In 2003, the Bush Administration faced a myriad of problems negatively impacting the U.S. economy. Such problems included a two-year-old recession, depressed public equity markets, the aftermath of 9/11, and the corporate regulatory fall-out. In an effort to spur economic growth, the Bush Administration implemented a series of tax cuts aimed at individuals to foster discretionary spending and economic expansion. The tax cuts included a reduction in the top federal income tax rate from 39.6% to 35%, a reduction in the maximum dividend tax rate from 39.6% to 15%, and perhaps most relevant to business owners seeking liquidity, a reduction in the capital gains tax rate from 20% to 15%. As the current administration’s term comes to a close, the next President and Congress will be responsible for enacting a tax code to replace the Bush tax plan that is set to expire in 2010.

Unfortunately for business owners, the Bush tax cuts are expiring regardless of which political party occupies the White House in 2009. With a Democrat administration, there is a high likelihood that new tax codes calling for higher taxes could be put in place as early as 2009. Under this scenario, business owners seeking to sell their companies may be subject to a significant tax increase on the portion of their business that is subject to capital gains treatment. With a Republican administration, an extension or revision of the current tax policy is the most likely scenario. However, this process could experience resistance depending on which party holds congressional majority. Under either scenario, an increase in the capital gains rate is likely.

What does a potential tax hike mean for business owners? While the magnitude of change is unknown, estimates of an increase vary from five to fifteen percentage points. Weigh this against a struggling merger & acquisition (M&A) market over the past 18 months (due primarily a reduction in credit availability and stringent equity requirements), and it is easy to see why many business owners are struggling with the decision of when to execute exit or liquidity strategies. Further complicating the matter is the overall instability of the U.S. economy, which has kept many buyers and investors on the sidelines.

The 2003 capital gains tax cut enacted under the Bush Administration proved to be quite favorable for the M&A market. In fact, the tax cuts coincided with a record rise in M&A activity. In the year preceding the tax cuts, the number of announced middle-market transactions fell 10%. From 2003 (when the tax cuts were implemented) to 2007, the number of transactions announced each year increased at a compounded annual growth rate of approximately 9.1%, from just over 9,000 transactions in 2003 to over 12,800 in 2007. While deal volume growth over this period was attributable to multiple factors, including favorable debt and equity capital markets (except in late 2007, when lenders significantly tightened credit policies), a 25% reduction in the capital gains tax from 20% to 15% encouraged business owners to sell.

With a potential increase in the capital gains tax looming as early as 2009, it is not too late for owners to re-assess their exit or liquidity options, and exploit tax minimizing strategies. As a result, pursuing a sale ahead of a likely tax-hike may be the best strategy. If a full or partial sale is not planned, but a liquidity event is desired in advance of a likely tax hike, other alternatives exist, such as a debt recapitalization.

Waiting several years to consummate a transaction until debt and equity markets recover could result in lower proceeds to the seller due to a higher capital gains tax. Although transactions in today’s market will likely attract lower valuations, sellers may be better positioned to maximize after-tax proceeds by taking advantage of the current 15% capital gains tax. In summary, while uncertainty surrounds the future of the U.S. tax code, particularly the capital gains tax and its impact on M&A transactions, there will likely be a different tax policy in the near future. Are you ready?