THE TAX CUTS AND JOBS ACT
represents a sweeping overhaul of individual, business and international taxes. And while it has broad impact in every corner of the U.S. economy and everyone in it, the new law impacts business owners more than anybody.
Signed into law by President Trump on December 22, 2017, the new law reshapes how owners must approach their exit planning. For example, under the new laws which type of business entity is the most advantageous? How could the new laws impact M&A markets? How do the new laws impact exit planning for family businesses? All of these are critical questions for owners to examine.
Summary impact to individuals:
- Individual income tax rates were lowered, and brackets expanded. For example, married filing jointly top tax rate, was dropped from 39.6 percent to 37 percent and top income brackets moved from $480,000 to $600,000.
- State and local taxes (SALT) and property taxes are now limited to a total $10,000 deduction, bad news for high income tax states and those with high property taxes.
- Many changes impact mortgages, alimony, gambling losses, moving expenses, child credits, 529 plans, charitable giving and more.
- There was no change to capital gains rates.
Summary impact to businesses & exit planning
Largest corporate tax rate cut in history!?
Tax rates were permanently reduced from 35 percent to 21 percent for C-corporations. That represents a 40 percent reduction off the top – which is great news if that is your corporate structure. However, that represents just 10 percent of business enterprises today.
With regard to exit planning, if an owner intends to sell their business at exit, commonly the transaction will be an asset sale (or deemed asset sale). Asset sales trigger double-taxation with C-corporations.
The first tax is when the corporation sells its assets to the buyer. The second occurs when the corporation distributes the after-tax proceeds to the seller. As such, C-corporations remain disadvantageous upon sale. To avoid this double taxation, an owner can convert to a pass-through entity, i.e. Subchapter S. However, the owner is required to do so at least five years prior to sale, to avoid Built in Gain Tax.
A big new deduction for pass-through owners … or is it?
Sole proprietorships, partnerships, LLCs and S-corporations are pass-through entities for federal income tax purposes. This means that these entities are not subject to income tax. Rather, the owners are individually taxed on the income, taking into account their share of the profits and losses.
Owners of pass-through entities may receive a 20 percent income tax deduction on qualified business income through 2025, when it automatically sunsets.
A 20 percent income tax deduction off the 37 percent top bracket equals an effective top tax rate of 29.6 percent. That’s potentially good news for the majority of small to mid-market businesses. However, a dizzying array of restrictions and limitations exist. For example, the deduction has industry restrictions. It is generally unavailable to professional service firms (legal, accounting, medical, consulting, financial services). Or, if income levels are below $315,000 to $415,000, for those who are married filing jointly, the deduction does not apply.
Planning strategy for owners impacted by these restrictions may be to evaluate their business lines
to determine if separating them (i.e. revenues) may make sense in order to capture the 20 percent deduction. What is clear is the necessity for owners of pass-through entities to consult with their CPA or tax adviser for more details.
Continued Strong M&A Markets?
All signs seem to indicate that the tax changes support continued strong merger & acquisition activity for owners seeking a sale to outside buyers. Most sellers are pass-throughs, but most buyers are C-corporations (larger strategic buyers and financial buyers such as private equity groups or family offices).
Lower corporate taxes free up buyers’ cash and increases the after-tax earnings from successful acquisitions. Fueling cash reserves for large C-corporations also includes “repatriation of earnings,” which brings cash back to U.S. balance sheets.
With regard to exit planning, it is even more critical for owners to solidify their exit strategy. If an outside sale is likely, it may be wise to consider their ideal timing.
These market conditions are not likely to continue forever. In fact, even if an owner thinks they want to transition to family or key employees, they may want to test this exceptional market.
Estate and gift tax limitations doubled … until 2025.
The amount each taxpayer can shelter from estate/gift/generation-skipping taxes doubled from about $5.5 million to more than $11 million. This, in addition to portability between spouses, means that a married couple can now shelter up to $22 million from estate and gift tax.
If an owner’s exit strategy is to pass the business to family, this may represent a once-in-a-generation opportunity — if they act. Gifting strategies are usually implemented in stages over several years. And it’s reasonable to expect that Congress may take further action, even before 2025.
Reaching financial freedom just got easier.
Achieving financial independence is typically the number one goal at exit. Potentially lower corporate and personal income taxes may make reaching financial freedom easier and/or faster. Every owner’s financial independence plan should be reviewed and recalculated.
Bad news for ESOPs?
One of the significant benefits to a C-corp Employee Stock Ownership Plan (ESOP) is that owners can sell stock to the ESOP and avoid the capital gains tax on the sale, presuming they reinvest proceeds into qualified replacement property. However, lower potential corporate and personal rates (as much as 40 percent) may reduce the value of dollars saved using an ESOP. While many non-tax benefits exist for establishing ESOP’s, owners looking to identify an internal transition will need to explore all available options more carefully.
The new Tax Cut and Job Acts indeed impacts both corporations and individuals alike. As such, it has never been more important for business owners to revisit their exit plan options.
Dyanne Ross-Hanson is president and CEO of Exit Planning Strategies, LLC., which assists business owners in developing ownership transition plans: 651.426.0848; firstname.lastname@example.org; www.exitplanstrategies.com.
About Dyanne Ross-Hanson
President & CEO of Exit Planning Strategies, LLC., which assists business owners in developing ownership transition plans.