A near-doubling of the capital gains rate and the tightening of the step-up in basis loophole would make a sale expensive.
Published in Financial Planning magazine in its July 2021 edition. By: Lynnley Browning
The Biden administration has promised that family-owned businesses and farms won’t suffer under its proposed tax hikes on the wealthy, the linchpin of a $1.8 trillion package of spending and tax cuts aimed at boosting workers, families and children.
In fact, financial advisors say, a giant tax bill can eventually materialize for owners who decide to make a quintessentially American move: cash in on a lifetime of hard work by selling the successful family enterprise.
The tax increases are “a huge negative for somebody who’s built up a net worth in that business, if they sell that business,” says Duane Donner, the founder and CEO of Founders Advisors, a mergers-and-acquisi-tions firm in Birmingham, Alabama.
President Joe Biden says his plan would shield business owners from a tightening of a long-standing loophole that vastly reduces taxes on assets when passed to heirs.
Under current law, the “step-up in basis” benefit means that, when a person inherits a business, property, stocks or other assets, they don’t owe tax on the gains those assets made before they inherited them.
Biden wants to end the loophole starting next year for people who make more than $1 million a year, including through inherited assets ($2.5 million for couples). His plan has a special exception for family-owned businesses, which range from aluminum screen manufacturers to mom-and-pop restaurants to the maker of Purell hand sanitizer. Heirs wouldn’t owe capital gains tax unless they eventually sell the firm.
The second punch in Biden’s proposal is a near-doubling of the current 23.8% capital gains rate (including the 3.8% Obamacare levy) to 39.6% for those making at least $400,000 a year, with the start date retroactive to April 28. That’s also Biden’s top proposed individual rate (the current is 37%).
When it announced the plan on April 28, the White House pledged that it “will be designed with protections so that family-owned businesses and farms will not have to pay taxes when given to heirs who continue to run the business.”
The Treasury Department attempted to provide detail, saying in its accompanying “Green Book” that families who sell their business or who cease to both operate and own them would have 15 years to pay any tax owed. That might seem to be a partial reprieve for the nearly 7 million family-owned businesses in the U.S. — around one in five of all small businesses — according to data from the Small Business Administration. Most are in manufacturing, construction, retail and the food and restaurant industry.
Treasury’s reasoning, says Ali Hutchinson, a managing director and senior wealth planner at Brown Brothers Harriman in New York, is that many owners won’t have piles of cash on hand to pay a new tax bill all at once when they sell, so giving them 15 years can ease the pain.
By contrast, paying upfront could require more money than the business actually earns in a year, and thus force the owner to sell business assets or take on new debt — moves that could weaken or kill the enterprise, according to an EY analysis for the Family Business Estate Tax Coalition.
That’s probably not as big an issue for the deep-pocketed heirs to the Mars, Cargill and Chick-fil-A fortunes should they decide to sell their stakes. But advisors say it’s definitely not good news for owners of much smaller family enterprises. So the 15-year payment proposal is seen as a positive for small business owners. The proposals have to pass Congress, where they’re headed for a big fight and potential changes before becoming the law.
The key questions
Here’s what advisors say are the big puzzlers regarding the proposal: What happens if an owner dies suddenly but the heir can step in only months later to run the business, because she’s already tied up running another company and needs time to sort things out? Would she now immediately owe capital gains tax on the appreciated value of the inherited business — that she will eventually run — since it began decades ago? What happens if a family owns a business but contracts its daily operations to a highly skilled professional — a vineyard, say, that hires a Silicon Valley executive as CEO?
It can be easy for small business owners who sell to push their taxable income over $1 million, where the tax hit kicks in.
What if a family business — such as a restaurant that wants to open new locations — brings in an outside investor, either with a minority or majority stake?
Are real estate holdings considered a family business? What if no heirs want to actually run the business but still want control of it?
“We don’t know,” says Hutchinson. “There is a lot of legislating to do.”
Data on how many businesses pass to the next generation is wildly varying: a 2018 study by U.S. Trust, Bank of America Private Wealth Management and the University of Virginia Darden School of Business found that only one in three outlive their founders to survive through the next generation; even in some of those cases, the company needs an outsider to step in and run things.
Here’s a look at how things could change. Say — in a simplified example from the EY report that Financial Planning modified to reflect the current total capital gains rate and Biden’s proposed increase — someone started a wine distribution company two decades ago.
The business initially had no market value. When that founder dies in 2025, his daughter inherits the company, now worth $550,000 with annual revenues of $40,000. Under current law, the company’s value for tax purposes would be “stepped up” to that new amount, and the daughter wouldn’t owe capital gains taxes on her inheritance.
Next, say she sells the distributor five years later for $710,000, when its annual income has grown to $50,000 and she’s ready to cash out. Under current law, she would owe the 23.8% capital gains tax on its appreciation under her wing, or more than $38,000 ($710,000-$550,000 = $160,000; $160,000 x .238 = $38,080).
Under Biden’s proposal, she wouldn’t owe tax upon inheriting and running the business her father started, but neither would it get a stepped-up basis. So when she eventually sells the company for $710,000, she would owe capital gains tax, at Biden’s higher rate, on its total appreciation since it started from zero.
That’s a tax bill of more than $281,000 ($710,000 x .396 = $281,160). Under the proposed plan, her tax bill is over seven times higher. She can pay it over 15 years, at over $18,700 a year, but may not have the cash from its sales.
When someone who earns perhaps $300,000 a year sells a company after 20 years, “the liquidity event is going to push them over $1 million in taxable income” — the level at which Biden’s higher capital gains rate kicks in — says Alyson Nickse, a CFP at Crestwood Advisors, an RIA in Boston.
“The pain,” she says, “is going to be largely on the high-income earning families, but also lower-earning families when they’re looking at the sale of a family business.”