Small Business Tax Changes Under a Biden Administration: Are You Prepared?
How to prepare for the capital gains changes in the Biden tax plan.
Jan 07, 2021
The tax rules for small businesses tend to change from one presidential administration to another, and the 2021 presidential transition is no different. Business owners are waiting to find out what changes the new Biden tax plan may bring to current small business tax rates. While updates to the tax code may initially have to take a backseat to more pressing matters (such as the coronavirus pandemic and a response to the related job losses across the country), most experts feel tax changes are inevitable under the new administration.
One item of focus is the capital gains tax. Small business owners who want to sell their businesses may face a higher capital gains tax rate than they did under the Trump administration. Under the Biden plan, the capital gains tax rate for the sale of appreciated assets that have been held for more than one year could essentially double for those in the highest tax bracket.
Changes coming to capital gains tax
This new tax plan for small businesses would only apply to those with incomes of at least $1 million. But it’s surprising how little it takes to find yourself in the $1 million category if you contemplate the sale of your business. Those in this category may also have to pay the additional 3.8% net investment income tax, which is not proposed to change. Here is an example scenario of how this could play out:
Eric invested $1 million into building up his manufacturing business. He grew the business for many years and found a buyer willing to pay $5 million for it. Under current tax laws, Eric would only pay $800,000 (20%) in capital gains tax on his $4 million of profit.
The proposed small business tax changes could raise that rate to 39.6% for both Eric’s income tax and his capital gains tax. Under the Biden taxes, Eric could wind up owing $1,584,000 ($4 million x 39.6%), an increase of about $784,000, on the sale of his business. Eric’s capital gains tax rate will have nearly doubled from 20.0% to 39.6%.
The capital gains tax rate for small businesses is a flat rate that is not graduated, meaning you would immediately become liable for the 39.6% tax rate upon reaching the highest tax bracket. As the example above shows, this could mean hundreds of thousands or even millions of dollars in additional taxes that you might need to pay when you sell your business.
Small business tax credits and deductions
In addition to potential capital gains tax changes, the new Biden tax plan may reduce or remove certain tax deductions, such as the Qualified Business Income Deduction (QBID). This deduction could be phased out for business owners who earn more than $400,000. Here’s an example of how this could impact a small business owner:
Let’s say that Eric in the example above earns $1.5 million in business income, and he is a sole proprietor. He pays his employees $400,000 a year in total wages, incurs additional expenses of $300,000 per year, and takes in a personal net income of $800,000.
Under the current tax laws, Eric is entitled to a deduction equal to the lesser of half of the wages he paid out ($400,000 x 50 percent = $200,000) or 20 percent of his net income ($800,000 x 20 percent = $160,000). This reduces his taxable income from $800,000 to $640,000. After the potential changes, he would not receive a QBID, so his taxable income would remain at $800,000.
Biden’s tax plan will likely increase the Child and Dependent Care credit by a substantial margin. This small business tax credit provides relief to those who have children under age 13 or dependent parents to care for. The revised credit could be as much as $8,000 for those who qualify.
The new tax plan may also contain provisions implementing the 12.4% Social Security tax on incremental income above $400,000, split evenly between employers and employees. The current wage cap of $137,700 would remain in place, creating a Social Security tax-free gap on all income between those ranges.
How to prepare for the new tax plan
Tax changes should be a single factor among many when deciding to sell your business. It’s vital to consider your future goals, like retirement and estate planning, as well as the overall lifecycle of your business and even proper diversification of your net worth. If you’re thinking about selling your business, know that there are various structures available that offer liquidity while also potentially providing the benefit of reduced taxes:
- Exit – Some business owners who may have been contemplating a sale in the near future will undoubtedly decide to sell their businesses immediately to take advantage of the current capital gains and small business federal tax rate.
- Earnout or Installment Plan – Business owners who are willing to monetize the sale of their business over a period of time may realize tax benefits that are unavailable when receiving all the funds at closing. This carries additional risk, as the seller must rely on the new buyer’s operational success to receive the full sales proceeds.
- Minority Stake, Joint Venture, or Partial Sale – Selling a minority stake of your business or entering into a JV brings in new capital and ideas for growth. Some owners may opt to sell a minority portion of their business to avoid ending up in the highest tax bracket while simultaneously achieving wealth diversification. The owner can arrange to buy back the minority stake or sell the remaining share of the business in the future.
If you are a small business owner who is looking to explore options for tax savings and selling your business, now is the time to take action. Consult a professional advisor who can provide you with additional ideas and explore all avenues available to achieve your desired goals.