Receding Pandemic, Reviving Economy and Reality of Tax Increases…A Good Time for Businesses to Reevaluate Dividend Recaps

Today’s Market Creates Highly Favorable Conditions

Over the last year or so, Washington has had a few pressing issues including the pandemic, election verifications and changing administrations.?New priorities will be popping up and right or wrong, tax policy will take center stage.?In that light, we thought we would highlight some items to think about.

A big movement is on the horizon in the Biden Administration’s proposed American Families Plan (AFP) ?regarding Long-Term Capital Gains (LTCG) and qualified dividend tax rates.?Currently, the LTCG and qualified dividend rate is 20% and far lower than the current highest personal marginal tax rate (PMTR) at 37% - potentially 39.6% under the AFP.?There is a reasonable chance the Biden Administration will be successful in adjusting ?the LTCG advantage and move to equal the highest PMTR for taxpayers with taxable income above $1 million. ??Just to bring that concept home, that is an 85% tax hike.?

Further, there is talk of moving the PMTR up from 37% to 39.6%.?In other words, it is quite conceivable that the LTCG will basically double in the foreseeable future and when you add the additional 3.8% net investment income tax that would apply in this case you’re looking at 43.4%!?Just to make things a little more interesting, conversations have included notions of tax rate increases being retroactive to earlier in the 2021 tax year.?In fairness, we believe retroactivity is a remote possibility.?That type of move generates profound economic uncertainty and sets a very disruptive precedent.

In dollar terms, this move results in a $2,000,000 added tax burden for each $10,000,000 of transaction value. ??Given transactions of size, that could add up to real money. ??

While selling an entire business is an option to avoid higher taxes on long term gains, that might not be the best solution and will prove to be detrimental if you’re planning on selling under the installment sale method (a majority of businesses transactions take this approach). The installment sale method allows you to spread the gain to subsequent tax years as you receive the principal payments from the buyer—sounds good until you realize you are now paying twice the amount of tax by picking up LTCG in subsequent years. If you are at all close to closing a transaction (or any stage for that matter) and have not discussed the option to opt-out of the installment sale with your CPA it will make sense to have that conversation. Opting out places the full amount of the LTCG in the tax year of the sale. It would make more sense to look at loan options to cover the initial tax hit and then paydown the loan as you receive installment payments. This alone would be a far bigger savings than paying higher LTCG in subsequent years and would be a good insurance policy against the legislation passing.

If you are not selling, there are multiple recapitalization scenarios that allow owners of medium- to large-sized companies to withdraw funds at the current LTCG rates while maintaining control of the business, since the owner(s) give up no equity. Dividend recaps are one such solution; in this scenario, the company takes on additional debt to fund a one-time cash dividend to shareholders.

Another way to reward shareholders is through a share repurchase program. A share repurchase program has the obvious benefit of potentially increasing EPS, cash flow per share and return on equity. Another benefit is profits on shares are taxed only when they are sold.?However, if the company’s revenues falter after the buyback, the stock price will likely decline, providing a less attractive reward for shareholders.

Dividend recaps are being prompted by tax changes, but they are supported by four beneficial aspects of the current economy and factors intrinsic to a recap transaction.??These include:

·??????Historically low interest rates

·??????A strong economy

·??????Substantial bank liquidity

·??????Dividend recaps are typically done without an equity component

Dividend recaps can be a viable option for companies that have a strong record of revenue growth and profitability, a strong market position and consistent cash flow. Other forms of leverage can also be arranged for less stable companies if there are unencumbered assets.

Why Dividend Recaps Are Something to be Considered

A healthy economy for most of the last decade has enabled many business owners to build successful, profitable businesses with little or no leverage.?Interest rates remain at or near historic lows. Lenders are eager to find new areas for investment. These and other factors create an ideal situation for dividend recaps. Many consider dividend recaps as an option only for investment firms and larger corporations but in fact, they are a viable option for the owners of mid-sized private companies as a strategy to increase liquidity and diversify their assets.

Recently, BizCap facilitated a transaction along these lines.?A B2B business owned by two principals had reached an attractive inflexion point.?EBITDA was beginning to spike as the company had achieved economies of scale.?In the prior fiscal year, EBITDA approximated $4 million but was on track to achieve approximately $8MM in the current fiscal year.??BizCap arranged for a $15 million cash flow term loan leaving a $6 million line of credit completely available for continued working capital requirements.??Proceeds were used to fund a like size dividend.??The owners achieved significant diversification of net worth and a competitively priced term loan.??A growth focused lending community competed to provide attractive term sheets and the prognosis for the business remains strong supported by a resurging economy.

Dividend Recaps Aren’t for All Circumstances

However, while dividend recaps offer owners several benefits in terms of diversifying the net worth and creating liquidity, there are potential risks.?The most obvious is that a recap increases leverage without a commensurate increase in revenues or cash flow.?If an economic downturn occurs while the company is paying down the debt, the company may become significantly weakened. Added debt may also preclude the company from pursuing new opportunities and/or constrain day-to-day operations.

While owners of private businesses may have fewer options for taking cash out of their businesses than public company shareholders, many options do exist. Owners should evaluate carefully their financial goals, the health of their company and the broader economic climate before embarking on a dividend recap, any type of leveraged recapitalization or any new financial event for that matter.

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About the Author

Chuck Doyle, CTP, is Founder, President and CEO of BizCap (Business Capital since 2002). BizCap delivers the best available cost of capital and industry leading structure to middle-market and lower middle-market companies seeking innovative financial strategies. The Company’s experience and long-standing network of high-level relationships with capital providers across a variety of disciplines allows the firm to efficiently deliver solutions for clients, particularly when they need immediate liquidity at a time when conventional sources of funding may be challenging or unobtainable.