Recently there has been a rash of pet business owners asking me “Carol, given the uncertainty regarding the capital gains tax, should I sell my company in 2012?” It’s a highly valid question given that the top tax rate on capital gains will rise from 15% to as high as 23.8% in 2013 – an increase of almost 60%.
Bush-era tax cuts are set to expire at the end of the year. Republicans believe the tax cuts should be extended for all taxpayers. Democrats believe they should be extended only for the middle and lower classes. The fate of the Bush cuts likely will be decided by a “lame-duck” Congress convening between Thanksgiving and Christmas 2012. The Congress that returns for that session will be the existing Congress – a Republican-led House and Democratic-led Senate. President Obama will still be in office then: either he will have been re-elected and feeling newly empowered to enact his policies OR he will be a lame-duck president who can do what he believes is right without concern for the consequences.
Short of having a crystal ball, only time will tell just what kind of penalty (in the form of higher taxes) an owner will incur by waiting to sell their company. But a little research does provide some clarity on what the experts feel will actually happen and what we should do to minimize the effect on our taxes:
1. Sell assets to take advantage of existing capital gains tax rates.
Owners who are considering selling their business or investors thinking of dissolving a concentrated stock position should consider selling assets while the top capital gains tax rate remains at 15%. A recent study by Parametric Portfolio Associates determined that, if asset values grow by 4% per year and the capital gains rate increases as scheduled, an owner/investor would have to hold assets for an additional fifteen years to be better off than he would be had he sold the assets initially and paid tax at the lower rate.
While the official capital gains rate increases to 20% in 2013, a new 3.8% tax on investment income (e.g. interest, dividends, capital gains, rents, royalties) for families whose adjusted gross income is above $250,000 also kicks in, making the overall rate on capital gains 23.8%.
If you are an investor, you can lock in gains and redeploy the assets to investments that may offer stable growth and downside protection, a strategy that might prove prudent in uncertain times. Or, if you’d like to keep your investments but want to take advantage of the 15% rate, you can sell a security, recognize the gain, and immediately repurchase the security to reestablish your position. The “wash sale” rule, which requires investors to wait thirty days before repurchase applies only to the recognition of losses, not gains.
2. Receive ordinary income currently rather than in a later year when tax rates may be higher.
When the current regime expires, the top-rate on “ordinary” income such as wages and interest will rise from 35% to 39.6%. A business owner/investor might act to receive additional taxable income in 2012 rather than in later years. For example, executives could consider exercising non-qualified stock options this year so that the resulting income is taxed at current rates.
Next year also brings a new 0.9% Medicare tax on wages for most joint filers with adjusted gross income above $250,000 ($200,000 for single filers).
3. Defer discretionary deductible payments (such as charitable contributions) to later years when they may be worth more due to higher tax rates.
The tax benefit of a deductible expenditure increases as tax rates increase. Therefore it may be worthwhile to defer deductible payments until higher tax rates take effect.
4. Convert a traditional IRA to a Roth IRA
All individuals are now eligible to convert their traditional IRS to a Roth IRA, which permits future investment earnings to be received tax-free. In the likelihood of rising tax rates, converting to a Roth IRA may provide significant value. If you expect to be in the same or higher tax bracket in future retirement years, you should consider this option seriously.
It is an election year and much depends on what happens November 6th. Most tax experts believe Congress won’t address tax rates before the election. After November 6th, the current Congress might pass another temporary extension, as happened in late 2010, which is considered the path of least resistance – especially if it comes with a promise of tax reform in 2013.