Podcast: Potential Changes to Capital Gains Tax Rates & How to Prepare

Mike:

Hi there. It's Mike Langford. Welcome to the Advisor Financing Forum, a podcast presented by SkyView partners. This week on the show, Aaron Hasler and I are joined by Dave Hinnenkamp, CEO of BergenKDV, a comprehensive business, financial and technology solutions provider that does a little bit of everything to help your business with whatever it needs most. If you swing by bergenkdv.com/about, and watch there do more video, not only will you learn a bit more about what they do, you'll get your money's worth and entertainment value as well. I promise. Really great video.

Mike:

We asked Dave to come on the show because of his unique perspective on the proposed changes to the federal capital gains tax rate and how it might affect the climate for RIA mergers and acquisitions. Make sure you have your notes app handy, because Dave is dropping some serious knowledge bombs in this episode. And if you find yourself inspired or curious to learn more about the best path forward for buying or selling an RIA or independent financial advisory business during a rapidly changing landscape, please feel free to reach out to the team at SkyView by swinging by skyview.com or if you're feeling old school, pick up the phone and give them a ring at (866) 567 6282.

Mike:

Lastly, before we get rolling with our conversation, please make sure you subscribe to the show on Apple podcast, Spotify, Stitcher, or YouTube, if you're feeling fancy and want to see how amazing my man Aaron looks now that he's got himself a haircut and he's out of the bunker and in the SkyView office. You're going to want to check that out. And if you have questions or suggestions for guests or topics for the show, please shoot us a note at podcastatskyview.com or hit us up on the socials. SkyView is active on LinkedIn, Twitter, Facebook, Instagram, and YouTube. We would love to hear from you. Okay. Let's get to our conversation with Dave Hinnenkamp. Well, Dave Hinnenkamp, Aaron Hasler, so awesome to see you gents. I didn't know we were supposed to coordinate the color blue. I'm a little darker blue. You can't tell, it almost looks black here, but welcome to the show. It's great to have both of you.

Dave:

Great to be here.

Aaron:

I can't speak for you two, but I look good.

Mike:

This is true. Well, for those who are tuning in and have seen you before, Aaron, two things are noticeably different about you. Number one, your background looks a little different. You are no longer in the Hasler bunker. You're you're in the SkyView offices, which is awesome. You also look like you've got a haircut and are not wearing a baseball hat for the first time, I think, ever on one of these shows.

Aaron:

It feels good. I must say. Everybody's kind of survived the pandemic in their different ways, but it is nice to be back in the office and start to feel like we're getting back to normal. I'm looking forward to this.

Dave:

Yeah. And actually, when you think about it, when we see ourselves on video, we haven't done that for a long time. The pandemic brought that about. So, I look at it from myself. I look at you two and you're much younger than I am, but I've got a delusional mirror in my house here. So, when I look into that delusional mirror, I see someone that's 25 years old and I look like I did back then. So, I look great too. So, great to be on the show.

Aaron:

Great, yeah. Welcome.

Mike:

[crosstalk 00:03:28]. You ever see that Seinfeld episode with the skinny mirror episode where they talk about it. I think Elaine goes and she tries on some clothes and then she gets home and she thinks it's terrible. She's like, "Oh, skinny mirror in the dressing room, it made me look amazing. And I get this home and I look terrible."

Dave:

I did, I love the Seinfeld series.

Mike:

That's wonderful. That's wonderful. Well, Dave, I'm so thrilled to have you on the show, because the stuff we're going to be chatting about today, capital gains tax stuff, at the high level, I know a lot of people are like, oh, this is super nerdy, but it's really important. And I can geek out on it in a fun way, I think. And I think the two of you will as well. There's so much interesting stuff here.

Mike:

And a lot of it will have an impact on advisors that are considering entering a transaction. So, whether they're there on the seller or the buyer side, this is going to come into play. So, I thought a great way to start us off might be with some of the fundamentals on capital gains tax to ensure that everyone is kind of on the same page here. So, why is the tax rate on capital gains different than the taxes we see on ordinary income? What's kind of the origin story there, if you will?

Dave:

Yeah. That's a great question, Mike. Going way back, the whole idea behind having a favorable tax rate on capital gains ... And let me say first, throughout this show, when we talk about capital gains, we're going to talk about long-term capital gains held more than a year, as opposed to short-term capital gains, held less than a year, because short term gains is most, I believe now are taxed at whatever the ordinary rates are. So, long-term capital gains, or we'll just call it capital gains have had favorable treatment over time, simply because it was a great way to incent people to take risk, to invest. So, if I have a choice in buying a bond or investing in some company that might go out of business, obviously I want a greater return on that other investment on the one that I've got more risk with. So, having favorable capital gains rates was a way to ensure that people would take those risks. So, it was an incentive to take those risks.

