Capital Gains Tax. How proposed 2012 year-end capital gains tax changes will affect business owners preparing to sell in the next months.

Transcription

1 Capital Gains Tax How proposed 2012 year-end capital gains tax changes will affect business owners preparing to sell in the next months.

2 Proposed Year-End Changes How Capital Gains Tax Changes Affect Sellers Executive Summary The special tax rate on long-term capital gains is set to expire on December 31, In 2013, if Congress does not take action, the tax on long-term gains from a sale of a business will increase from 15 to 20 percent. Additionally, the distinction between ordinary and qualified dividends will disappear, and all dividends will be subject to the ordinary tax rates. Also beginning in 2013, capital gain income will be subject to an additional 3.8 percent Medicare tax. For business owners looking to sell in the next months, this may represent a material amount of money and for many this change is what drives a decision to accelerate a sale before year-end Long-Term capital gains tax changes Income from the sale of a company is considered capital gains and taxed at either the short-term or long-term capital gains tax rate. Long-term rates are in effect once assets have been held for one year, so the proceeds from many company divestitures and sales fall into this category. The long-term capital gains rate was reduced in 2003 to 15 percent. However, because of pending tax changes the proceeds from a sale could be taxed at an effective rate of 25 percent, an increase of 66 percent over the current rate, if no action is taken before Jan. 1, There are three major components to this increase: Total Effective Tax Rate (%) Tax Rates First, the 2003 capital gains tax reduction is now set to expire on Dec. 31, This return to pre-2003 tax levels raises the long-term capital gains tax by five percentage points to 20 percent. Second, the expiration of the act extending the Bush tax cuts means a return for the 3 percent disallowance of itemized deductions for high-income taxpayers effectively adding an additional net 1.2 percent capital gains tax Current Tax Potential 2013 Tax Disallowance of Itemized Deductions 1.2% Healthcare Reform Law Addition (PPACA) 3.8% Base Long-term Capital Gains Rate 15 20%

3 Third, the Patient Protection and Affordable Care Act (PPACA), the health care legislation that became law in March 2010, imposes a new 3.8 percent tax on net investment income for top earners. Together, these increases mean that sellers could face a long-term capital gains tax of 25 percent beginning January 1, Financial impact of increased tax rate An increase in taxes will result in less cash to owners post-sale. But to fully grasp the extent of this decrease, consider the following scenario: a business owner sells his/her company, which results in a $50 million capital gain. At the current 15 percent capital gains tax rate, the owner will net $42.5 million before state and local taxes. However, at a potential effective tax rate of 25 percent, the same deal completed on or after January, 1, 2013, will net the owner $37.5 million, a $5 million decrease. The chart (right) depicts the after-tax proceeds on a $50 million capital gain under several tax scenarios, depending if Congress limits some of the projected tax changes. Another exercise is to determine the necessary selling price in 2013 for sellers to receive the Earnings, in Millions Net Proceeds on Capital Gain of $50M After-tax proceeds Taxed at 15.0% (2012 Rate) Taxed at 18.8% (PPACA Increase Only) Taxed at 23.8% (PPACA and Base Increase) Taxed at 25.0% (Maximum Increase) same proceeds before state and local taxes as they would had they sold in The graph below shows that the company would have to see a substantial increase in value in 2013 in order to net the after-tax proceeds that they would have received in Continuing to use a company with a $50M capital gain as an example, martinwolf s analysis shows that owners wishing to take home the same amount before state and local taxes in 2013 as they would in 2012 would have to see their valuations rise by as much as percent (assuming the 25 percent effective capital gains tax rate). This translates to a $56.67 million valuation. Again, the exact amount of the increase is contingent on the final tax figures but assuming a minimum tax rate of 18.8 percent, the sale price would have to rise 4.68 percent to million.

4 Effect on IT Services and Tech-Enabled BPO sectors In the IT Services and tech-enabled BPO sectors, a company s valuation is often based on revenue and a multiple of its earnings before interest, taxes, depreciation and amortization (EBITDA). To put the effects of these tax rates in perspective, we look at the current revenue growth rates in the sectors in which we directly work: the IT services and tech-enabled BPO sectors. An easy way to measure this is to look at the MW Scoreboard, which is a proprietary listing Valuation, in Millions Valuations for Equivalent Sale Proceeds in % 23.8% 20.0% 18.8% 2013 Effective Tax Rate 2012 Valuation 2013 Valuation Necessary for Equivalent Sales Proceeds of the median multiples in every IT Solutions market niche, compiled weekly by martinwolf analysts. It reveals that given current market conditions, the number of months it would take after the new tax structure was implemented for companies to attain equivalent values varies significantly. Even for the highest performing sectors, such as Managed Services and Infrastructure Services and Software as a Service, would face an approximately 6.5 month wait (assuming June 2012 growth rates 24.6 and 24 percent, respectively) until they were able to achieve equivalent sales proceeds. For lower-performing sectors, such as IT Management Software and European Business Process Outsourcing (again using 2012 growth rates 12.6 percent and 5.8 percent, respectively), the wait could be as long as one or two years. Of course, this is assuming that companies maintain a steady revenue growth rate. Unforeseen circumstances can significantly delay or accelerate the process, causing outcomes to deviate from these projections. Making the right decision The impact of the capital gains tax is an important factor to consider when deciding to sell your company in the near-term. With the pending tax changes, owners should educate themselves about the potential consequences of delaying a sale. martinwolf consistently urges owners to consider who the best owner of their company is today, we are emphasizing that the when can be just as important a question as the who. This

5 pending tax change adds urgency since it usually takes three to four months to complete a sale. If you have questions about the proposed tax increases and how they may affect your company, feel free to contact Anthony Lembo at alembo@martinwolf.com. He can tailor these examples to your company and provide you with a comprehensive overview. About martinwolf With offices in San Francisco and Bangalore, India, martinwolf is the world s leading middle market IT M&A advisory. Since 1997, the firm has completed more than 115 transactions in six countries. Its knowledge and experience with IT outsourcing and managed services combined with its disciplined approach, which includes a proprietary, proven, step-by-step work plan customized for each client, has produced one of the highest transaction completion rates in the industry. martinwolf is a member of the Merrill Lynch PS Referral Network and is an exclusive strategic partner to ICICI Bank, India s leading private bank, for acquiring U.S. IT companies. Member FINRA, SIPC. For more information, visit