Private Company Capital Newsletter: Brereton, Hanley and Company, Incorporated

Basic Tenets of the New Tax Bill
Narrowly passed by the Senate, President Bush has called the 2003 tax cut "a vital action" that will stimulate the economy and create jobs. Just how big a cut was it? The new tax bill contains a 10-year, $350 billion tax cut, making it the third-largest tax cut in the nation's history. Which is why we thought it was important to bring up again here.

While there are many components of the Bill, ranging from marriage penalty reductions to child credit increases, business owners will likely be most affected by two provisions relating to the sale of their business:
1. The capital gains tax rate cut.

2. The rate cut on shareholder dividends.
Among other provisions, the Bill temporarily reduces the rate on both corporate dividends and capital gains. The Bill lowers the rate on income from dividends and net long-term capital gains to just 15% for individuals. The new Bill marks the first time in at least the past 60 years that we can enjoy a capital gains tax rate below 20%. In addition, it is the first time that dividends are taxed at rates below income tax rates. But, these benefits are temporary. Both rates are subject to a sunset clause. The reduced rates are due to expire after 2008 and revert to 2002 levels in 2009.

The tax cuts could affect the private business owner on several levels. At a macro level, if the tax bill does its job, businesses and M&A could benefit from a boost in the economy. The tax changes also produce direct financial benefits when selling a business. We has seen that under the new capital gains tax rate, most business owners will see a 5%-8% increase in their after-tax proceeds following a sale. There is also the potential for tax savings from the change in the dividend income tax rate. Under the new bill, the rate is dropping from a maximum of 38.6% (personal income tax) to 15%, a 61% decline in the rate for eligible dividends. Private business owners looking to partially cash-out may be able to initiate a self-recapitalization so that the returns are treated as dividends and are taxed at the new, lower tax rate. Whether a company is structured as an S-Corp or a C-Corp and initiates a traditional recapitalization, a self recapitalization or an outright sale, the bottom line is that this tax bill creates new opportunities for the private business owner to partially or fully exit his company in a tax advantaged manner.

Let’s examine the effect of the capital gains rate reduction on a business sale. The maximum capital gains tax rate will fall from 20% to 15%, resulting in greater after-tax proceeds following the sale of a business.

The following example shows the effect of the new tax rate on a hypothetical business sale. In this example, the company sells for $8 million (on a debt-free basis). Because of the difference in tax structures between an S-Corp and a C-Corp, the capital gains tax reduction will have a varying degree of impact on individual companies. Let us assume that the two companies in our example are identical, with the exception that one was a C-Corp, and the other an S-Corp, from inception. Both companies were started with an initial investment of $100,000 and no additional outside capital was invested thereafter. Both companies have book equities of $2 million (with neither company using accelerated depreciation) and $2 million in debt. Because of their different tax structures, the taxable basis for the two companies is different. For the S-Corp, the basis in the company's stock is equal to the firm's equity, $2 million (the basis in the company's assets is $4 million). For the C-Corp, the basis in the company's stock is simply equal to the initial investment, $100,000 (the basis in the company's assets is $4 million). The following example shows the effect of the change in the capital gains tax rate on our hypothetical business sale, whether the company is structured as an S-Corp or as a C-Corp.

($ in 000)

S-Corp

C-Corp

Purchase Price

8,000

Debt Assumed by Buyer

—

-2,000

Price Paid for Company's Stock

—

6,000

Basis

-4,000

-100

Long-Term Capital Gain

4,000

5,900

Capital Gains Tax

At 20%

At 15%

At 20%

At 15%

-800

-600

-1,180

-885

Debt to be Paid Off by Seller

-2,000

—

Net Due Owner (after debt and taxes)

5,200

5,400

4,820

5,115

Savings under New Tax Law (i.e., percentage increase in Net Due Owner after Debt and Taxes)

3.85% (or $200,000)

6.15% (or $295,000)

(Note: This is a mathematical illustration only and may not be typical of an actual sale. For purposes of this illustration, the S-Corp assumes an asset sale, the C-Corp assumes a stock sale and M&A fees have not been factored in. Furthermore, this example assumes that current and fixed assets are not written up above their taxable basis.)

In the above example, under the new tax rate, the net due owner to our S-Corp seller increases 3.9%. The net due owner gain for our C-Corp seller is even more dramatic, 6.2%. In other words, in this example, the new capital gains tax rate results in the seller keeping about an additional quarter of a million dollars when he sells his company.

This tax bill, while encouraging, is not the final word on taxes. In the case of dividends and capital gains, the rate cuts are effective only through 2008. Whether or not the new rates will be extended beyond that date, or raised before that date, is anyone’s guess. Some believe the cuts will be made “permanent” beyond the sunset date. Others believe the rates will rise again, citing the narrow margin by which the Act passed, and considering that the Fed will soon be wrestling with a way to fully fund Social Security retirement and Medicare benefits for the baby boom generation.

The new Bill marks the first time in at least the past 60 years that we have enjoyed a capital gains tax rate below 20%. In addition, it is the first time that dividends are taxed at rates below income tax rates. Because it can take anywhere from 6-18 months to sell a business (on average, one year), business owners thinking of selling should prepare for market now, so they can take advantage of what we believe to be a unique and probably impermanent opportunity.