Mike:

That makes sense. And we think about that as a business owner. I want to keep investing in a business and if I sell my business, I want to take that, what I've gained from that business and maybe invest it another business. So, as if I reduced my ability to invest. I can't buy another business. I can't hire more people. Yeah. So, really-

Dave:

Right. And if the tax rate gets too high, then people won't sell those businesses and make the next investment. They might just sit on that business. So, there've been incentives over the years to get people to take risks. And that's really what has driven the American economy for many, many years, small business.

Mike:

Yeah. Yeah. It makes sense.

Aaron:

And has that capital gains rate, Dave, always been lower than the regular income rate historically?

Dave:

With the exception of three years, 1988, 1989 and 1990. And I might be off by a year or so, but in those years, the capital gains rate was the same as the top ordinary rate at 28%. And that was the only time period. So, it was a very brief time period in history. So, when you look at the capital gains rate, if you go way back, there's always been a difference between almost, with the exception of those three years, there's always been a difference between the capital gains rate and the ordinary income rate.

Dave:

So, if we just take a couple of spot checks, if you will. So, 1954 of the capital gains rate was 25%, but the top marginal ordinary income tax rate was 91%. So, huge spread in that. And let's fast forward to 1977. At that time, it was actually the highest capital gains rate was just under 40%, 39.875. And the reason I put 0.875 is the proposal now is 39.6. But we'll talk about in a little bit that it might actually be a little bit higher than that, but in 1977, the top marginal tax and ordinary income was 70%. So, there's always been a spread, with the exception of those three years. And keep in mind when it was those three years when there was no difference, both rates were relatively low. So, there is, within history, there's always been an incentive to invest capital and thereby getting a lower tax rate on the gains relating to that

Mike:

Makes sense. So, let's talk a little bit about the proposed trade ... changes, excuse me, almost said proposed trades. Maybe trades has got to be a part of this, but the proposed changes. There are some changes to the capital gains tax and the Biden administration's tax plan that advisors may have heard about in the news. So, let's shed some light on what's happening there. At a high level, what's your understanding of the outline of the proposed changes? You mentioned that there's a potentially much higher rate that's there.

Dave:

The one most people hear about in the news is simply that if you "make over a million dollars", your capital gains is going to go to 39.6%. The top proposed marginal rate for ordinary income. There is in addition to that, there is something called a net investment income tax, the so-called Medicare tax. It was enacted a number of years ago, that adds 3.8% of that. So, effectively the federal rate would be at 43.4%. For those, again, "making over a million dollars". Now that terminology, especially if you have a tax background drives you absolutely crazy because what does it mean to make more than a million dollars? Does that mean your gross income is over a million? Does that mean your taxable income is over a million? It's almost as vague as pay your fair share.

Dave:

So, when I think about that, there's so many things that come into play when we think about it. And let's think about it in terms of someone selling a business as an example. The question is, well, if you make over a million dollars, the rate is 39.6 plus 3.8% net income tax, or 43.4%. What they don't provide you as information about, okay, well, exactly what does that mean? So, the first question you would have is should, or would the gain itself on the sale be used in determining whether you made a million dollars or not? Or is it everything excluding that? Should part of the gain be excluded? They don't talk about that. And then here's really the biggest thing. The biggest thing is this, if you think, well, why are they doing this?

Dave:

What they're really trying to do is they're trying to capture tax on passive investors who have huge gains, because they deem them to be "wealthy". So, your typical investor that buys a stock or whatever, it may be ... unfortunately, whenever you have tax policy, there are unintended consequences. And I think one of the unintended consequences here is the fact that you have business owners that have worked their lifetime building a business, and now they're in a position to sell. And it could be perhaps one of the most inopportune times to sell. So, the real question, I think, is this, should an owner who is active in the business be treated differently from someone who is merely a passive investor? Stated another way, should the rate hike only apply to taxpayers who report investment income relative to that gain on sale and not to taxpayers who report business income relative to the gain on sale.

Dave:

I think those things are going to be clarified yet as we move forward, because my belief is that it was not intended to capture the business owner who has built a business over their lifetime. And now is in a position to do a once in a lifetime sale that is intended to support them for the rest of their lives, what they've worked their entire life for. So, there's a lot that's going to be coming out yet. And I think we're just hearing what's on the surface. And I think that's the opening salvo, if you will, to negotiation. Even if it's negotiating not across the aisle, but within the democratic party itself was which right now controls, by narrowly, but controls the house and the Senate.

