Small-business owners still navigating the tax benefits of the COVID rescue packages are bracing for an emerging challenge: tax hikes once the pandemic ends.
A potential increase in business and individual rates is “the biggest issue that small-business owners face,” says LJ Suzuki, the founder of CFOShare, a financial and accounting company for small to mid-sized businesses in Denver.
To preemptively blunt the impact of President Biden’s proposed increases, advisors are using a stable of strategies.
Managing Your Firm in a Post-COVID World
The planning comes as Biden weighs raising federal rates on businesses and the wealthy to pay for his forthcoming infrastructure bill and programs to combat inequality and climate change.
Under his nascent suggestions, the current 21% rate for corporations would rise to 28%. A lucrative 20% tax benefit for passthrough businesses like sole proprietorships, S corporations, partnerships and limited liability companies, the bulwark of American small business, would be scaled back. And the current top individual rate would go back to 39.6% from 37%, and affect people making at least $400,000 a year.
Biden has also proposed making the current top capital gains rate of 23.8% (20% plus the Obamacare tax) the same as the top individual rate for those making at least $1 million a year. Separately, some Senate Democrats are considering a proposal to tax unrealized capital gains of $1 million or more at death.
The ideas haven’t been put to Congress, which likely would not approve them without a knock-down fight from Republicans, who championed the 2017 tax cuts. Treasury Secretary Janet Yellen has said that any hikes wouldn’t go into effect “immediately.”
But some advisors say clients should move now to avoid their impact should they become law.
One strategy involves accelerating income, by invoicing customers early. Assuming that any tax hikes don’t go into effect until 2022, doing that this year locks in today’s lower rate on taxable income. “A lot of times, small-business owners defer income because often they feel like the further out you push your tax bill, the better,” says Mary Ahearn, a CFP at Rincon Financial Group, a RIA in Tucson, Arizona, whose small-business clients include doctors and contractors. “But if you’ve got some income you could take next year, take it this year.”
Advisors are also urging clients to cash in paper profits. “If you’re anticipating a large capital gain, the days may be over when you have a rate of 20%,” says Tim Tikalsky, a CPA at Sensiba San Filippo in Pleasanton, California, whose clients include mid-sized companies and closely-held larger firms. Ahearn says that she’s “calling everyone and saying, ’Do you have any gains to take this year?’”
Another method, says Perry Green, a CPA/PFS, CFP and CFA and chief financial officer at Waddell & Associates, a RIA in Memphis, Tennessee, is to postpone taking deductions for business expenses until next year. Higher tax rates next year would “make the deductions more valuable next year.” Green says he’s also advising business owners who are close to retirement to consider selling their companies or commercial real estate this year to avoid losing the 20% capital gains rate on profits over $1 million.
Most small businesses are run as pass-throughs, and pass their income onto an owner’s individual returns. After the 2017 corporate rate cut, some small businesses converted to C corporations. But even if the corporate rate rises, they might want to stay that way. That’s because a special tax break designed to encourage start-ups allows individuals who own C corporation stock for at least five years to avoid a hefty capital gains tax bill when their company is sold. Business owners can avoid tax on gains up to $10 million or 10 times their original investment, whichever is larger. Even though their profits are capital gains, Biden hasn’t currently proposed eliminating that specific benefit, according to accounting firm BDO.
Suzuki cites the example of clients who own a software company with losses. Without profits, the C corporation’s owners don’t owe income tax on their business, “so a rate hike doesn’t matter.” If the company makes a small profit — say $1 million — it would owe $280,000 in tax under Biden’s proposal.
Now say the owners sell the company for $50 million after five years. They would owe $10 million in capital gains tax under the particular capital-gains benefit that Biden hasn’t targeted. Without selling, they would owe $280,000 a year for as long as the new 28 percent rate stayed — an amount that could within a few years outweigh the immediate tax bill. “The magnitude of a capital gains event is so significant that it doesn’t matter if Biden raises the corporate rate,” Suzuki says.
Selling Your Business Before Capital Gains Increases
If you are like many who have been planning an exit strategy over the next 3-5 years, now may be the best time to sell. Business owners who were on the fence are now taking active steps in hopes of selling their businesses in the 2021 calendar year.