Introduction
There were 66 million babies born between 1945 and 1964. The era was known as the “Baby-Boom” and the “Boomers” are reaching retirement age. In fact, the oldest are now turning sixty-seven and the youngest are embarking on their forties and fifties. As such, many of these people have worked hard throughout their lives and have built businesses from the ground up and purchased houses. A very considerable amount of wealth has been created and those owners are now looking to retire or move on from their businesses.
Currently, in 2012, we have favorable tax rates which allow you and your company to pay fewer taxes on the sale of a business as opposed to waiting until 2013. There are also favorable laws on the books regarding estate planning and home foreclosures. For the past decade, both capital gains and dividend tax rates were decreased to 15%. Those tax cuts are now set to expire December 31, 2012. The rates coming in 2013 will be 20% for capital gains and the ordinary tax rate for dividends can be as high as 35%.
Capital Gains
The capital gains rates are currently 0% and 15%. Historically, the capital gains rates have been as high as 20%. This means that capital gains will be taxed at 0% if the combined Adjusted Gross Income of the selling taxpayer (including capital gains) is at or below the two lowest tax brackets. The amount of capital gains earned by a taxpayer that is at or over the 25% bracket is currently taxed at 15%. These new rates produce much more favorable tax consequences than in past years.
For example, if a company is sold and capital gains are determined to be $1,000,000, in this tax year, the seller of the company would pay $150,000 in capital gains taxes as opposed to $200,000 in a future year. The result is a tax savings of $50,000 just given the fact that the sale happened this year as opposed to next year.
Unless Congress acts to the contrary, the capital gains tax will go up in the next year. If you fail to take gains this year, they will be taxed at a higher rate next year.
Dividends
If you own stock in a C Corporation you most assuredly have had, at one time or another, dividends distributed to you. Currently, and for the good part of the past decade, dividends have been taxed at 15%. No matter what income level you were at, dividends received a preferential rate making the C Corporation a good buy and a good business entity for tax purposes. The laws giving rise to the preferential treatment are now coming to an end as of December 31, 2012. On January 1, 2013, dividends will be taxed at the ordinary income tax rate of the taxpayer.
The significance is that 2012 is a very opportune time to cash in corporate retained earnings. This is sometimes done during business sales to cash out the retained earnings, lessening the tax burden. If this is done in 2012, the tax rate will be 15%. Next year, dividends are taxed at a maximum rate of 39.6%, as the ordinary income tax rate regains its old position as well.
To illustrate the point, a taxpayer in 2012 who cashes out retained earnings of $1,000,000 will pay $150,000 in taxes. Next year, the same taxpayer could pay up to $396,000, well over double the 2012 tax consequence. This is a difference of $246,000 for the same amount of dividends distributed to the same person.
Further, if your S Corporation has retained earnings from years operating as a C Corporation, the above applies as well. It is recommended that all C Corporation earnings in subchapter S Corporations be removed by the end of 2012.
Estate Planning
Yet another area of concern in tax practice is that of estate planning. Since 2000, the estate tax exemption amounts have steadily increased, yet the threat of sudden reduction in the exemption amount has been ever present. In 2011, the exemption amount was $5,000,000. In 2012, it was adjusted for inflation to $5,120,000. On January 1, 2013, the amount reverts back to $1,000,000, inadvertently trapping many middle class households within its grip. Those with businesses and considerable estates are advised to plan for this change.
Mortgage Indebtedness Forgiveness
This is being mentioned last in this article because it could be the most important. Normally, when a loan debt is forgiven in a charge off or a foreclosure, the amount written off is considered income to the party losing their home or possessions. For calendar years 2007 through 2012, the Federal government allowed those who have had their homes foreclosed to not include the forgiveness of indebtedness in their income.
It seems trivial to most, but to the afflicted it is very serious. Taxes affecting items of income are an annoyance (you are splitting part of your gains); on the other hand items affecting the treatment of forgiven debt can be absolutely detrimental (you are being taxed on what you lost). Imagine losing your home, and then opening a letter in your mail on January 31 of the next year stating you have an addition to your income in the amount of your mortgage on a home you lost! A typical mortgage is $250,000 in this country. Having to pay 30% of that to the IRS is $75,000, not pocket change for many. Bottom line, if your home is in foreclosure it is time to start planning for consequences that will result if this law expires on December 31, 2012. The consequences can be serious.
Conclusion
With a potential loss of certain tax provisions including an increase in the capital gains tax and the dividend tax rates, owners of closely-held businesses are well advised to sell their businesses this year as opposed to next in order to take advantage of the lower tax rates. If you are interested in discussing your succession or exit plan, please contact The Center at (618) 997-3436.
By: Dr. Bart Basi at the Center for Financial, Legal and Tax Planning for Transworld M&A Advisors