Mike:

You know what's really interesting? So, obviously we're not a political punditry show here, but there's some interesting elements to it. I'm always reminded of the quote from Michael Jordan years ago when people were giving him a little bit of a hard time, because he wasn't more politically active on certain things. And he said, listen, Republicans buy shoes too. And he sells sneakers. It was his big thing.

Aaron:

I remember that.

Mike:

When I think about this issue specifically, the way we were just talking about it, it's like, listen, Democrats own businesses too. There's lots of people and they're not, to your point. Some of them have had family businesses and invested 30 years of their life building that business. And they're like, "Wait a minute. You can tell me that when I sell this business, I'm about to get just much, much higher tax rate than I would have when the previous administration was in place. Let's pump the brakes a little bit here." So, I could definitely see there being, to your point, maybe some clarifying there. What have you heard? So, obviously you've got your ear to the ground when it comes to this types of discussion, because it's your biz. What are you hearing? Are you hearing that there's a lot of conversations about that, looking for clarification on these issues?

Dave:

I don't believe there's support in the Senate right now for a 39.6 rate or 43.4% rate. There are a couple of senators, Senator Menendez from New Jersey who comes from a State with a lot of wealthy people and business owners who has constituents that he is representing. He has already spoken and said, "I could support a higher rate, but not at that rate, not at 39.6." Senator Manchin from West Virginia is another one. So, I think it's going to be really difficult. Even the house, it's a fairly narrow margin, but I think it has a better chance of passing the house than it does the Senate.

Dave:

I think the Senate is going to be very difficult. The only way they'd get it passed is to go along party lines and have vice-president Harris cast the tie-breaking vote. I don't believe that you're going to have all democratic senators say yay to a 39.6% rate. That's my speculation. So, my thought is to sit back and pay attention to it. It is likely that we're going to see an increase in the capital gains rate. It unlikely that it's going to be as high as what Biden proposed. That would be my 30,000 foot view, if you will.

Mike:

Do you think, [inaudible 00:15:01], you made the really important distinction there of capital gains rate is kind of a blunt instrument, if you will, because it's treating, if I bought shares in a company and I traded them two years from now, and that treats that capital gain the same as if I sold my business. So, that's a blunt instrument. It's not taking into account ... We talked about the incentive.

Mike:

Why would we want to have a lower capital gains rate than ordinary income rate is because what we want to incentivize capital going to work, to do things, to build new businesses, to go for extra opportunities that as an example, green energy is really important for the future. So, you might want to encourage somebody to sell one business and then start building green energy businesses and so forth. So, have you got any indication that there may be the appetite to, hey, capital gains rate on stock sales. Passive income or passive investment, or is going to be higher than, again, to those you're active in the business?

Dave:

Right now they're not talking about it specifically. They're inkling along those lines. I believe that, that conversation is going to come up, because when you think about it, you could invest in a stock at any age. You can be 80 years old and buy a stock and decide whether you want to hang onto it. And to your point, I mean, it's a totally discretionary event. You don't need to pay capital gains taxes. All you do is you just simply don't sell that asset.

Dave:

However, if you're a business owner, it's completely different because you get to a point in time where for whatever reason you might have for family and personal reasons, it might be health. It might be, hey, you're burned out. You don't have the purpose and drive that you once had. And as I've gotten older, I will tell you, I don't have the same energy level. I can't sustain the same energy level that I was when I was in my 20s and 30s.

Mike:

No matter what that mirror says in your house. No matter.

Dave:

Exactly. Let's be clear. I look the same. I don't have the same energy level. So, I think it's incredibly important that, that distinction be made. Because in my mind, there is a huge difference between the passive investor and capital gains that come about as a result of passive investing and someone who's active in the business. And when you look at, especially at advisors service type business, most of it is capital gain, because you usually are not selling a lot of hard assets. So, I think it's an important distinction that has to be discussed. And I believe as time passes, it will be discussed. Now, history has shown that sometimes they pass a law only to find out a year or two later after getting a lot of pushback that, hey, you know what, we need to make a technical correction. So, sometimes those errors, or, hey, we didn't think of this, are corrected. And usually relatively quickly.

Mike:

Aaron, I want to get your take on what you're seeing and hearing from the advisor population. So, SkyView is in the business of facilitating mergers and acquisitions in the advisory space. So, some advisors are considering selling. And yeah, this is a great time for me to start considering to exit the business. Are you hearing advisors say, hey, what's the deal? Should I move quicker?

