Two principal ways tax increases negatively affect business owners, and what you can do to overcome them.
In our discussion of the headwinds business owners face in growing and exiting their businesses, I’ve discussed how the sluggish state of today’s economy poses a formidable challenge to a successful exit. Today, I discuss another headwind: the 2013 tax hikes, and how the U.S. Government’s increasing appetite affects our ability to grow and reap business value.
No, I am not jumping into the shouting match about cutting or increasing taxes on “the wealthy.” I am concerned about the generally overlooked negative effect of increased federal taxes on a business owner’s ability to grow the company during ownership and receive needed sales proceeds when he or she leaves it.
The tax increases negatively affect business owners in two principal ways.
First, bigger tax bites on earnings mean less capital available for business growth. Second, a higher capital gains tax means less net proceeds when you sell your company. Higher taxes (like lower GDP growth rates) affect the speed at which owners can reach successful exits. Let’s tax each tax, one at a time.
Capital Gains Tax: On New Year’s Day, 2013 the federal capital gains tax rate increased from 15 percent to 20 percent on income in excess of $450,000 for joint filers. This is imposed on the sale of stock of either a C or an S corporation.
Investment Income Tax: The Affordable Health Care Act (Obamacare) imposes a 3.8 percent tax on investment income (including capital gains on the sale of a C corporation stock, but not (yet at least) on the sale of S corporation stock) for taxpayers earning above $250,000 per year. Had you sold your business during 2012, the government would have taken 15 percent of the gain. Today it can collect 20 to 23.8 percent (if you sell the stock of a C corporation). That is an increase of 33 percent to 59 percent. Ouch.
Creep in Marginal Income Tax Brackets: Also on New Year’s Day of 2013 the marginal income tax brackets for individuals increased. The new top tax bracket for joint taxpayers earning over $450,000 is 39.6 percent. Taxpayers in this bracket potentially face a combined 43.4% (39.6% + 3.8%) marginal tax rate on their income.
Because owners of S corporations, sole proprietorships, LLCs and partnerships are taxed on business income directly the additional tax affects not only your personal income, but the amount of after-tax income available to your business for growth, expansion, acquisition of other companies, etc.
The point the Government seems to have missed is that much of the income taxable to the business owner must be kept at the company level if the business is to expand. The money retained in S corporations is taxed, in effect, at the highest marginal tax rate of the owner. Raising income tax rates reduces the amount of capital available to fuel growth.
My biggest ah-ha moment came several years ago when I met with the owners of a rapidly growing construction services company and their CPA to discuss year-end tax planning. The two owners were lamenting their low salaries–$125,000 each–and asked their CPA how much of a year-end bonus or S distribution they could take. The pre-tax earnings of their company were a bit over $5,000,000. My thought, which I fortunately kept to myself, was that they could each bonus themselves $500,000 or more. Their CPA had a different idea. He answered, “You can’t take any bonus. At the rate you’re growing and want to continue to grow, the company needs every cent and more to fund that growth and to provide collateral for surety bond purposes.”
To illustrate the link between tax rates and ability to capitalize your company, let’s compare the 2012 and 2013 tax bites on $1,000,000 of taxable income for married individuals filing jointly.
| Taxable Income | 2012 Tax Bill | Net After Taxes | 2013 Tax Bill | Net After Taxes |
|---|---|---|---|---|
| $1,000,000 | $319,139.50 | $680,860.50 | $343,645.60 | $656,354.40 |
The business owner in 2013, 2014 and until rates change again pays $24,506.10 more in taxes (or approximately 7.67 percent more) than in 2012.
As you can see, increased personal taxes reduce your ability to expand your company, or, if that isn’t critical, reduce the amount of money available to you to invest outside of the business.
In sum, the increased taxes affect you in a number of ways: First, if you had sold your business before 2013 and, after taxes, had exactly enough cash to achieve financial security, you’d have to sell that same business today by five-plus percent more to cover the higher capital gains taxes to end up with the same amount of cash in your pocket. If the cash flow of your business is projected to grow at five or six percent a year, tack on another year or so of growth to the end of your journey.
Second, the increased tax bite will likely reduce the amount of capital available to the business, slowing the rate of cash flow growth.
Third, increased income taxes reduce the amount of money available to you to invest in assets outside the business.
More tax equals both less money for you and your business every year, and reduced net sale proceeds when you exit.
Taxation has always been a headwind in the face of business growth, but the Feds have increased its velocity. Yet, we are not helpless. In fact, we have several tools to overcome higher taxes–but most must be employed long before we transfer ownership to be effective. Minimizing or avoiding taxation is an important component of successful Exit Planning so you haven’t heard the last from me on this topic.
