2010 Actual 2011 Proposed Budget* Married [1] Single Rate Married [1] Single Rate

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1 This article contains general information and is not intended to be a specific analysis of the tax issues that could affect an individual s specific circumstances. In 2011, changes in capital gains and ordinary income tax rates will significantly affect the proceeds from the sale of a business. The Bush tax cuts are to sunset in 2011 and the recently passed healthcare law will also implement new taxes in coming years. Business owners that are considering selling in the next two to three years may want to consider selling in 2010 in order to maximize their after tax proceeds. Leonard Tannenbaum of Fifth Street Capital was quoted on May 6, 2010 at a large private equity conference, You may see the biggest fourth quarter [of dealmaking] in history; there is going to be a massive tax hike coming. Tax Law Changes According to current law, the Bush tax cuts are to expire at the end of 2010, replacing the current tax brackets of 10%, 15%, 25%, 28%, 33% and 35% with fewer tax brackets at the higher rates of 15%, 28%, 31%, 36% and 39.6% experienced under the final years of the Clinton Administration. However, the 2011 proposed budget appears to indicate that the tax rates for individuals making under $200,000 and families (married filing jointly) making under $250,000 may not increase as shown in the chart below (the brackets have been adjusted for the standard deduction and personal exemptions) Actual 2011 Proposed Budget* Married [1] Single Rate Married [1] Single Rate $ $ 10.0% $ $ 10.0% 16,750 8, % 17,000 8, % 68,000 34, % 69,100 34, % 137,300 82, % 139,500 83, % 209, , % 235, , % 373, , % 379, , % 1. Married filing jointly *Tax Policy Center Brackets have been adjusted for std deduction and personal exemptions If the Bush tax cuts are allowed to expire, rates on long term capital gains will increase 33% to a rate of 20% in Additionally, the recently passed healthcare bill will tax investment income (interest, dividends, royalties, rents, capital gains and income from passive activity and annuities) for the first time beginning in 2013, by adding a 3.8% tax on individuals making over $200,000 and families making over $250, E 2013E* Capital Gains Rate 15.00% 20.00% 23.80% Increase over % 58.67% *Includes 3.8% medicare tax on investment income from Healthcare Bill *Only applies to individuals with income over $200k and families over $250k May 17, 2010 Page 1

2 Tax rates on dividends are also expected to increase. Under current law, the 15% tax rate for dividends is scheduled to revert to the individual s ordinary income rate, but the current administration has proposed that dividends will be taxed similarly to capital gains in its 2011 budget. For those business owners who are considering selling all or part of their business, these tax increases could have a substantial effect on the proceeds from a transaction. Transaction Assumptions In order to put the tax changes into context, it is important to make some basic assumptions about the sale of a company. Below is a summary of a sample company in terms of revenue, earnings before interest, taxes, depreciation and amortization (EBITDA), debt, net worth, etc. Company Statistics Revenue $ 20,000 Adjusted EBITDA 3,000 Working Capital 1,000 Tax Basis in Fixed Assets 3,000 Acc. Depreciation 2,000 Debt 6,000 Net Worth 1,500 For the purposes of this article, it is assumed that the acquirer will purchase assets for $16.5 million (5.5 times EBITDA), and there are transaction fees equal to approximately 4% of the transaction value. Most acquirers prefer to purchase assets rather than stock due to unknown liabilities. Corporate structure plays an important part in the overall tax liability in a transaction. Subchapter S corporations (S Corp) and limited liability companies (LLC) are treated similarly since the tax liabilities of the company are passed through to individual taxpayers. A C corporation is taxed at the corporate level. Any distributions to owners, other than wages and salaries, are typically taxed at the dividend rate. Since the corporation is taxed, and the individual is taxed on dividends, those distributions are double taxed. The only way to avoid double taxation when selling substantially all assets of a C Corp is through a sale of the stock. If an owner of a C Corp has no intent to sell immediately, he or she may want to consider an S Corp conversion, especially if the company is expected to grow its revenues and profits over the coming years. State corporate and personal income tax rates are ignored for the purpose of this analysis. May 17, 2010 Page 2