Aaron:

A tremendous amount of interesting questions about it. I would say for most advisors between their own businesses themselves and the clients they work with, this is their number one question. And then I think advisors are always accustomed to being the source for answers. And so to have something that's pending like this is kind of a stress point. And as Dave was kind of alluding to it, a lot of advisors have started these businesses from scratch. So, it's not like they have a large cost basis. The cost basis on these is typically zero, because they built this business up one client at a time. So, we're seeing a tremendous amount of stress and interest on it. Advisors wanting to speed up their timetable, some as early as September, or for sure by the end of the year.

Aaron:

And it's an interesting kind of conversation to have. I can understand it's stressful though, as you're dealing with, like you said, it's the challenge we have is that you have advisors that have spent 30, 40 years building up a business, and you always knew in the wealth management industry that say the market might be a risk or tax changes could possibly affect a sale. And we're working on some ideas on how to mitigate this and hearing Dave's expertise is awesome, but it's certainly a big stress and concern for our clients.

Mike:

Yeah, I can imagine so, because I'm sitting there thinking to myself, if I'm 65 years old and I've been thinking about selling this business or a chunk of the business, because I know that a lot of the advisors don't sell a 100% when they're ... maybe just going to sell half the business and bring on a new partner or whatever. This can give you some pause or give you like a ... Because I read something, I was doing a little research for this episode and kind of just going through like, will he bone up on my capital gains tax nerdery so I don't sound like an idiot on this. But there was one quote that I thought so apt, I guess, is the right phrase. It was capital gains is a discretionary event.

Mike:

You make a decision to sell. So, income, ordinary income is like, I'm making money. I have to live. I'm out there. I've got a job or I'm paying myself a salary for my business. I am earning income, but I guess that's discretionary too, you can be lazy and not make money. But it is really interesting. So, there's a decision that has to be made on the behalf of the advisor and the RIA ownership to sell or to not sell the business. So, this could absolutely have an impact, I imagine.

Aaron:

Yeah, I think the thing we struggled with a little bit too, is for a lot of advisors, it's the right decision to sell. At the end of the day what they're looking at is it's continuity for your clients. It's better care. It's often allows for the business to grow faster when you incorporate more people and add more services. So, it's a conflicting process here as you're you're saying to people, "Hey, this is the right time to sell." So, when you have the energy and your ability to transition your clients, tomorrow's never guaranteed. And in a relationship based business, we want to help people secure that work. And so to have pending tax changes like this come in, adds some stress to a already emotional conversation for a lot of advisors.

Mike:

You made the point, you started talking about sell when you still have the energy, you're still running the business. You don't want to let that decay. There's some risk to holding on. I mean, if you're sitting there going, well, tax rates may go up from in the 20s to 40. So, it might be freaking you out that you might have to pay all this extra money in capital gains tax in your brain, but there is some risks of saying, yeah, well, that's it, I'm not selling, I'm just going to stick with this business. The business could decay, right, Aaron?

Aaron:

Yeah. I mean I think at the end of the day, these businesses always have strong relationships and the revenue is consistent, but today's point, we all look beautiful on this call, but at the end of the day, our energy level probably isn't what it was 10, 20 years ago. I know in our house with a baby in the house, it aged me rapidly. There's a lot of wear and tear there that's happening for me. But I think that what we see is there are all these other factors for clients. It's client attrition through death. It's for older advisors not connecting with the inheriting generation and wanting to bring team members in to help fill that gap. And it's just the idea that at the end of the day we see it all the time, we get calls from advisors that they might get a bad diagnosis or a health event that really has an eyeopening experience for them, maybe a pandemic.

Aaron:

I don't know if anybody's ever experienced a pandemic before, but sometimes that can cause external pressure. And so we always are in the business of encouraging people to plan early, plan often, which is the advice advisors give their clients. And then have these scenarios where you can have several contingency options. But I guess I've always been somebody that's probably purchased insurance and looked at what are my protection mechanisms in place so that I can ensure my business lives on, my clients are taken care of. And that's the conversation we're having today. And it's always interesting.

Dave:

Aaron, I think that's spot on. And through the many years that I've advised clients on their businesses, what I've always stressed is look at the economic reasons for why you're doing what you want to do, not the tax reasons. So, the unfortunate part about this tax conversation that's in place now because of Biden wanting to raise the capital gains rate is people are looking at that and say, hey, should I sell? What I always say is, don't make taxes the number one reason you buy or sell anything. That should be a secondary or perhaps even a tertiary concern. Look first at, hey, what is my plan? And for many years I've asked clients, "Well, what are your plans?" "Oh, I plan to retire in five years." And I had a colleague once that said, "Well, you know why they say five years, don't you?" And I said, "Well, I guess I haven't thought about it." "Well it's short enough to be believable, but it's long enough that I don't have to do anything today." And I thought that was really intuitive.

