2011 Capital Gains Tax Increase and the Impact on Business Owners

The last couple of years have been difficult for business owners and financing markets, to say the least. Limited credit, economic uncertainty among businesses and consumers, and poor financial performance across industry sectors contributed to curtailed growth prospects, and have some wondering what their long-term strategy might entail. As we head into 2010, however, there are many reasons for optimism that merger and acquisition activity will increase, including improving economic indicators, cash heavy balance sheets of strategic buyers, better than expected fund raising by private equity groups and Key Take Aways increased confidence in the private and public sectors. For potential sellers, 2010 is also an important time to consider valuation risks now versus future years due to the scheduled increase in the capital gains in 2011.

Originally signed into law in 2001, the capital gains tax rate was reduced as part of President Bush's Economic Growth and Tax Relief Reconciliation Act. Under the reduced rate, long-term capital gains and qualified dividends were taxed at 15% for the lowest two income tax brackets. The lowered rate was set to expire in 2008; however, reduced rate was extended in 2006 under Bush's Tax Reconciliation Act and is scheduled to expire at the end of 2010, at which time the rate will revert to the 2003 rates, which were 20%.

Given the capital gains tax rate increase represents a 33.33% higher effective tax rate, there is significant motivation for owners and shareholders already considering a potential sale in the near-term to consider action in 2010. Beyond avoiding a higher tax rate on long-term capital gains, sellers also need to carefully plan the timing of a potential exit in 2010 in order to secure the most attractive buyer and preserve leverage in the negotiations of the purchase agreement.

While owners and shareholders may be hesitant to pursue an acquisition without greater economic certainty, there are multiple indicators suggesting that 2010 is likely the right time to at least consider a potential a sale, given favorable terms. The capital gains tax increase serves as motivating factor; it is by no means the only one.

The following are key points for understanding the impact of the capital gains tax rate increase on M&A activity in 2010:

Consider the overall economic picture.

There are signs at the corporate level that are encouraging to mid-size firms considering being acquired. Over the last three months through January 2010, deal flow is up 16.8% over the same period a year before. Of course, last year was the one of the worst years in our economic history. However, major deals are being completed, which can cause a "bandwagon effect." In addition to corporate confidence, many private equity groups with a strong track record continue to raise money. In 2009, the average fund size raised by private equity groups was $1.5 billion, the second highest on record. This indicates more private equity groups than expected will have cash in 2010 and will need to put it to work. With a return in confidence to the markets and increasing signs of an economic stabilization, 2010 is likely to see a number of buyers enter the market with cash on hand seeking good deals.

Understand your long-term growth realities.

While the economy is expected to undergo further recovery in 2010, many mid-size firms are simply not going to be able to grow at the same rates experienced in the 2003-2008 period. Given modest growth expectations, overall business growth in the next three to five years will not be significantly higher than its current state in 2010.

It is projected that the economy will grow at an average rate of less than 3.5% for the next 3-5 year, which will mimic the growth of most industries. (There are, of course, exceptions to every rule.) Given this outlook, a company should consider a realistic growth projection as part of their calculations for keeping their business or selling it now or five years from now. This is especially so considering what will most likely be a higher capital gains tax rate in 2011 and beyond.

Think critically about timing.

Early in 2010, the market will be more favorable to sellers, who will have a range of potential buyers to choose from. Moreover, the capital gains tax rate increase puts buyers not paying all cash at a disadvantage, since the increased tax rate will apply to deferred payments at the time the payment is made. Deferred payments are likely to continue into 2011 and beyond for non-cash buyers. Therefore, sellers are more likely to find buyers with cash in hand earlier in the year.

In addition to increased choice of buyers, owners are in a better negotiating position earlier in 2010. As potential buyers know that sellers have a range of options and varying deal structures to minimize tax obligations, they are more likely to agree to terms favorable to the seller. As 2010 progresses, the buyer will be able to use the impending tax increase as leverage in deal negotiations, aware the seller has significant motivation to close before 2011. In fact, if negotiations are still ongoing in 4Q10, buyers are likely to try and discount the purchase price by 1% to 5% or seek tougher terms in the purchase agreement, knowing the seller will try and avoid paying the higher tax rate.

While not appropriate for all owners, those considering a sale in the near-term future are likely to experience favorable conditions 2010 as closing before year end avoids paying higher capital gains taxes. Additionally, early movement will prove advantageous for sellers by yielding a greater range of potential buyers and a strong position in deal negotiations. Overall, 2010 is likely to experience a significant revival in M&A activity, attracting a number of interested buyers to the market.