Surviving 'Taxmaggedon'

Is your firm making the most of 2012 tax rates while they last?

For come 2013, the “Four Horsemen” of the US “Taxmaggedon” will ride in in the form of a 3.8 percent Medicare tax under Obamacare; expiration of the alternative minimum tax patch; expiration of the “tax extenders” package and payroll tax cut; and of course Bush-era tax cuts set to expire in January.

A divided Congress may be able to extend some of the tax cuts, but if history is anything to go by, it will be a bitter fight that goes down to the last minute. As such, PE Manager provides a few points to consider in the meantime:

Create a trust: Do employees have any compensation subject to vesting? It could be smart to channel any unvested bonuses or other types of “golden handcuffs” into a secular trust. Under this arrangement the compensation placed in trust is taxed at current rates and can be later released to partners immune from future tax rates, explains Steve Bortnick, a tax partner at Pepper Hamilton.

Distribute bonuses before the ball drops: To secure a 35 percent ordinary income tax rate for top earners (which jumps to 39.6 percent under a deadlocked Congress), consider distributing annual bonus cheques, if possible, before New Year’s Day.

“Step up” your portfolio: By transferring assets to a new legal entity in a manner that does not qualify as a tax-free exchange, which “steps up” their value to their current market price, GPs can tax any value increase at the lower 2012 tax rates. However the tax would need to be paid even though no cash is generated, and the risk in doing so is paying taxes on any value increase that later vanishes at the time of actual realisation, warns Peter Furci, tax partner at Debevoise & Plimpton.

Engage sellers: Entrepreneurs and family businesses have an eye on 2013 tax hikes too. Negotiating a buyout may be easier with a tax time bomb ticking in the background.

Exit early: A simple way to avoid 2013 tax rates is to sell before they kick in. Of course a portfolio company should never be rushed into a sale to capture tax savings, but any exits scheduled for January could feasibly be pushed up a few weeks to save thousands of dollars in tax with minimal damage.

Dividend recaps: Or if not ready for a 2012 sale, a dividend recap offers a way to take some money off the table at the current 15 percent capital gains rate on dividends.

Measure your losses: On the flipside of things, waiting for higher tax rates makes sense when selling companies at a loss. Offsetting losses against a 20 percent capital gains rate (assuming the Bush tax cuts expire) provides a bigger tax shield against investments underwater.

No one knows how ‘Taxmaggedon’ will play out next year. But like all looming threats, preparation will be key. 

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