Capital Gains Taxes & Non-Competes: Recent Insights on Proposed Changes

By: Billy Pritchard

Our deal teams at Founders Advisors are reviewing and processing important news items on key macro environmental factors for lower middle market business owners. Two notable proposals for legislative changes at the federal level are currently in the spotlight:

  • President Biden’s proposal for Capital Gains Tax Increases, and
  • The FTC’s rule proposal Banning Noncompetes.

Let’s review what each policy change considers and discuss the potential impacts on near-term M&A activity.

1) Capital Gains Tax Increase Proposal

“[The President’s Budget] also proposes taxing capital gains at the same rate as wage income for those with more than $1 Million in income…”The White House Fact Sheet

President Biden’s FY 2025 Budget proposal (released last month) includes tax policy change which aims to increase the capital gains tax rate for high-income earning taxpayers. Under this proposed plan, the tax rate on long-term capital gains could nearly double, rising from the current rate of 20% to 39.6% for those high-income earners. When combined with the existing Net Investment Income Tax (NIIT) of 3.8%, the effective capital gains tax rate could reach 43.4%.

Impact on Lower Middle Market Business Operations and M&A Activity

For lower middle market businesses, especially those structured as pass-through entities such as S corporations and partnerships, owners often realize significant capital gains upon the sale of their businesses. The proposed tax increase could significantly impact the after-tax proceeds for private business shareholders, potentially altering their investment strategies, operating timelines, and exit plans.

The prospect of higher capital gains taxes may incentivize business owners to accelerate their exit timelines to avoid potential tax hikes. Following President Biden’s election win in 2020, we saw a similar surge in deal activity as a capital gains tax increase was discussed heavily during that election cycle. As a result of this recent Budget Proposal and the pending election on the horizon, we might witness a similar uptick in M&A activity towards the back half of 2024.

A surge in deal activity can be beneficial for owners that are well prepared to pursue a transaction in the near term. However, as we saw in 2020 and 2021, this type of deal activity ramp up can cause resource constraints on the industry as a whole. It may prove difficult for sellers to get the attention of prospective buyers, and third parties that are critical to the execution of these transactions (like a Q of E provider) may become resource constrained.

For founders and owners considering a future exit, we would suggest speaking to both a tax and M&A advisor in the near term.

For additional reading, please review the Department of the Treasury’s General Explanations.

2) FTC’s Final Rule Banning Non-Competes

“…the Federal Trade Commission issued a final rule to promote competition by banning noncompetes nationwide, protecting the fundamental freedom of workers to change jobs, increasing innovation, and fostering new business formation.” – FTC Press Release

Earlier this week, the Federal Trade Commission (“FTC”) voted in favor of a rule banning noncompete agreements nationwide. Noncompete agreements are common practices in the lower middle market across a variety of industries. These agreements, often included in employment contracts, restrict employees from working for competitors or starting their own competing businesses for a specified period after leaving their current employer. The final rule will become effective 120 days after publication in the Federal Register.

Impact on Lower Middle Market Business Operations and M&A Activity

Noncompete agreements have been a common tool for businesses to protect their intellectual property, trade secrets, and client relationships. While this ban may foster innovation and entrepreneurship, it could also pose challenges for businesses seeking to safeguard their proprietary information.

Additionally, the ban of noncompete agreements could impact the attractiveness of private companies in M&A transactions, depending on the business model. Buyers may perceive increased risk if key employees are not bound by non-compete agreements, potentially affecting valuation and deal structures. In those scenarios, sellers would need to rely more heavily on other forms of protection, such as retention bonuses and stock option incentive plans to mitigate the risk of talent departures post-acquisition.

The proposed ban does include notable exceptions, including the continued exception for the sale of a business. It is very common for selling shareholders (and option holders) of a private business to be subject to noncompete provisions in the transaction documents for a period of time post-sale. This exception would still remain in the FTC’s proposed rule, which should give sellers and buyers structure options to derisk the potential departure of key employees after the deal.

This FTC rule is already meeting resistance and immediate legal challenges. While the viability of this rule is hard to predict, founders and owners considering a future exit should begin thinking through alternatives to a traditional non-compete agreement.

Concluding Thoughts

As a business owner, it’s imperative to monitor proposed legislation changes and consider the potential impact on business operations and M&A activity. President Biden’s Capital Gains Tax Increase and the FTC’s Ban on Noncompetes represent major policy shifts that could significantly impact the M&A landscape in the lower middle market. As always, we recommend staying informed through conversations with our team of M&A advisors.

Please reach out to discuss these policy changes, as well as other questions about the current M&A market.