Trend Tracker October 2021

October 8th, 2021 by Nathan Hobbs

Capital Gains Taxes: These Shouldn’t Be Deciding Factors in M&A Transactions

By Michael Collins

At each year-end, there is a rush to capture tax benefits by completing business sales when possible. This year has been no exception. And with the current administration announcing a push for increasing capital gains taxes, the focus on taxes and timing is particularly sharp.

The proposed tax increase only applies to families earning more than $1 million per year. While most owners of small- to medium-sized businesses pay themselves less than that annually in W-2 wages, annual distributions often push them closer to that cut-off. For this reason, completing even a relatively small business sale would likely push any owner of a door and window manufacturing company over the $1 million limit. Thus, if capital gains taxes are increased from their current level of 20% to the proposed level of 39.6%, it is likely that change would impact the
sellers of most fenestration businesses.

A Look at the Ramifications

An increase in the capital gains tax means that, other things being equal, the proceeds from the sale of a given business would be lower under the new tax scenario. At a high level, that should decrease the desire of a seller to bring their company to market. So, should we assume that such a meaningful increase in capital gains taxes would mean that business sales will dry up in our industry and others? There are several reasons that this is not likely to be the case.

One of the primary reasons business sales will continue, even under higher tax scenarios, is that owners decide to sell when the greatest possible number of factors point to the correct timing. Not least among these is the general performance and outlook of the industry in which a company operates. Numerous building products companies decided in 2021 to seek a buyer for their companies because they see this as an ideal time to market their businesses. If an owner decided to “wait out” tax law changes, that may not be the case when the owner is ready to sell. The future is never certain, but even small changes in a company’s EBITDA or in the prevailing level of EBITDA valuation multiples can outweigh the impact of higher capital gains taxes.

Another aspect to consider is that, if the capital gains tax increase passes, we may already be living in the period it will apply. In other words, such a tax increase—if passed in 2022—may look back to January 1, 2022. However, there have been discussions about backdating the relevant period for sales back to April 2021. Such backdating would mean that the current year-end scramble to close deals may be for naught.

The details of nearly every tax increase create opportunities for minimizing taxes. Tax advisors can study and allocate cost basis to the various assets of a company. In this way, selling owners can reduce their tax burdens while still complying with tax laws.

The other danger of planning for potential tax increases is they may never be passed. Several legislative initiatives that were predicted to pass with little opposition have resulted in gridlock and endless debates. Business owners should make their plans for buying or selling based on factors that never change. On the sell side, these include preparing for retirement, ensuring the successful transition of management and gaining access to the resources of larger, acquiring companies. Whether actual or potential, tax code changes should not be the primary driver of M&A-related decisions.

Michael Collins is an investment banker and a partner in Building Industry Advisors. He specializes in mergers and acquisitions in the door and window industry.
mcollins@buildingia.com

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