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Capital Ideas for Private Business

Bidding Farewell to Tax Cuts in 2011

Looming capital gains changes may affect when you should sell your business.

By David DuWaldt, Managing Director
Los Angeles Office, Corporate Finance Associates

Tax CutsThey say that in life, only two things are certain…death and taxes. Indeed, taxes are a certainty in our lives, but the rate at which we pay our taxes is ever changing. On December 31, 2010 the tax cuts we enjoyed under the Bush Administration are set to expire and we will be facing one of the steepest tax hikes in US History.

Historical Perspective

To fully understand the impact of tax changes arriving in 2011, it is instructive to look back at the history of income taxation in the United States, including the tax treatment of capital gains. Although there was an income tax first imposed during the American Civil War and later in the late 1890s, taxation on income in the United States was permanently activated in the year 1913 with the passage of the Sixteenth Amendment to the Constitution.

For simplicity’s sake this discussion applies to the individual income tax only. From 1913 to 1921, all capital gains were taxed in the same manner as ordinary income, which started with a maximum rate of 7%. It certainly did not take long for income tax rates to increase. In 1916, the top tax bracket was 15%, jumping to 67% in 1917, 77% in 1918 and by 1921 dropping back down to 73%. After tax legislation was passed in 1921, gain from the sale of assets held for at least two years was taxed at a rate of 12.5%, thereby creating a lower tax rate on long-term capital gains.

After 1921, the maximum tax rate on ordinary income varied substantially, from 56% in 1923 dropping to 25% by 1928. During the 1950s, the top tax bracket for ordinary income was as high as 92%! It was not until 1969 that tax legislation was passed whereby earned income (e.g., salaries and wages) would not be taxed at a rate greater than 50%. In 1969, the top tax bracket for unearned income (e.g., interest, dividends, and royalties) was 77%.

In 1934 the 12.5% rate on capital gains derived from the sale of property held for at least two years was replaced with a new method of computing tax on long-term capital gains. Under this new computation, percentages of gains were excluded from income based on the period that the capital asset was held. In the case of an asset held for at least one year, 20% of the gain was excluded from income. If the asset was held for at least two years, then 40% was excluded, five years, then 60% was excluded and if the asset was held for at least ten years, then 70% of the gain was excluded from income. The portion of the gain included in income was combined with ordinary income and deductions with the resulting taxable income being subject to the applicable tax rate schedule.

Starting in 1942, the capital gain exclusion was simplified whereby 50% of the gain from a capital asset held for at least six months was excluded from income. There was also an election available to apply a 25% rate if the ordinary income tax rate exceeded 50%. Pursuant to tax legislation in 1976, the holding period for obtaining the 50% capital gain exclusion changed from six months to nine months in 1977 and from nine months to one year in 1978.

Although there was an increase in the rate of tax on capital gains pursuant to tax legislation in 1969, beginning in 1978 the maximum rate of tax on long-term capital gains went back down to 28% because the long-term capital gain exclusion was increased to 60% while the top tax bracket in 1978 was at 70%. In 1982, with the top tax bracket at 50% and the 60% long-term capital gain exclusion, the maximum rate on long-term capital gains moved down to 20%. As part of the Tax Reform Act of 1986, the capital gain exclusion was repealed and a maximum rate of 28% applied to long-term capital gains.

In 1997, the Taxpayer Relief Act of 1997 was signed into law by President Clinton, which provided for an eighteen month and five year holding period connected with lower tax rates (20% and 18%) on long-term capital gains.

Expiration of Tax Cuts on December 31, 2010

Approximately seven years ago, President George W. Bush signed into law the Jobs and Growth Tax Relief Reconciliation Act of 2003, which included a lower tax rate on long-term capital gains and qualified dividends. Other than a few exceptions, this tax bill provided for a maximum tax rate of 15% on long-term capital gains and qualified dividends. Originally these tax cuts were scheduled to expire December 31, 2008.

In May 2006, the Tax Income Prevention and Reconciliation Act of 2005 was signed by President Bush, which extended the expiration date for the lower tax rate on long-term capital gains and qualified dividends to December 31, 2010. Therefore, beginning in 2011, assuming there is no further tax legislation, and with some exceptions, the maximum tax rate on long-term capital gains will increase to 20% and dividends will be taxed at the same rate as ordinary income. It is useful to note that the maximum capital gains tax rate of 18%, for qualified property held at least five years, will be reinstated in 2011.

Higher Tax Rate on Capital Gains and Investment Income in 2013

Earlier this year, President Obama signed into law a health care reform package consisting of the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010. Under this new legislation, beginning in 2013, a new Medicare tax of 3.8% will apply to investment income, including capital gains, for couples making more than $250,000 per year and individuals making more than $200,000 per year.

If you are a business owner and are currently contemplating a sale or reorganization, timing becomes increasingly important. Most business sales include both capital gains and ordinary income as components of the tax computation. As the tax breaks expire and higher rates on capital gains and investment income kick in, it is critical to examine current business values and potential sales prices with a keen eye on taxation and what you net from the transaction. With help from your M&A and tax professionals, you can determine if the risk of economic uncertainty, industry weakness or potentially even higher tax rates in 2011 and beyond is outweighed by hopes of an increase in the sale price. In many cases a sale in 2010 will not only reduce your investment risk, but result in a significant increase in your net dollars at the close of your transaction. We cannot stop the inevitable tax changes that are around the corner…but we can certainly manage them to our advantage.

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