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Tax plan could increase costs of succession planning

By Cris Collingwood, BridgeTower Media Newswires

Business owners looking to leave their business through succession planning may be facing more tax decisions if the Biden administration gets its tax code revisions through Congress this year.

Don Petrille, senior lawyer with High Swartz, Doylestown, said the 2017 Tax Cut and Jobs Act created a lot of exemptions for business owners. However, many of those will go away by 2026, if not sooner.

Succession planning is when a business owner or owners decide to sell to family or employees or gift the business to family.

The Biden administration is looking to pass the American Jobs Plan that would change the current Step-up in Basis law that Petrille explained using stock purchases.

“If you buy a stock at $10, that is your basis. If it appreciated to $15, your capital gain is $5,” he said. “If you give the stock to someone, they get your basis. So, under the current rules, the basis is based on what it is worth now (when bought).”

That relates to selling a company. If an owner sells a company, the basis is what it is worth when it was started. Under the Biden proposal, the basis would be what the company is worth when sold. That will increase capital gains taxes.

John Reed, partner with Barley Snyder, Lancaster, said he thought capital gains would increase last year. “We all think change is coming, but we don’t know when.”

The takeaway, he said, “if someone is thinking about retiring, they should do it now when we know what the rules are.”

Colin Keefe, partner with Fitzpatrick, Lentz & Bubba, Allentown, agreed. “It’s a good time to sell because we believe taxes will go up in 2022.”

Reed said succession planning comes with many challenges. The proposed changes could make the financial challenges even greater.

Most succession planning is for a business owner to sell to family members or employees that worked closely with the owner to run the operations. There are many variations to this, Reed said.

“There is risk inherent in this. If (the owner) needs to get money out of the business (to live on), he may sell to others and rely on monthly income. There is risk in that,” he said. “You hand control over to someone else and you no longer have control over the running of the operation.”

Petrille said owners have to take a holistic approach to keep the business going. “You have to look at what the departing owner is taking with him; his knowledge, vendor relationships, and what he contributes daily to the operation. How are you going to finance that?”

Insurance can be a vehicle for just that. It can be used to retain people who can run the business or to get through rough times during the transition, he said.

Many entrepreneurs, he said, will use a self-directed IRA to start a business. The ownership is then tied to that. The Setting Every Community Up for Retirement Enhancement Act (SECURE) of 2019 says if you inherit an IRA, or a business funded by one, you have to liquidate it and pay income tax and penalties or pay income tax on the money over a 10-year period.

“This is also integrated with estate planning because you own a business and that business has value which is taxed by Pennsylvania,” he said. “So, you need to have liquidity to pay the taxes owed nine months after the person’s death.”

Inheritance tax now stands at 4.5 % for children and 12% for siblings.

“Business owners are perceived to be wealthy,” Petrille said. “But wealth doesn’t always mean you have liquidity.”

When faced with increased taxes, the company must look at where the money will come from. Petrille used an example where a construction worker starts his own business using his personal truck. The basis for this business is zero. As the business grows, and the owner hires more workers, buys more trucks and maybe even establishes a shop, the business value goes way up.

There might be value in the company, but no extra cash flow, he said. If the owner would sell now, the capital gains would be on the basis of zero. If the Biden plan is passed, the basis would be on the value of the company now. “So, if the business is worth say $10 million, the taxes could total $4 million. Where do you get the cash to make the transaction?” he said.

Keefe said it is a good time to sell if a business owner is thinking of retiring. “There are lots of buyers right now and the interest rates are still low.”

Biden’s tax plan is still in debate in committees. The proposed $4 trillion of new federal spending over 10 years will be partially funded with higher taxes on individuals and businesses. Members of the House and Senate have put forth bills that include everything from increases in capital gains and corporate income taxes to new individual and business tax credits, according to the Tax Foundation.

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