Calculating the Proposed 2022 Tax Change Impact in M&A

In early June of 2021, the Biden administration proposed a new framework for comprehensive tax changes. These proposed changes would affect both the ordinary income tax rates and the long-term capital gains rate. Here is a review of the proposed changes:

  • Ordinary Income Impact: Taxpayers with an adjusted gross income of more than $1 million would be taxed at ordinary income tax rates. Under the proposal, the top ordinary income tax bracket would rise from 37% to 39.6%.
  • Long-Term Capital Gains Impact: The long-term capital gains (preferential) rate is currently at 20% (assets held for over a year). Biden’s plan would completely eliminate this preferential rate and revert the tax rate to the top ordinary income tax bracket (39.6%) mentioned above. This is at least a 19.6% increase!
  • Overall Impact: The change will likely impact taxpayers who don’t annually earn anywhere near $1 million, but do have a once-in-a-lifetime taxable event, such as the sale of a business, that can temporarily push their income over the $1 million mark.
  • Net Investment Income Tax: Additionally, sellers may be impacted with an additional net investment income tax of 3.8% on the sale of qualified business property or working capital. We have not included any calculation in this respect in the model below. Please consult with your CPA.
  • Date of Implementation: The announcement stated that the “proposal would be effective for gains required to be recognized after the date of announcement.” Although critics and business owners are doubtful that changes will be retroactive in their effect and experts weighing in stated “it’s rare for a tax change of this magnitude to apply retroactively, and the possibility will make it difficult for tax professionals to advise their clients on what to do.” Realistically most believe that “we would be looking at an effective date of Jan. 1, 2022.”
 (in $Ms) Current Tax Rates Proposed Tax Rates
Business Value $5.0 $5.0
Gain Subject to Capital Gains* $4.0 $4.0
Current Capital Gains Rate ** 20.0% 39.6%
After-Tax Proceeds $3.2 $2.4
Reduction in Proceeds (%) (24.5%)
Original After-Tax Gain $3.2
New Tax Rate 39.6%
New Gain Required to Match Original Gain Given New Tax Rate $5.3
Valuation Increase Required in Gain to Match (%) 65.6%
for illustration purposes only

*fixed asset value and short-term assets subject to ordinary income rates. Estimated 80% of the purchase price subject to capital gains rate for this illustration.
**federal only – no state impact; applicable to over 441,451 in income.

Increasing a gain from $3.2M to $5.3M is substantial. Consider that if the hypothetical business sold had EBITDA of $1.25MM (x4), the EBITDA is going to have to increase to ~$2MM in order to realize the same net proceeds! At 20% EBITDA margin, sales are going to have to increase from $6.25MM to $10MM. We do not encounter many businesses that are able to quickly add $3.75MM in profitable sales!

In the illustration above we used 80% of the business value as consideration subject to the capital gains rate. In proportion, to meet the new gain required of $5.3M (in order to net the same proceeds) this likely means valuing the business at least $1.6M higher! (over $6.62M).

We have not even begun to touch on the potential effect of inflation, which has increased rapidly and which will likely remain at elevated levels for some time to come. For instance, according to the Washington Post, between May 2020 and May 2021 inflation rose to 5% which was much higher than expected and the biggest jump since 2008. Higher tax rates coupled with mounting inflation are not friends to your dollars!

Given all of this uncertainty combined with labor shortages and wage increases, it is no wonder that our phone has been ringing off the hook as of late.

If (or when) the Biden plan becomes law, a seller would need to realize a 65.6% higher price to net the same after-tax proceeds of a sale taxed at the current rates. This is why advisors are urging any owners that are considering a liquidity event in the near future to begin planning immediately.

Those contemplating the sale of their business in the coming years will want to seriously consider whether to accelerate (or not) the sale in 2021 given the sizable one-time tax savings that may be available! Even if you are not thinking about selling, but want to be proactive in your planning, please don’t hesitate to reach out.

Disclaimer: Calder Capital are not CPAs and the examples given are purely hypothetical.

Have any questions? Reach out to a Calder Advisor today.

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