Dave:

The point being, hey, have a plan. Whatever that is. It might be because of age. It might be because a burnout. It might be because of health. And not that you plan on that necessarily, but there are so many other reasons to sell your business or to start having that discussion. And then the tax side in my mind is at best secondary and in today's environment, what I would look at it and say is, hey, if you plan to sell within the next year and maybe even the next two years, well, yes, maybe you do consider, hey, should I do that a little bit earlier? But if your plan was to wait a few years, that's okay. But at the same time, I wouldn't. Let's say capital gains rates did go up. I wouldn't say, well, now I'm going to hang on until they go back down.

Dave:

I wouldn't do that either, because there are other factors that determine the price of the business. I mean, if you look at it right now, I think valuations are relatively high. You've got lots of dollars chasing the deals. Secondarily, I think the asset levels are high, because the market's been relatively high. And then there's this ... Yeah, exactly. Thanks, Aaron, I forgot about that part. And then if you look at the capital and special purpose acquisition corpse, I mean, they're the SPACs that you hear about. There are so many dollars out there. I want to believe in 2020 was that it was over $80 billion that was raised, which was six times greater than the year before, which was another record. So, there's so much capital. And by the way, they have to use that or put that to work within two years. But SPACs can go public in about two months versus about six months, if I want to take a company public.

Dave:

So, what they've done is they take these SPACs public, and then they go buy the company and rather than taking the company public itself. So, there's so much money out there that I think valuations are high. So, you know what, so what if I pay a little bit higher tax rate in a future year, if my valuation is so much higher, my net might still be higher. So, don't ignore taxes, but don't make that the driving reasons why you enter into a transaction. I don't know if that makes sense.

Mike:

A 100% makes sense. I mean, Warren Buffet often talks about that. He's like there was lots of wealth created when those tax rates were at that astronomical level you were talking about, the 70 to 90% ordinary income of top marginal rate. There were still people becoming millionaires back then. So, taxes, a friend of mine I always says, "I wish I could have a tax problem. Because that means I've made a lot of money." It's true. It's like easily. No, I get it. If you're an advisor and you're like, "Hey, listen, man, I've been thinking about selling this business for a little while. This is my plan. And now the tax rates are going to go up." But the point that you just made, Dave, I think is so apt is like, look, valuations have been going up, access to capital for our business acquisitions through SkyView is available where it wasn't only a few short years ago.

Mike:

You would have had to own or finance this deal. And now it's like somebody can come along and borrow the money at historically low rates and buy your business. And in my mind I'm thinking, well, we already know that there's a lot more buyers out there than there are sellers. So, just like in my neighborhood, there's almost no inventory on houses. And so I'm seeing some ridiculous prices and my neighborhood. Did somebody really just pay a million dollars for that house that I know sold for like 600 grand only a few years ago? Like, Hmm. That's interesting. So, I think the same thing is likely to happen with businesses. Are you seeing that too, Aaron? Have you been seeing like kind of valuations creep up lately?

Aaron:

Yeah, that's a good question. Yes. I mean the short answer is people ask that all the time and I have kind of two answers for them. And then usually it depends, because to some extent, valuations are going up, but we also are entering into an era of bank financing that hasn't been available before. And part of the reason that valuations were what they were, even three, four, five years ago was because there wasn't a way to finance these. It was really all seller financing. And so, it's been interesting to see during this pandemic is how much businesses have evolved and adapted. And there have been all of these talks about fee compression in our industry and the idea that advisors are going to be working harder for every dollar.

Aaron:

But what's been also happening is that as technology has gotten better, especially the tools in our industry, which really hadn't been invested in until about maybe six, eight years ago is advisors can do so much more with their time. So, they're providing these services anyway. We've seen some of that thread of fee compression not actually be realized. And then we're bringing in bank financing. So, I would argue that valuations are probably coming up to an appropriate level and I hope to see that they maintain, because the [inaudible 00:30:47] bank financier. But it does help that, like you said, the market has been on a long great run here. So, I think it's all of these factors involved.

