By Wayne Farlow
If you are considering retirement and have an ownership position in your business worth $250,000 or more, the two year extension of the “Bush tax cuts” could provide an opportunity for significant tax savings.
For the next two years, long term capital gains and qualified dividends will be taxed at a maximum rate of 15 percent. In 2013, capital gains tax rates will likely increase to at least 20 percent and could increase to 28 percent on the “wealthy” (couples earning $250,000 or more per year). On top of this likely tax increase, 2013 will also usher in increased Medicare taxes which could add 3.8 percent in taxes to all investment income. Let’s look at what this could mean if you are considering the future sale of your business interests.
We assume that you are married and that you and your spouse’s Adjusted Gross Income is $250,000. Let’s also assume that your business ownership interest has a net gain of $1 million. If you sell your business ownership interest by the end of 2012, the federal income taxes owed from the sale of your business interests will be $150,000, allowing you to keep $850,000. However, if the same business ownership is sold at the end of 2013, federal taxes owed will likely be significantly higher.
Assuming that long term capital gains rates only rise to 20 percent in 2013, you will owe $200K in capital gains taxes, an increase in federal taxes of 33 percent. However, since your 2013 AGI remains at $250,000, the $1 million income from the sale of your business will be fully subject to the 3.8 percent Medicare tax, providing an additional $38,000 in federal taxes owed. Selling your business at the end of 2013, instead of 2012, will likely add a minimum of $88,000 to your federal tax bill, representing a 58 percent federal tax increase.
Many people believe that the capital gains rates for the “wealthy” could increase to the 1996 level of 28 percent in 2013. If this occurs, the total federal taxes that could be owed on the sale of a $1 million business interest would rise to $318,000, leaving only $682K remaining after federal taxes. If this scenario occurs, postponing the sale of a business could more than double the amount of federal income taxes that must be paid.
Thanks to the recent extension of current tax rates, there is a two year window of tax certainty. Based on previous government actions, it seems reasonable to expect that nothing further will be done regarding taxes until the end of 2012, at the earliest. If you are considering the sale of a substantial business interest in the near future, it might be wise to begin this process now, so it can be completed before the end of 2012.
As with all investments, you should never let the “tax tail” wag the investment dog. If you are enjoying your business and expect it to keep growing in value over the years to come, short term tax consequences will be diminished by the increase in total value that you will receive by selling your business in the future.
However, if your business is not growing rapidly and you are not enjoying it like you once did, it may be time to sell. As the economy continues to improve and banks begin to offer business loans, preparing your business for a sale by the end of 2012 could maximize your after tax business returns
Wayne Farlow is the founder of Financial Abundance, LLC, providing fee-only financial planning, asset management and retirement planning services. He is the author of “Financial Abundance Guide,” available at www.finabguide.com. He can be reached at 303-554-0309.
(originally published in the January 2011 eNewsletter)