Many of BGSA’s private-owner clients are talking with us about liquidity strategies in advance of the 2011 or 2012 tax increases. Given the major tax hikes pending, many owners are comparing the prospect of high future income tax rates (45%+) to low current capital gain rates (15%). The conclusion for many is to consider a range of options, including a liquidity event in 2011.
Here’s how the math works.
First, assume that you own a company, generating $5 million in operating profit, which you pay yourself at the end of each year. You founded the company with a nominal cost basis, and built it up to the current levels. Then, let’s say your long-term growth rate is the same as that of the overall economy, which is 3%. Next, let’s model a sale at an average multiple of five times operating profit. Lastly, let’s apply an annual discount rate of 20% for our forecast, given the normal uncertainties of the future for small- to mid-sized companies in the current economy.
Under these assumptions, what would happen? In 2010, you would pay the federal government $1.8 million in income taxes. In 2011 or 2012, your tax bill could increase by 35%, to $2.4 million.
Let’s say you saw these numbers, thought about your options, and decided to explore the sale of your contract packaging or contract logistics company. If you decided to sell your company in 2010, you would reap $25 million. Your capital gains tax bill to the federal government would be $4 million. Net of taxes, you would keep $21 million. However, if your deal closed after tax rates went up, you could have to pay a capital gains tax of $7 million. This would be a 79% increase in your tax bill. Net of taxes, you would keep $19 million.
Finally, let’s say you decided not to sell. You could run your business for the next 20 years. At the end of that time period, you would go ahead and sell, at the same profit multiple. You would continue to take year-end dividends. However, they would be reduced by the tax bite. In addition, the discount rate (reflecting inflation, uncertainty, and other modeling assumptions) would reduce the current value of those proceeds. In the end, the present value of those 20 years of hard work would be less than the present value of the 2010 sale proceeds.
In sum, when you compare these three scenarios, with these assumptions, your present value is highest when you sell under current tax laws, because of the historically low capital gains levels.