Is it Too Late to Sell Your Online Business to Avoid New Capital Gains Tax Increases?
November 3, 2021
If you’re a business owner, you’ve probably dreamed of building a successful business that will make its mark in the history books.
But having your profits slashed by one of the largest tax increases in history probably isn’t what you had in mind.
As we rocket towards the new year, the race is underway among American entrepreneurs who are searching for ways to avoid paying increased long-term capital gains tax.
The House Ways and Means Committee has approved President Joe Biden’s new tax proposal to increase capital gains tax for high-income earners from 20% to 25%. The top corporate tax rate will also increase from 21% to 26.5%, with a lower rate offered to small businesses. The top marginal individual income tax rate has been increased back up to 39.6%.
Taxpayers hoping to sidestep the higher tax rate by maximizing their deductions and exemptions are out of luck as the tax will be based on adjusted gross income as opposed to taxable income.
Personal finance experts recommend that in order to avoid the upcoming tax changes, entrepreneurs looking to sell their online business valued at over $1,000,000 should aim to complete the transaction by the end of the year.
The question is, with just a few months left in 2021, is it too late to sell your online business to avoid the new capital gains tax increase?
What the Tax Hike Means for Selling Your Online Business
When the Biden administration first suggested a change to tax policy, they proposed a top rate of 39.6%. Many people breathed a sigh of relief when this amount was lowered to 25%. However when combined with other changes to the bill, like the 3.8% Net Investment Income Tax (NIIT) and the 3% surtax for income over $5m, the effective tax rate for high net worth individuals could be as high as 31.8%.
This puts business owners in a precarious position. If you want to sell your online business valued at over $1 million dollars, you could lose over one-third of the business’s value to tax when you make your exit.
Obviously, this is not ideal, but since the new tax plan has already been passed, what options are available to you to ensure you’re not caught on the back foot?
While the window of opportunity has closed for many business owners, there is still a small glimmer of hope.
Built into Biden’s proposal is a grandfathering or transition rule. This rule is designed to allow taxpayers to continue to be taxed under the current capital gains rates if they entered into binding sales contracts before September 13, 2021, provided they close the deal before year-end.
In addition to this, the surtax and NIIT increases won’t come into effect until the new year. This creates an added incentive to close transactions prior to year-end even if you are taxed at the 25% capital gains rate.
The prediction is that these incentives to sell will create a flurry of activity on online business acquisitions during the remaining months of the year. Not only does this put your business in a strong position to be acquired, but it can also give you leverage in negotiations.
More Likelihood for Earnouts Post-Tax Hike
The increased capital gains tax rate will likely affect the way that earnout deal structures are negotiated.
On average, seller’s typically want as much cash up-front as they can get. However, the new tax reform may incentivize sellers to take much longer earnouts so that they can stay under the yearly capital gains threshold.
For example, when making an offer on a $2 million business, a buyer could propose an amount of $800,000 upfront to help prevent the seller from paying the increased long-term capital gains tax amount for anything above $1 million. The following year, the buyer could pay another $800,000, paying off the remaining amount in the third year.
This deal benefits both parties. It helps the seller avoid paying higher tax rates and gives buyers greater spending power as they don’t have to raise as much initial capital to purchase the business.
It’s worth noting that by going the route of an extended earnout, buyer trust is paramount. Getting the full value of your business hinges on the buyer’s ability to run the business successfully so make sure the buyer has the skills to keep the business afloat, and better yet, growing so cash flow for payments never becomes an issue.
2021 is the Best Year Ever to Sell Your Business from a Market Perspective
You may be thinking you missed your prime opportunity for a lucrative exit, but the year-end still holds a ton of potential.
Tax aside, this is the best ever year to sell your online business. The turmoil created by the recent pandemic has caused a shift in the online M&A space into what we like to call “The Season of the Seller”.
After the introduction of COVID in early last year, investors were wary and held back on purchasing online assets. As more and more people were confined to their houses, there was a surge in online buying, causing the revenue of online businesses to quickly rise. With that rise, new investors entered the market to seize growing assets.
Thanks to the capital influx in Q1 of 2021, the scene was set for aggregators and private equity firms to swoop in and inject that capital into online assets, buying more businesses than ever before.
The competition between the high net worth individuals and companies has only increased since then. As a result, online businesses are selling much faster and for higher multiples.
Let’s put this into perspective. In Q4 2019, the average sales price for an FBA business was $448,940.59. Just one year later, as the Season of the Seller came into full effect, the average sales price of an FBA business in Q4 2020 was a whopping $1,561,931.24!
This uptick in growth was consistent across the board for all business models. Before Q4 2020, our average deal size was $171,340.55. The next three quarters blew this number out of the water, coming in at $557,338, $544,133, and $542,006 respectively.
Selling your business before the end of the year can help you ride this wave of momentum and make a more profitable exit.
Our Two Cents
If you’ve been considering exiting your business, the best way to successfully navigate the tax hike is to try to sell your business before the end of the year.
As with everything in life, this requires some give and take. In order to time the sale of your business with the tax changes, you will likely need to entertain more offers for a longer-term earnout, which means less cash up front.
Over and above avoiding paying top capital gains rates, exiting your online business before the new year allows you to dip your toes into a very promising marketplace that is currently skewed in the seller’s favor.
With all of that said, selling your business is certainly not an easy choice, and shouldn’t be something you rush into. Remember, sell when you feel the time is right, not simply to avoid
top tax rates.
If you’re ready to make a profitable exit from your business, schedule a call with one of our expert seller advisers, or use our free business valuation tool to find out how much your online business is worth.
