Strategies to Minimize Capital Gains Tax Liabilities in the Coming Year

The current administration has proposed a number of tax changes, including a potential increase in the capital gains tax rate. With a little advance planning, business owners can reduce their long-term tax liability if they can’t sell while tax rates are still favorable.
 
As soon as 2022 (and even retroactively to April 2021, in some proposals) the current administration’s proposed capital gains tax could increase significantly. Rates may almost double from the current 20% federal rate plus 3.8% Medicare surtax to a proposed 43.4% federal rate—and that’s not including state taxes. Although it's uncertain if rates are going to rise to that level or when the effective date will be, the current Congress and administration have embraced raising capital gains tax rates substantially. Sellers will, therefore, realize substantially less cash from the sale of their lifetime’s work.
 
To put it another way, the difference between selling your business in 2021 as opposed to 2022 (or whenever the new tax rates go into effect) could result in you paying an additional 19.6% in taxes. For top earners and high net worth individuals, the proposed capital gains rate increase means paying an additional $980,000 in taxes for every $5 million in business valuation they sell. This has the greatest impact on those reporting earnings of at least $1 million per year, a threshold that will almost certainly be breached by the sale of most businesses.
 
However, high net worth individuals don’t need to despair over the changing tax code. By taking advantage of the current tax rules, or setting themselves up for reduced tax liabilities once conditions become favorable again, they can increase their cash retained. 
 
Business owners have choices: they can expedite the sale of their business before the new tax rates take effect, explore alternatives to selling, or take advantage of the tax benefits that may present themselves when planning an exit strategy well in advance. These are all viable options for business owners—they just need to weigh their options carefully, and be prepared to act quickly. 
 
If you’re in a position to sell your business to an ideal third party before a potential capital gains rate increase, get on the phone with your financial advisor immediately. If not, consider these options. 

Sell your business...to your employees

One alternative to a third-party sale that business owners have found to be particularly advantageous is the Employee Shared Ownership Plan (ESOP). An ESOP is a tax-advantaged vehicle for the departing shareholder to gain liquidity while passing along the shares of the business to the employees over time, at no cost to the employees. The shares are then typically held in a trust until the employees’ retirement or until they exit the company. This is a great option for business owners looking to maintain their culture and corporate structure while rewarding the employees who helped to make the company successful. When certain conditions are met, the capital gains from the sale to an ESOP are deferred until the asset purchased from the proceeds is itself sold. An ESOP is also ideal for sellers looking to maintain a certain level of privacy and want to avoid either making their financial records available to potential competitors or enduring the public embarrassment of a sale potentially falling through. An ESOP provides a discreet and quiet exit strategy that bypasses the need to actively market the sale of one’s business.

Start drawing up a detailed succession plan

If you’re not in a position to sell your business before capital gains tax rates increase, the best thing to do is to create an advanced succession plan so you’re prepared to exit once tax conditions become more favorable again. The more lead time you devote to identifying and grooming the future leaders of your organization, the better. The more time you give yourself to get your successors in place, the more likely it is you’ll be able to take advantage of prime opportunities to sell and favorable tax conditions when they present themselves.

Consider buying instead of selling

Instead of offloading assets, the expected capital gains rate increase may present a prime opportunity to bolster your portfolio. Because other business owners may be looking to sell quickly to avoid the anticipated greater tax liability, buyers are poised to acquire new businesses at reduced prices from sellers motivated to receive the bulk of their sale proceeds upfront. When planning to make the most of the current capital gains tax rate, time is of the essence. Even if you’re not able to exit your business when the capital gains tax rate is in your favor, it’s never too early to start planning ways to reduce your future tax liability.