Dave:

I think that's a great point, Aaron. And you pointed that out to me in a previous conversation that when you think about the bank financing side of it, you're absolutely right. It was very difficult in the past to get debt on an intangible asset. When you went to a bank, you could more easily borrow money to buy a Lamborghini than you could to buy an investment business. Because they had this hard asset that had some value, even if it was depreciating. And if you look at the investment business and you were the one that pointed out that this to me, and it's intuitive and obvious, but unless you think about it, it's not obvious to you.

Dave:

So, which is you have an asset that is increasing in value, because over time market returns are increasing the value of that asset. And I think that's an incredible point. And to your point, access to capital through bank financing. And I know SkyView has been active in helping with that. That's another key point and you're right. Values are high relative to the past, but are they high relative to what they should be? And I think your answer to that was no, I think they're coming up to where they should have been.

Aaron:

And I think it's interesting, one, is you can't wrap a wealth management business around a tree by driving too fast, I suppose you could do other things to it, but then you can't wrap it around a tree. But we always laugh because when we're explaining cashflow lending and finance to wealth management businesses, banks love tangible assets. And as we've proven through this pandemic is that all businesses or so many varieties of found new ways to create revenue and, or adjust and maintain their revenue. And that's what I think has been absolutely fascinating.

Aaron:

And I can't wait to five, six years from now start to read some of the books that, and articles that will come out about how all of these businesses have adapted and adjusted. But I mean, here we are doing a webinar and a conversation on Zoom. I've talked with Dave now, what, three times. We've never met in person. And yet I can see his face on a moment's notice, assuming I can log on properly. So, it's really created an opportunity for advisors to expand their business. And that's what I really liked about not just our industry, but I'm sure many industries is we've created new ways to sell a portion of the business or create a succession plan and then phase out over three or four years as opposed to doing an immediate sale. But I think we can get creative just like we've gotten creative in this pandemic.

Mike:

Very interesting. So, one of the things that came up in our prep call that kind of just logically jumps to mind here is if capital gains are something that are of significant concern to an advisor, and they're kind of feeling that they might want to hold onto the business a little longer. Kind of stay there. What are some alternative options that might not trigger a capital gains, but it will allow the advisor to kind of begin to exit the business or start to take some of that money off the table and kind of begin their glide path as the SkyView team calls it?

Dave:

Yeah, I think when I look at the options that are available out there, and of course we have to wait until we see what the final tax bill looks like, but let's assume for a minute that higher capital gains rates kicked in at a million bucks. At that point in time, what you could do is you could sell on an installment sale and make sure, work with your CPA, and make sure that you keep the income below that million dollar threshold. And another thing they haven't clarified is if you go over a million dollars is only the portion of a million that's taxed at the higher rate or everything once you hit that, in other words, is it a cliff? My presumption is that only amount above a million. So, in other words, work to keep the income down as much as possible by doing an installment sale.

Dave:

And again, it depends upon the size of your business. Now, unfortunately what that does is it forces you to retain some risk. Because to the extent do you haven't collected the cash, you're still on the hook for it. So, again, I'll go back and say, hey, look at the economic conditions first before you make a decision based totally on tax. But one thing you could certainly do is to sell it over time and on the installment method. You get to defer that over a period of time for a vast majority of the gain that you have, which for advisors being it's largely Goodwill, customer lists. Those you would be able to defer on. Certain assets you have to recognize immediately, but that really not worth a lot of time on a discussion for the advisory type business.

Mike:

Aaron, you talk about this all the time though, that it's becoming, and we actually mentioned it earlier in the show, that it's becoming increasingly common for advisors to do a partial sale. That they're not going, hey, I'm selling the whole business, good luck next generation of advisors, I'm out going fishing. It's more likely that they sell 25% of the business and bring on a new partner and then gradually again, glide out over years. And then, so I'm 65 now, but I'm going to be completely out by the time I'm 75, but I'm not selling it all at once.

Aaron:

I mean, it is interesting. The wealth management industry has always been almost a lone wolf industry. A lot of these founders got in and started businesses as individual entrepreneurs. And didn't take on business partners and then grew large enterprises and hired people. And so the idea of partnerships and mergers for a lot of older advisors is challenging and something that they're not necessarily accustomed to. But what's interesting is through proper guidance here at SkyView, we have a business partnership, we have many people that have created the company of what it is today.

Aaron:

And so what we're finding is that with a little bit of work and ingenuity, advisors can create partnerships, but then we can cheat a little bit too, which is that we can use bank financing to our advantage. And one of the things that SkyView has really worked hard at is creating a 100% financing or liquidity for that business owner. But then you can use the resources the bank has, which is escrow accounts, putting some money into trusts. Dave mentioned the installment sale. So, what we've been able to do is say, okay, maybe you can finance a 100% of that business today, but then create an installment structure to keep below say that million dollar income threshold. So, I think in working with all professionals in this industry, we can come up with some really creative ideas.

