The impact of tax changes in 2021 to your firm value
In yesterday’s ViewPoint, MarshBerry discussed the negative effects on a seller’s proceeds if multiples were to decline to the highs last seen just prior to the 2008 recession. In that scenario, multiples decreased by 50% from March 2020 levels. If such a scenario played out, one’s business would have to double in revenues before its value would equal today’s value. When viewed from the perspective of growth, if a business grew at an average rate of 7% per year, it would take another 10 years before a firm recovered all of its lost value due to a multiple contraction.
Let us suppose, however, that multiples remained at today’s current levels, but taxes increased in 2021. In recent weeks, MarshBerry has spoken with several senior executives in the insurance brokerage industry who believe that taxes are likely to increase in 2021 in order to fund the trillions of dollars of CODIV-19 rescue financing that the federal government has infused into the economy to keep it afloat. Equally important, most executives believe that taxes will increase, potentially double, no matter if it’s a Democrat or Republican in the White House – regardless of the wisdom of such an increase.
If capital gains taxes do increase in 2021, there is potential that Congress could retroactively impose the tax to January 1 of the year in which the increase is passed. Should such legislation be completed by the end of 2021, such a tax increase could affect anyone who sold their business in 2021, even before a new Congress was sworn in.
An increase in the capital gains rate could have a major impact on net proceeds to sellers. For the sake of simplicity, let’s assume one is selling a $50 million revenue agency with a 30% operating margin (e.g. $15 million of EBITDA – Earnings Before Interest, Taxes, Depreciation and Amortization). Let’s also assume that Congress raises the federal capital gains rate to equal ordinary income taxes rates (e.g. ~39%). In the table below, you can see how net after tax funds to shareholders are negatively effected:
Under the 39% capital gains rate scenario, the net after-tax proceeds distributable to shareholders is $109.8 million, a $34.2 million reduction in proceeds, or 24%, from the $144 million realizable under today’s federal capital gains tax rate.
Thought about differently, $109.8 million of net proceeds to shareholders under the current capital gains rate of 20% is equivalent to $137.25 million of pre-tax sale proceeds [$109.8 million / (1-tax rate)]. From a multiple of EBITDA perspective, $137.25 million of pre-tax proceeds is only a 9.15x EBITDA multiple (vs. 12x in the current environment). In other words, sale price EBITDA multiples would need to decrease 24% (to 9.15x or less) under the current capital gains tax before a firm is better off waiting to sell their business under a higher capital gains tax rate as described above.
As a result of the possibility of Congress increasing the capital gains tax, many sellers are considering accelerating their sale dates.
If you have questions about Today’s ViewPoint, or would like to learn more about the Evolution of M&A and Succession Planning in today’s marketplace, please email or call Gerard Vecchio, Senior Vice President, at 212.972.4886.
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Marsh, Berry & Company, Inc. and MarshBerry Capital, Inc. do not provide tax or legal advice. Tax and legal professionals should be consulted separately before making any decisions that may have tax or legal implications.