The Two Year Tax Reprieve

Posted on December 28th, 2010 in Investments, Newsletter Articles, Retirement Planning, Taxes by wayne

If you are considering retirement and have an ownership position in your business worth $250K or more, the two year extension of the “Bush tax cuts” could provide an opportunity for significant tax savings.

For the next two years, long term capital gains and qualified dividends will be taxed at a maximum rate of 15%.  In 2013, capital gains tax rates will likely increase to at least 20% and could increase to 28% on the “wealthy” (couples earning $250K or more per year).  On top of this likely tax increase, 2013 will also usher in increased Medicare taxes which could add 3.8% in taxes to all investment income.   Let’s look at what this could mean if you are considering the sale of your business interests.

We assume that you are married and that you and your spouse’s Adjusted Gross Income is $250K.  Let’s also assume that your business ownership interest has a net value of $1 million.  If you sell your business ownership interest by the end of 2012, the federal income taxes owed from the sale of your business interests will be $150K, allowing you to keep $850K.  However, if the same business ownership is sold at the end of 2013, federal taxes owed will likely be significantly higher.

Assuming that long term capital gains rates “only” rise to 20% in 2013, you will owe $200K in capital gains taxes, an increase in federal taxes of 33%.   However, since your 2013 AGI remains at $250K, the $1 million income from the sale of your business will be fully subject to the 3.8% Medicare tax, providing an additional $38K in federal taxes owed.  Selling your business at the end of 2013, instead of 2012, will likely add a minimum of $88K to your federal tax bill, representing a 58% federal tax increase.

Many people believe that the capital gains rates for the “wealthy” could increase to the 1996 level of 28% in 2013.  If this occurs, the total federal taxes that could be owed on the sale of a $1 million business interest would rise to $318K, leaving only $682K remaining after federal taxes.  If this scenario occurs, postponing the sell of a business could more than double the amount of federal income taxes that must be paid.

Thanks to the recent extension of current tax rates, there is a two year window of tax certainty.  Based on previous government actions, it seems reasonable to expect that nothing further will be done regarding taxes until the end of 2012, at the earliest.  If you are considering the sale of a substantial business interest in the near future, it might be wise to begin this process now, so it can be completed before the end of 2012.

As with all investments, you should never let the “tax tail” wag the investment dog.  If you are enjoying your business and expect it to keep growing in value over the years to come, short term tax consequences will be diminished by the increase in total value that you will receive by selling your business in the future.

However, if your business is not growing rapidly and you are not enjoying it like you once did, it may be time to sell.  As the economy continues to improve and banks begin to offer business loans, preparing your business for a sale by the end of 2012 could maximize your after tax business returns.

A Tale of Two Economies

Posted on December 28th, 2010 in Investments, Newsletter Articles by wayne

As 2010 draws to a close, I believe that we are experiencing two distinct and different US economies.  The challenge for 2011 (as it was in 2010) will be in determining the best investment strategies to take advantage of these two different economies.

In the fourth quarter of 2010, much of the US economy showed signs of revival from the 2008 to 2009 recession.  Consumer spending is once again edging toward 70% of GDP and many manufacturing and services businesses are starting to hire and make new capital investments.  This “positive economy” continues to grow and could provide buoyancy for the stock market in 2011.

As the “positive economy” expands, there will likely be inflationary pressures seen with any expanding economy.  In 2010, the price of certain commodities rose, especially in the areas of food and energy. These prices will likely continue to rise in 2011.  Investors will also expect higher returns on their risk capital, putting upward pressure on longer term interest rates and stock dividends.  If not for the “negative economy,” the US could be well on the way to a bullish recovery.

The “negative economy” is mainly represented by the banking and housing industries.   Since 2009, approximately 300 banks have failed and most of our largest banks maintain a significant amount of “toxic assets” on their balance sheets.  The Fed’s free money policy has kept large banks afloat and continues to be a major contributor to their earnings.  At the same time, the housing industry continues to be moribund with nationwide housing prices expected to drop another 5% to 15% in 2011.

Because of the “negative economy,” core inflation rates (of which over 40% is represented by housing costs) continue to stay near zero and many economists maintain concerns that our economy could suffer from the effects of deflation.  Banks, remaining in a precarious financial position, continue to provide only “risk free” loans, while “safe” investments such as CDs yield less than 1%.

The Fed appears to believe that it must support the banks, Wall Street and other contributors to the “negative economy,” even when these actions adversely impact the “positive economy.”  This was recently confirmed in the Fed’s decision to implement Quantitative Easing 2 (QE2).

Thanks to the stronger than anticipated “positive economy” and the Fed’s continued support (enabling?) of the “negative economy,” the S&P 500 was up almost 13% in 2010.  However, it should also be noted that gold was up over 25%, a barrel of oil was up 17% and the Australian currency was up over 11% in 2010.

What do these two divergent economies portend for your investments in 2011?  Knowing this answer would lead to untold wealth.  Since my crystal ball is no better than yours, let’s consider what might occur.

1) The “positive economy” will likely continue to strengthen in 2011.  This could be very positive for stock valuations, especially those of large multinationals with rising dividend payouts.

2) Commercial real estate, supported by REITs, will likely strengthen as the “positive economy” improves.

3) The lack of bank lending will likely increase mergers and acquisitions of some solid small and mid cap companies.

4) The Fed will likely continue to support the financial markets in ways that will further devalue the dollar.

5) Fed actions will likely keep short term interest rates low, while longer term rates may rise as the value of the dollar decreases.

6) A weakening US dollar will likely cause commodity prices (food, energy, gold) to continue to rise in 2011.

Successful investing in 2011 will require correctly anticipating how the events occurring in the the forthcoming year will affect both economies.  Since it appears that we have two divergent economies and a Fed that is determined to protect and defend the big money interests of large banks and Wall Street, investment decisions for 2011 will remain as challenging as they were in 2010.