reciprocal back-scratching. In the House, it will require some relief on the SALT deduction. In the Senate? I wonder what West Virginia needs in the way of public works.
[xlix] Love the reference to the ancient Greek custom of placing coins on the eyes of a deceased as payment to Charon, the ferryman, for conveying their soul across the River Styx.
But we are not addressing the federal estate tax today – only the tax on capital gain. Plenty of time for the estate tax, yes?
[l] Which, necessarily, must consider taxes.
[li] IRC Sec. 453(d)(2), Sec. 453A(d), Sec. 453B.
[lii] Not to mention the interest charge under IRC 453A in respect of the deferred tax liabilities attributable to the installment obligation.
[liii] IRC Sec. 1014.