Business owners looking to sell or transfer their business to a family member may have some tax decisions to make if the Biden administration gets its tax code revisions through Congress this year.
Don Petrille, senior lawyer with High Swartz, Doylestown, said the 2017 Tax Cut and Jobs Act created a lot of exemptions for business owners. However, many of those could go away by 2026, if not sooner.
The Biden administration’s American Jobs Plan would change the current Step-up in Basis law that Petrille explains using stock purchases as an example. “If you buy a stock at $10, that is your basis. If it appreciated to $15, your capital gain is $5,” he said. “If you give the stock to someone, they get your basis. So, under the current rules, the basis is based on what it is worth (when bought).”
That relates to selling a company. If an owner sells a company, the basis is what it is worth when it was started. Under the Biden proposal, the basis would be what the company is worth when sold. That will increase capital gains taxes.
John Reed, partner with Barley Snyder, Lancaster, expected capital gains to increase last year. “We all think change is coming, but we don’t know when.”
The takeaway, he said, “if someone is thinking about retiring, they should do it now when we know what the rules are.”
Colin Keefe, partner with Fitzpatrick, Lentz & Bubba, Allentown, agreed. “It’s a good time to sell because we believe taxes will go up in 2022.”
Reed said succession planning comes with many challenges. The proposed changes could make the financial challenges even greater.
“There is risk inherent in this,” he said. “If (the owner) needs to get money out of the business (to live on), he may sell to others and rely on monthly income. There is risk in that,” he said. “You hand control over to someone else and you no longer have control over the running of the operation.”
Petrille said owners have to take a holistic approach to keep the business going. “You have to look at what the departing owner is taking with him; his knowledge, vendor relationships, and what he contributes daily to the operation. How are you going to finance that?”
Insurance can offer some protection, he said. It can be used to retain people who can run the business or to get through rough times during the transition.
Many entrepreneurs will use a self-directed IRA to start a business, he said. The ownership is then tied to that. The Setting Every Community Up for Retirement Enhancement Act (SECURE) of 2019 says if you inherit an IRA, or a business funded by one, you have to liquidate it and pay income tax and penalties or pay income tax on the money over a 10-year period.
“This is also integrated with estate planning because you own a business and that business has value which is taxed by Pennsylvania,” he said. “So, you need to have liquidity to pay the taxes owed nine months after the person’s death.”
Inheritance tax now stands at 4.5 % for children and 12% for siblings.
“Business owners are perceived to be wealthy,” Petrille said. “But wealth doesn’t always mean you have liquidity.”
Consider the construction worker who starts his own business using his personal truck, he said. The basis for this business is zero. But, as the business grows, and the owner hires more workers, buys more trucks and maybe even establishes a shop, the business value goes up. And though the value has increased, there may be no extra cash flow. If the owner sells the capital gains would be on the basis of zero.
If the Biden plan is passed, the basis would be on the value of the company at time of sale. “So, if the business is worth, say $10 million, the taxes could total $4 million. Where do you get the cash to make the transaction?”
Keefe said it is a good time to sell if a business owner is thinking of retiring. “There are lots of buyers right now and the interest rates are still low.”
Biden’s tax plan is in committee. The proposed $4 trillion of new federal spending over 10 years will be partially funded with higher taxes on individuals and businesses. Members of the House and Senate have put forth bills that include everything from increases in capital gains and corporate income taxes to new individual and business tax credits, according to the Tax Foundation.