Mike:

I love it. I love it. So, you started to dip your toes into this a little bit, Dave, and for those of us who are, again, novices at this concept of capital gains, as it relates to an advisory business, maybe you can share a little bit how that's calculated. Because in the traditional sense, capital gains is, hey, you bought something at one price. If it is a business or an asset and you made some improvements to it, you get to put that into the capitalization of that. And when you sell it, whatever you sell it for, minus what you bought it for and the improvements you made, that's your capital gain. When we look at an advisory business, because there's no assets there, is it really all capital gain? Like you started this business from zero, you grew it, congratulations, you have a 100% capital gain or are there other components to it?

Dave:

I think you nailed it from that perspective, Mike. So, if we run through a very, very simple example of let's take a piece of equipment. I buy a piece of equipment for a $100,000. I depreciate that piece of equipment. And when the depreciated value is 50,000, low and behold, for some reason it appreciated in value, I'm able to sell it for 110,000. So, my gain at that point in time is 110,000 minus my, it's called tax basis or 50,000, because I depreciated down to that. So, my total gain is 60. All right. Of that $60,000 gain, $50,000 is due because of the previous depreciation that you took. That is calculated or taxed at a different rate than the additional 10 that you got above and beyond what you paid for it.

Dave:

The capital gain is that 10,000, the 50,000 is called recapture, which is a rate between capital gains and ordinary income. Now we're really digging into the weeds and really geeking out. But now let's look at an advisory business, but for maybe a few computers and things of that nature of vast majority, like Aaron had mentioned, is, it's people starting a business from virtually nothing growing it over time. And really what they've created is a customer list and an income stream that suddenly has a lot of value to the marketplace. So, what is your tax basis in that? Well likely nothing, because all of the expenses that you incurred in building that you wrote off each year as you ran your business, so your tax basis is zero. So, if your tax basis is zero, when you sell that asset, it is all 100% capital gain if you held it for more than a year, which I don't know, I guess if I could grow a $30 million business in nine months, I'd take the short-term gains and pay it and say, thank you very much.

Dave:

But in all these cases, obviously, it's a lifetime of labor and love. And you've built a business and it will largely be all capital gain subject to the capital gains rates. And what I mentioned earlier is I think there's a huge distinction between generating a capital gain in that matter versus, hey, I passively bought an investment and it increased in value, because I held it a long time. So, that's the real basics of how capital gains are calculated for the advisory business. And like I said, there are some exceptions to that if you have some hard assets, but it's relatively inconsequential to the whole deal.

Mike:

Fascinating.

Aaron:

Yeah. And per your comment earlier though, Dave too, I think in looking at the glass is half full approach, is that the benefit of even though there's not a lot you can depreciate on these investment advisory businesses. I think the advantages for the most part, I know compared to a lot of other industries, the margins are higher. And so that's been, the benefit is, you don't have a huge infrastructure that you've got to go higher and you can service and charge a good rate with relatively strong margins, which is how we've been able to prove that these businesses have value, have transferable value and are bankable because of that margin. So, it can benefit in a number of ways.

Dave:

Yeah, and I can confirm that. So, at BergenKDV, we've got a number of different businesses, but if I look at the CPA business, the technology business and the wealth business, and I just look at those three. Well, both the gross margin and the net margin is higher for the wealth management side. Now that doesn't mean the other businesses aren't valuable. Of course they are, but the margins are higher there. But there's also more volatility because the price will change as the income changes as well with changes in the market. So, it's what you stated is absolutely right, Aaron.

Mike:

Very, very smart. Well, as we're thinking about wrapping this up here, I imagine advisors listening to this are like, oh, I have some questions. I want to start digging into this. And I would encourage the advisors who were starting to think about buying or selling a business to dive into this topic a little bit deeper and talk to a CPA who knows this space really well, such as yourself, Dave. How should an advisor work with their CPA firm in a rapidly changing environment, like the one we're in, to make sure they're prepared and ready to either, as a seller or buyer, to move in the right direction?

Dave:

Yeah. And I think it would go beyond the CPA, Mike. I think when you look at SkyView, for example, if you're in the business of helping companies sell a business, I think the key, whether it's CPA or the whole team, there has to be great communication. So, let's be talking to our client about, hey, what is it that you want to accomplish? What is your timeline? And then as a team, how can we structure it to maximize not only what we make, but what we keep. And I always tell the story about what caused me to think about, hey, we should start a wealth management business. And it was going back to my days of tax planning, where I would do some tax planning for a client and at the end of the year, after the end of the year, I would get all the information.

