Should You Worry about Tax Increases? Maybe Not!

A businessman on the phone in a trendy loft office.

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There's been no shortage of handwringing about the prospect of tax increases over the course of the past year. Worried about potential tax changes, some business owners pushed ahead with sales or other liquidity events, while investors raced to book gains in 2021.

However, as 2022 progresses, the tax legislation spurring those actions faces a highly uncertain future. And for business owners and investors who were facing increases, the most recent drafts of the Build Back Better Act suggest several future planning options to mitigate the pain.

First, Put Matters into Perspective

Let's start big picture. Tax considerations are important, but they are often secondary to business and investment planning. Focusing on business operations and growth can drive valuation increases that more than pay for future tax hikes given the right investment timeline. This same logic applies to investment assets, as investors weigh expected value appreciation against the potential for tax increases. Attempting to complete sales before tax changes take effect could result in lower tax rates, but might also come at an economic cost.

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Fortunately, financial projections and tax modeling can bring clarity to an uncertain future.

The Build Back Better Plan Has Evolved

It's worth noting that the most recent legislative proposals are a significant retreat from the earlier push to raise capital gains taxes for the highest earners to a combined 43.4%. Instead, the version of the Build Back Better Act most recently under consideration in Congress would add a surtax to push up rates on all income — not just capital gains — for taxpayers only over specified income thresholds.

That surtax would be:

5% on income over $10 million.
An additional 3% on income north of $25 million.
For trusts and estates, significantly lower thresholds of $200,000 (for a 5% surtax) and $500,000 (for an additional 3% surtax) would apply.

Those income thresholds would narrow the scope of tax increases as compared to an actual increase in capital gain rates. They also serve as the key to tax-planning opportunities.

Let's also remember that the proposed tax increase on capital gains through the surtax is just that — a proposal, subject to congressional negotiations. Last fall it appeared that there was momentum for tax legislation on Capitol Hill, as the House passed a version of the BBBA and the Senate began its deliberations. However, that progress stalled, and the likelihood of significant tax increases is diminishing.

Opportunities for Business Owners

That said, tax increases do matter, and if you're already planning to transition out of your business or investments, tax planning could minimize your liability.

One tactic business owners might consider is an installment sale. Stretching out the payment of purchase price over an agreed-upon number of years could help sellers keep their annual income recognition from the sale below the threshold that would trigger the surtax.

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Installment sales aren't for everyone. They have the notable drawback of sellers assuming economic risk for the unpaid portion of promissory notes until the final payments are received. An interest charge may also apply to the deferred tax liability, depending on the amount of deferred gain.

A similar but potentially less risky option would be to sell businesses in phases, with each sale of a stake treated as a stand-alone liquidity event.

Sellers might also explore selling stock under the qualified small business stock gain exclusion. Those rules uniquely allow for the permanent exclusion of taxable gain, though the eligibility requirements are strict. The Build Back Better Act included proposals to reduce the maximum benefit of the gain exclusion. However, a gain exclusion of any type is always beneficial and would provide amplified benefits to taxpayers above the surcharge thresholds.

The potential for tax changes could also prompt business owners to revisit their plans around gifting or succession, both potential avenues to divest from the business in a tax-efficient manner. Tax changes involving gifting and estate planning were removed from the Build Back Better Act during the legislative process, but business owners should continue to watch that area closely.

The Bottom Line

There's little we can be certain about with upcoming tax changes. But it's a safe bet that taxes won't go down anytime soon, and business owners are right to pay attention. Yet, setting out to eschew growth to escape a future of higher taxes may be counterproductive. It’s often better to focus on making your business as successful as possible, and then when it comes time to sell, figure out the most tax-advantageous way to do it.

"Above-the-Line" Deductions for Your 2021 Tax Return

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Stephen Eckert, J.D., L.L.M. taxation, is a senior manager in Plante Moran’s national tax office. He focuses on tax policy, legislation and other emerging tax issues. He is also a specialist in the nuanced tax aspects of business transactions, including expertise with the complex structuring of the sales and acquisitions of businesses.