Like many things coming out of Washington lately, the recently proposed Biden Tax Plan has, so far, inspired little other than confusion and angst across Wall Street, Main Street and Bourbon Street.
With the government and Federal Reserve teaming up to inject record sums of fiscal and monetary stimulus into the economy since the start of the pandemic, the real “bill” was bound to come due eventually. And while the proposed plan’s estimated $2.8 trillion of additional revenue over the next 10 years (in total, not annually) stacks up rather feebly next to the $5.3 trillion in federal stimulus doled out in the last 14 months, the new tax plan is likely to become law, in some form or another, given the de facto democratic majority within congress and the White House.
For better or worse, new tax rules are on their way. Biden’s current proposal leaves few stones unturned, overhauling the corporate tax rate, personal tax rates for top earners, estate tax exemptions, and a slew of other tweaks purportedly aimed at closing loopholes for big corporations and the ultra-wealthy. The big one, though, and the focus of this writing, is the change that has coffee houses and country clubs abuzz with speculation – the long-term capital gains rate.
More specifically, this writing will focus on the implications of higher long-term capital gains, or “LTCG” rates for the owners of small to medium sized companies, with the majority of their material wealth tied up in a closely-held business. Why? Well, the proposed jump in the LTCG rate only applies to filers with income over $1 million, so unless you’re an ultra-high net worth investor or someone with enough regular income to get over the threshold, this likely won’t have major implications for your brokerage account. Conversely, for the small or mid-sized business owner, who doesn’t have 20 in-house tax accountants or an army of corporate attorneys to sniff out the latest and greatest loopholes, this could have a multi-million dollar impact on their ability to maximize value when they ultimately exit their business.
By the Numbers
In recent years, shareholders contemplating a stock sale were generally faced with a 20% federal LTCG rate, a 3.8% net investment income tax rate (aka. Obamacare surtax), and anything additional imposed at the state level. For Californians, whose home state does not segregate LTCG income from ordinary income and also happens to charge the country’s highest marginal income tax rate, this could mean up to an additional 13.3% tax, implying an overall tax rate of around 37% on any realized gains.
Under the proposed tax plan, which would nearly double the LTCG rate for income over $1 million from 20% to 39.6%, those Californians could see that overall tax rate jump to over 56%.
So, apart from underscoring the already strong incentive for business owners to flee for tax-friendlier pastures, what can we expect to result from these changes if and when they become law?
Well, for starters, the answer may depend heavily on whether the changes take effect beginning in 2022, or apply retroactively to gains in 2021. If the former option prevails, we’re likely to see an unprecedented uptick in transaction activity during the later months of 2021, followed by a potentially significant slow-down in early 2022. Any sellers pursuing a sale will likely do everything in their power to accelerate the closing into 2021, and buyers may leverage this angle to negotiate lower multiples or press other buyer-friendly terms that the seller may otherwise not be willing to accept (ie. larger and longer escrow holdbacks, more onerous seller and company representations, etc.).
If the change ultimately applies retroactively to all of 2021, we may avoid some of the more frenzied selling before year-end. Even so, it’s likely that public and private markets would see some downward pressure on valuation as fund managers, family offices, and other sources of institutional capital recalibrate their after-tax rate of return targets and adjust their front-end valuations and price targets accordingly.
Given the relative outperformance of private equity in recent years, we think it’s unlikely that the tax change would spur a flight of capital away from sponsor-backed M&A in the US middle-market. That said, the change may push larger sources of private equity funding to explore a shift towards investing in tax-friendlier jurisdictions, which could translate to less dry powder for domestic sponsors looking to raise funds in the coming years.
Irrespective of when the change goes into effect, one exit strategy is likely to become significantly more attractive to potential sellers: employee stock ownership plans, or “ESOPs.” Section 1042, a treatment specially reserved for ESOP transactions, allows a seller to exchange their interest in the company for a portfolio of qualified replacement property, or “QRP”, without paying tax on the gain at the time of the sale. The definition of QRP is fairly broad, but in essence, it includes stock and bonds in publicly traded domestic companies. In short, an ESOP transaction with a 1042 election allows business owners to convert the illiquid stock in their closely held business to more liquid and diversified holdings in the market, while deferring the taxable event until they sell those holdings later in life.
Notwithstanding, there are other hurdles to qualify for this treatment that may limit its adoption. The company must be a C corporation, and the ESOP must end up owning 30% of the company’s stock, to name a couple. On top of that, a popular tax avoidance strategy, whereby the 1042 deferral is perpetuated through a leveraged floating rate note strategy, may lose its appeal if the ability to recognize a step-up in basis is eliminated, as proposed in the current version of the plan. Even so, we expect to see a significant increase not only in the election of 1042 treatment in ESOP transactions, but in the popularity of ESOP transactions overall, given that the option to defer the now-higher tax payment can meaningfully enhance the after-tax outcome of an ESOP relative to other paths to liquidity for business owners.
Despite the potential tax headwinds on the horizon, for those Baby Boomers and early Gen X-ers looking to step away from their businesses in the coming years, waiting it out may not be wise, nor even an option. With interest rates still hovering near all-time lows and equity valuations clinging to their frothiest level in modern history, we may not see a more opportune time to transition some or all of the ownership in the business for many years to come. What’s more, while taxes are likely going up in the near term, who’s to say the next move will be a return to lower levels?
As the plan takes shape over the coming months, we will continue to assess the impact for business owners, and provide updates to our expectations and insights. In the meantime, if you or your clients are considering a path to exit in the near term, Acuity Advisors can help you understand your options, anticipate the obstacles, and achieve the right result.