Dave:

And here, unbeknownst to me, a broker would do a transaction that blew up my tax planning. It wasn't the broker advisors fault. They're not tax experts. And I didn't think, hey, maybe I should call the broker and have a conversation, but the broker didn't either. So, the key there is, you've got to have communication that takes place. And it's so easy in today's world to communicate, look what we're doing now. It's easy to connect with someone. So, putting together that team, and it's not just the CPA and the client, it's also the advisor. So, here in SkyView, when you're working, you want a team of advisors. That's how we go about doing it. So, communication is the key and all parties understanding what it is their role is in that process. And then keeping the client at the center of the conversation, making sure we accomplish what the client wants to accomplish. I think those are the keys to making it work.

Mike:

Fantastic. And, Aaron, I assume similar advice on your end. So, as advisors or this is rattling around in their head, how does this impact me? How does this impact me? It's probably a smart idea for them to reach out to you and the SkyView team to talk a little bit about this to walk it through. You've actually navigated these waters quite a few times with advisors.

Aaron:

And it's a relatively new concept. So, the fact that advisors don't know this in detail is understandable. And to Dave's point, the old commercial was, if you stayed at a Holiday Inn Express, you'd somehow have greater knowledge. I think I can stay at a Holiday Inn Express every night, and I wouldn't even get remotely close to Dave's knowledge about taxes. But what we enjoy is getting on with all of the different experts and learning all this stuff. I mean, this has been a fun conversation and fascinating to hear Dave's perspective and guidance on this. And so we do this all the time with clients, which is get on the phone with their CPA, get on the phone with their legal team, talk through ideas. And we love to, as we're going through these bank financing deals, is we love to hear about the deal structures and have insight from other advisors on how they've structured things, how they've merged partnerships.

Aaron:

It really gives us a window to a number of transactions that we may not have necessarily been involved in the detailed planning, but as we're going through the bank financing, we can see them in absolute detail. That gives us an interesting advantage. And I love getting on the phone or on these Zoom calls and collaborating with the different partnerships and brainstorming ideas. You walk away really energized and creating some solutions that are funded and used as a tool going forward. So, we love to bring in those teams and love to collaborate.

Mike:

Fantastic. Well, Dave Hinnenkamp, Aaron Hasler. It has been fantastic, as you say, Aaron, getting together, seeing each other face to face here over the screens. And I am looking forward to seeing the two of you sometime live in the next six months or so. We will be like hanging out enjoying beverages, maybe recording another one of these things. So, thank the both of you for joining us today on the Advisor Financing Forum. Wonderful to have you.

Dave:

Thank you very much.

Aaron:

Thanks, Mike. We appreciate the opportunity. And as you know, it's always much warmer up here in Minnesota than it is in Texas. So, come up anytime.

Dave:

We'd love to see you as a three-dimensional person.

Mike:

That's right, exactly. I promise you, I'm not just on a screen. Awesome. Well, thank you, gents. I appreciate it. Have a good one.

Dave:

Thank you. Have a great day.

Mike:

Thank you very much for listening to, or watching this episode of the Advisor Financing Forum podcast. It's always a pleasure to have you with us. I hope you found the show informative and actionable, but not panic actionable. Remember, a measured well thought out approach is always best when it comes to selling or buying an RIA business. Make sure you subscribe to the show on your favorite podcast platform or YouTube, if you haven't done so already. We are working on a lot of great content and you're not going to want to miss any of it. Here's thanks to Dave Hinnenkamp for joining us as well. I absolutely loved Dave's style. He really has a way of making it easy to understand complex topics while delivering guidance with a bit of a chill vibe. You just feel like you're in good hands with Dave. So, check them out at bergenkdv.com when you have a moment.

Mike:

And before I let you go, make sure you swing by skyview.com to learn more about your options for financing to facilitate your plans for buying or selling an RIA or independent advisory firm. The SkyView team is always there to help. Lastly, welcome to the home stretch of the pandemic. When you get your chance, take your shot. We are so close to opening the world back up again and see each other in person. I can't wait to be in person with the SkyView team recording one of these shows across the table from each other. It's going to be amazing and maybe we'll put together some sort of live event and you can come join us. That would be awesome too. All right. In the meantime, keep listening and watching the show. We will see you next time on the Advisor Financing Forum podcast. See you, bye.