If you have looked into every detail of Biden’s road to Presidency, you have heard about the American Families Plan. There have been a lot of speculations on the details of the plan because the White House has only shared a fact sheet of the intended proposal. The actual detailed content has not been yet made public. The plan simply states that individuals and businesses making over $1 million a year will pay the same 39.6% rate on all their income. This proposed capital gains tax increase on investors whose income is over $1 million would in essence be to fund President Biden’s American Families Plan.
With that being said, there is also a change in the capital gains upon the death of the taxpayer. The first one includes the reduction of the step-up basis allowance. The other one would be that death will signify the capital gains realization event.
Why is there a need for the increase? Let’s put it simply this way – to equalize the income from employment and through investments. The said plan aims to increase the income tax bracket to 39.6% from the previous 37%.
Even though the drafted legislation has yet to be released, capital gains would also mean the net capital gains. When we say net capital gains, it does not just include the capital gains earned in the long run but also the dividends. As there is an increase in capital gains, dividends would also follow. The current maximum we have today is 23.8%. It would rise to 43.4% when the plan is already implemented.
With everything increasing, this can sound like bad news. But it can be good news for many Americans because many high-income earners won’t be affected by this new rate. Why? Because as we have mentioned, the 39.6% tax rate would only apply if the total income of an individual is over $1 million.
Business owners can be subject to the 39.6% Capital Gains Tax
The proposed plan will not only cover those who are earning more than $1 million but also those who have once-in-a-lifetime income such as business owners. How does it work? Let us say that your business doesn’t get that up to that $1 million mark yet can get a sale of their business with a value of over 10, 20, or 30+ years and happens to get to the point of liquidity due to retirement. If the plan is implemented and the result of the sale exceeds $1 million, this once-in-a-lifetime sale of the business itself can be subjected to the capital gains tax. The good thing about it, is the accumulated years can be taxed in a single year once it is sold.
When do we think the new tax could be implemented?
On the 28th of May, on Biden’s budget request which is entitled as Blue Collar Blueprint for America, the said changes in tax should be effective retroactive to April 2021. We think it can’t be done, but yes, it is possible. Even though there is a chance the retroactive side can be implemented, there is a big chance it will not be done. There is a possibility that one senator will not say yes to that change given the implementation is midyear, and we are already halfway through 2021. Imagine having to be taxed at 20% for ordinary income before April 2021 and 39.6% for the later months. With all the factors that need to be taken into consideration, we can say that the tax change is unlikely to occur before January of 2022.
Best time for liquidity events
While there has not been a final decision on whether this new tax legislation will be passed, business owners should start the ball rolling towards selling their business if they wish to do so (for retirement or personal purposes). Selling a business has a longer sales cycle, and the owner should act now while the tax is still 20%.
Aside from securing the sale before the possibility of a higher tax by next year, business owners should also take that step now because the after-tax savings is still higher at the 20% rate. Let’s say you are selling your business for $3 million. You are considering reducing the price to entice a buyer. The after-tax would still yield more as compared to selling it once the new tax rate is implemented.
Installment Method vs. Opting Out
The installment method may sound great if you wish to lower your tax rate annually. But not until the new possible tax rate increase. This year’s rate could remain at 20%, but we are not sure with the coming years especially that by 2022, the new rate could be applied. With that being said, once you started an installment method on a sale of your business this year, you may be subject to the 39.6% tax which is pretty high when compared to the current 20%.
On the other hand, electing out of the installment method can also be risky. Even though you are preventing the bigger tax rate for the coming years, there is a downfall in declaring all of the taxable income within a single year. The tax can be paid one-time-big-time but the business owner can still receive partial payments for the sale. For example, if your business was sold within the year at $30 million and it is to be paid partially for 10 years, you’ll get to have the 3 million partial payments. But electing out of installment can mean you’ll have to be taxed at $6 million. In this event, you may want to consult with your financial advisor first.
There are a lot of factors to consider with the possibility of the upcoming tax change. Now is the time to rethink the possibilities and decisions for individual taxpayers. This is especially true for business owners. Consider hiring a financial advisor to guide you through these many impending tax changes.
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