World Class Mergers & Acquisitions  |  For Companies $5 Million to $100 Million in Revenue

Selling in 2010 Makes Good Tax Sense

Introduction

There were 66 million babies born between 1945 and 1964.  The era was known as the “Baby-Boom” and the “Boomers” are reaching retirement age.  In fact, the oldest are now turning sixty-six and the youngest are embarking on their forties.  As such, many of these people have worked hard throughout their lives and have built businesses from the ground up.  A very considerable amount of wealth has been created and those owners are now looking to retire or move on from their businesses.

Currently, in 2010, we have favorable tax rates which allow you and your company to pay less taxes on the sale of the business as opposed to waiting until 2011.  During the Bush administration, both capital gains and dividend tax rates were decreased to 15%.  Those tax cuts are now set to expire December 31, 2010.  The rates coming in 2011 will be 20% for capital gains and the ordinary tax rate for dividends can be as high as 39.6%.

Capital Gains

The capital gains rates are currently 0% and 15%.  Historically, the capital gains rates have  been as high as 20%.  This means that capital gains will be taxed at 0% if the combined Adjusted Gross Income of the selling taxpayer (including capital gains) is at or below the two lowest tax brackets.  The amount of capital gains earned by a taxpayer that are at or over the 25% bracket are currently taxed at 15%. These new rates produce much more favorable tax consequences than in past years.

For example, if a company is sold and capital gains are determined to be $1,000,000, in this tax year, the seller of the company would pay $150,000 in capital gains taxes as opposed to $200,000 in a future year.   The result is a tax savings of $50,000 just given the fact that the sale happened this year as opposed to next year.

Unless Congress acts to the contrary, the capital gains tax will go up in the next year.  If you fail to take gains this year, they will be taxed harsher next year.

Dividends

If you own stock in a C Corporation you most assuredly have had, at one time or another, dividends distributed to you.  Currently, and for the good part of the past decade, dividends were taxed at 15%.  No matter what income level you were at, dividends received a preferential rate making the C Corporation a good buy and a good business entity for tax purposes.  The laws giving rise to the preferential treatment are now coming to an end as of December 31, 2010 as well.  On January 1, 2011, dividends will be taxed at the ordinary income tax rate of the taxpayer.

Here, the significance is that this year is a very opportune time to cash in corporate retained earnings. This is sometimes done during business sales to cash out the retained earnings, lessening the tax burden.   If this is done in 2010, the tax rate will be 15%.  Next year, dividends are taxed at a maximum rate of 39.6%, as the ordinary income tax rate regains its old position as well.

To illustrate the point, a taxpayer in 2010 who cashes out retained earnings of $1,000,000 will pay $150,000 in taxes.  Next year, the same taxpayer could pay up to $396,000, well over double the 2010 tax consequence.  This is a difference of $246,000 for the same amount of dividends distributed to the same person.

Conclusion

With the imminent increase in the capital gains tax and the dividend tax rates, owners of closely-held businesses are well advised to sell their businesses this year as opposed to next in order to take advantage of the lower tax rates.  Your business sale this year resulting in a $3,000,000 gain is a mere $450,000 in tax.  Next year, a $3,000,000 gain could result in $600,000 due.  The difference in taxes between the two years is considerable.   If you are interested in discussing your succession or exit plan, contact The Center at (618) 997-3436 to speak to one of our professionals.

By: Dr. Bart Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors