Patrick J. Stoltz, managing director of Wintrust ESOP Finance, and Daniel F. Rahill, CPA, JD, LL.M., CGMA, managing director of Wintrust Wealth Management, share insights on potential tax law amendments and how these will impact your personal tax situation and your company’s existing capital structure.

With the many trillions of dollars in COVID-19-related relief bills approved within the last 12 months and the change in administration, it is widely expected that tax rates are going to increase. Experts predict that changes in tax law will be effective on January 1, 2022, although some could be effective sooner.

The proposed changes include:

• Increasing the top marginal income tax rate for high earners from 37% to 39.6% for taxpayers with taxable income over $509,300 for married taxpayers filing jointly and over $452,700 for single filers;
• Taxing capital gains of high-income individuals (with adjusted gross income over $1 million) at ordinary rates;
• Imposing capital gain tax on property transferred by gift and on property owned at death;
• Taxing carried interests as ordinary income for partners with taxable income over $400,000;
• Limiting the deferral of gain from like-kind exchanges to $500,000 per taxpayer ($1 million for married taxpayers filing jointly) per year; and
• Expanding the net investment income and Self-Employment Contributions Act (SECA) taxes so that all passthrough business income of high-income individuals is subject to either the 3.5% net investment income tax or SECA tax.

The proposed American Families Plan would increase the tax rate on long-term capital gains for high income individuals—currently 20% for most assets held for at least a year—to ordinary rates for people with adjusted gross income of more than $1 million. Since capital gains are also subject to the 3.8% net investment income tax, the new capital-gains rate would be 43.4% in 2022. The president’s plan calls for a retroactive effective date of April 28, 2021, for this provision, but many feel that congressional negotiations likely will likely result in a January 1, 2022, effective date.

If you have an interest in locking in the capital gains tax at the current rate but do not wish to sell your entire company to a third party, there are two tax strategies you can use, either to avoid paying the capital gains tax altogether or to lock in the current capital gains tax rate, if you act before the end of 2021.

Sell part or all of your stock to a company-sponsored Employee Stock Ownership Plan (ESOP) and elect tax-free rollover treatment under a special tax code section (1042) that only applies to ESOPs. Under this provision, the capital gains tax is never paid, provided (i) your company is a C-corporation (or converts to C status), (ii) the sale proceeds are reinvested in qualified replacement securities within 12 months from the date of sale, and (iii) these replacement securities are never sold during your lifetime.

Sell part or all of your stock to an ESOP and elect to pay tax on the entire transaction in 2021. With this approach, all of the gains will be taxed at the current capital gains tax rate. Even if you receive a seller note for part or all of the purchase price, the entire sale will be taxed at the current tax rate, provided that you do not elect installment sale treatment on your seller note.

For ESOP-owned companies that carry seller notes being taxed on an installment basis, refinancing these notes in 2021 may allow this liquidity to be taxed at current rates, saving significant tax dollars by electing to recognize the remaining gain in 2021 at the current lower tax rates.

Additionally, with interest rates near historic lows, but beginning to see signs of escalation, refinancing seller debt with low cost of capital bank debt may be in the best interest of the ESOP.

Some additional questions to consider as you make this decision include:

• Do I have subordinated seller debt in my capital structure?
• Is my company in a position to pull forward potential future higher taxable events into 2021’s potentially lower tax environment?
• Do I have a bank that understands ESOP finance?
• Does it make sense to revisit my current banking arrangement to more efficiently manage cash flows and create a lower cost of capital for the ESOP?

If you’re ready to make some changes to your current financing structure to prepare for the new tax environment, or have any questions you’d like to discuss, the Wintrust ESOP Finance team is here to help you make the right decision for your business. Visit wintrust.com/ESOP to connect with an expert banker.

Please note: The information above is provided solely for informational purposes and is not meant to serve as tax advice. We encourage you to consult with your legal, tax, accounting, or financial advisors, as necessary.