3 Proceeds from Sale of S Corp/LLC Assets There are two important key tax rates that would apply to a sale of S Corp and LLC assets. To the extent that any fixed assets are worth more than their existing tax basis, accumulated depreciation would be recaptured as income and taxed at the ordinary income tax rate. Any remaining capital gains, after paying transaction fees, would be taxed at the long term capital gains rate. Proceeds would be calculated by subtracting the debt, transaction fees and taxes from the purchase price of the assets. Based on these assumptions, the expected tax laws changes would reduce the net proceeds from a sale in 2011 by $584,000 as compared to a sale in If the transaction occurred in 2013, the reduction would be over $1 million compared to $7,800.0 $7,600.0 S Corp/LLC After Tax Proceeds 31.8% 34.0% 32.0% $7,400.0 $7,200.0 $7,000.0 $6,800.0 $7, % 30.0% 28.0% 26.0% $6,600.0 $6, % $7,080.0 $6, % 22.0% $6, E 2013E 20.0% Net After Tax Proceeds Effective Tax Rate After paying off debt and transaction fees, the effective tax rate as a percentage of proceeds is expected to increase substantially over the coming three years. In our example, it increases from 22.1% in 2010 to 28.0% in 2011 and ultimately to 31.8% in May 17, 2010 Page 3

4 Proceeds from Sale of C Corp Assets As previously discussed, a sale of C Corp assets incurs double taxation. All gains inside the corporation are taxed at the corporate level. The marginal corporate rate of 35% is not expected to change. However, the dividend tax rate is expected to increase from 15% in 2010 to 20% in 2011 and 23.8% in 2013 for taxpayers at the marginal rate. A liquidation tax must be paid when winding down a C Corp after the sale of substantially all of the assets. The rate on this tax is equivalent to the dividend rate. As a result of double taxation, the effective tax rate after paying off debt and transaction expenses exceeds 45% in 2010 and is expected to increase to nearly 50%. The after tax proceeds would fall from approximately $5.2 million in 2010 to $4.9 million in It is important to note that this is approximately $2 million less than a similar sale of S Corp or LLC assets. C Corp After Tax Proceeds $5,250.0 $5,200.0 $5, % 51.0% 50.0% $5,100.0 $5, % 49.0% $5,000.0 $4,950.0 $4,900.0 $5, % $5, % 47.0% $4,850.0 $4,800.0 $4,750.0 $4, E 2013E 46.0% 45.0% Net After Tax Proceeds Effective Tax Rate As previously discussed, the only way to avoid double taxation in the short term is through a stock sale. While double taxation cannot be eliminated entirely for an asset sale in the near term, its impact may be mitigated through an S Corp conversion. If an owner does not plan to sell in the next two to three years, he or she should contact his or her tax professional about the viability of an S Corp conversion. May 17, 2010 Page 4

5 Conclusion With the Bush tax cuts expiring and increasing federal deficits, tax rates are expected to increase in the future. Any business owner that is considering selling the near term should consider the effect of tax changes on their situation, especially if their corporate structure is an S Corp or an LLC. Most transactions can take several months to complete. If a business owner plans on completing a transaction in 2010, they should consult their advisors on the appropriate path to a sale as soon as possible. FourBridges Capital Advisors 2010 DISCLAIMER This article does not constitute legal or tax advice. An individual should contact his or her tax professional to assess their particular situation. The tax rates discussed in this article have been cited as to the source and may change. The amounts presented herein are based on the assumptions discussed in the article and may not apply to other situations. Pursuant to Circular 230 issued by the United States Treasury Department and relating to practice before the Internal Revenue Service, any comment or opinion in this communication relating to a federal tax issue is not intended to be used, and cannot be used, by a taxpayer for the purpose of avoiding tax related penalties that may be imposed on the taxpayer. About FourBridges Capital Advisors FourBridges Capital Advisors, a middle market investment banking firm based in Chattanooga, Tennessee, represents business owners in selling their companies, provides advisory services relating to acquisitions, sources debt or equity capital for growth, and provides restructuring services for lenders and corporate borrowers. The senior professionals have been corporate C level executives (CEO or CFO) and enable the firm to provide financial advisory services based on actual operating experience. May 17, 2010 Page 5

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