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Unbridled Capital

Season 2 Episode 13: Tax and Legislative Changes Affecting Franchise Valuations

Podcast

12.16.2020

Also Listen On:

How might looming tax changes affect the valuation and timeline of selling your business? Rick discusses the following topics and more alongside Dan Clift and Jim Ball, two tax experts:

1. Changes in Your ‘Sale Horizon’
2. Shifting Political Landscape
3. Looming Tax Changes
4. PPP Loan Forgiveness and Taxation

Welcome to the Restaurant Boiler Room, Season Two, Episode 13. I'm your host, Rick Ormsby, Managing Director at Unbridled Capital. Today in the Boiler Room, with the elections mostly behind us, we will be discussing possible tax and legislative changes that could affect franchisees in the operation, financing, and sale of their businesses in 2021 and beyond. I've invited two tax experts to share their expertise with us, Dan Clift and Jim Ball. These guys are excellent. It should be a very informative session for everyone.

The Restaurant Boiler Room is a one-stop shop for multimillion dollar merger and acquisition activity and financial complexities affecting the franchise restaurant industry. We talk money, deals, valuations and risk, delivered to the front of franchisees, private equity firms, family offices, large investors and franchise owners on a monthly basis. Feel free to find our content at Unbridled Capital's website at www.unbridledcapital.com. Now, let's enter the Boiler Room.

Welcome everybody to what we're calling the Tax and Legislative Changes Affecting the Franchise Valuations. I mean, this is a topic that is getting a lot of attention right now. Before I introduce our tax experts and good friends of mine, I'll say this, it was after ... I'm not a very political person, but I'll say it was just after the election was made to Biden, that Saturday, whatever that Saturday was. On Monday, I got I think almost a dozen calls from large franchisees saying, "What is this going to mean to the sale of my company?"

At that point in time, I kind of realized this is a topic that affects a lot of us, especially in a big life changing event like the sale or financing or the acquisition of a company, you are at a milestone event and recognizing a big tax event. You're obviously, if you're a franchisee looking to sell your company, you're clearly as interested or more interested in the net number than you are the gross number. So, this is one that hopefully you'll find applicable. Again, these are just going to be opinions, but hopefully they're good opinions and you can use them or follow-up with this any time afterwards.

You know me. I'm the ugly guy over there on the left as you're looking at the screen. I wanted to just quickly introduce Dan Clift and Jim Ball. Dan is Managing Partner at William Wetterer and Company. He's just an excellent guy, very, very smart guy. He's a managing partner there. He's a great CPA, gives a lot of good advice as it pertains to high net worth individuals and businesses. He's got a good perspective on tax that I think will be really valuable for you to listen to. He's located, as Jim Ball is, in Louisville, Kentucky.

Now, Jim Ball, interestingly enough, is Derek Ball's dad. Derek works for Unbridled Capital, as you know. Jim started off at the IRS. So, we didn't like him. Now we do. He's an attorney, got his law degree and focuses on estate planning, high net work individuals and has a great perspective on tax. The two of these guys together are like peas in a pod. So, thanks again, guys, for joining us. Welcome to the webinar.

How much do we owe you for that introduction?

Hey man, I'm all about spreading the love. You know know what I mean?

Yeah, yeah. Well, you also forgot to mention that Jim in his former life was also a CPA too.

Oh. I knew that actually. Sorry I didn't mention that. What else were you, Jim? Did you use to jump tall buildings with a single bound?

I really can't talk about that, but [crosstalk 00:03:30] another day.

How cool is it, as a side story, that ... I mean, I can share this, I guess. Dan is my CPA. As I was meeting Dan, he said, "Hey, Jim Ball's a friend of mine, and he's got this kid named Derek who you should talk to about coming to work at Unbridled Capital." That was about four years ago, and Derek's turned out to be one of our key folks in the company to help it grow. I don't know, man, it's a crazy little world we live in.

It is a crazy world. It really is.

Okay, so here we are, summary of discussion. I mean, I'm going to go through the first slide, spend a few minutes on it. Then after that, I think I'm going to turn it over mostly to these gentlemen so you can hear their expertise. They're going to talk about the shifting political landscape, some of the looming tax changes and what it might mean to you. I want to talk a little bit about the PPP loan forgiveness and taxation program. There's been some stuff come out today, guys, that I've been reading about a second round of PPP for people that have less than 300 employees. We experienced one quarter of 30% sales drop, a revenue drop over last year could apply for second round of it. That's something we may chat about, because it personally pops into my mind.

I want to talk about estate planning. I mean, I've been getting a lot of calls, I know you guys have been too, about the estate planning exemption may be changing and what that does for franchisees and for business owners. Then I think we'll spend some time talking about flexibility and what to do as you think about what's going to happen or what could happen to our tax and legislative situation. Then we'll answer some questions along the way. Does that sound okay with you guys?

It works.

Awesome. Okay. Well, I am going to refer a little bit to my notes again. I was just jotting down today, where have we been in 2020? Humor me for a few minutes. January to March 11th, before ... I can kind of consider the day that everything fell apart with the pandemic. We were in an environment where sales and profits for most brands were largely flattening. Margins were a little bit under pressure. You can remember that there was a big push by franchise owners for development, development, development. So, the storyline starting the year in 2020 was largely one of these of there's too many restaurants. Sales have flattened and headed downwards nationally across all of restaurants. Traffic was under siege because of overdevelopment and a little bit of moderating consumer spending.

So, you started seeing seven or eight, five or six of the national lenders in the franchise space kind of pull back. A couple of them stopped lending actively, shut down their franchise lending arms. Some others were quietly ratcheting back their lending platforms. M&A prices were still strong. There was a pretty good equilibrium between buying and selling companies. So, prices on a EBITDA basis and cap rates were largely kind of flat. I would express it as slightly beyond the crest of the wave. Margins for franchisees were a little bit under pressure. They were a little bit under pressure.

So, we jumped into March 11th. Unbridled had just received a Deal Maker of the Year Award down in Dallas for the Franchise Times for selling a hundred unit Pizza Hut business. Then as we were down there, wham, it all changed. I know each of you who's listening here can think about the fear and the confusion and everything related to it. If you own a business and you stare at the ceiling at three o'clock in the morning like I did ... I think about it like I know where I was in middle school when the spaceship blew up. Obviously I was at Vanderbilt MBA school preparing for a final exam when the Twin Towers came down. I mean, I will never forget where I was when, and I'm sure you won't either, when the COVID pandemic really hit.

We were all shocked. We were all shocked. We come into May. The PPP program was pretty widespread. Not a big believer in government programs, but I'll tell you, I think it really did a lot of good in getting capital in the hands of these businesses and had it filter through to employees and the average public. You started to see, quietly speaking, some franchisees and certain brands really start doing well. I know we eventually ended up selling it, it was like a 70 unit Sonic business, Buddy McClain's business in the Southeast, mostly in Florida and then up in Alabama too. We started learning that the Sonic brand was one, and so Wingstop and anything that had delivery and drive-thru, sales were all of a sudden up 20 and 30 and 40 and 50% year over year every day.

We started seeing the resiliency of people wanting to eat out, but they weren't doing it in casual dining and largely not fast casual either. They were doing it in QSR. So, we started seeing that. In the May timeframe, you started seeing a big push to pizza and to chicken. Obviously pizza is easy to understand why pizza was a concept that you can get it delivered, you can carry it out. It's easier to be contactless. Chicken was one that was a little surprising. Maybe because of the ability to order it for a family and the fact that it transports and it reheats well. Chicken QSR business really took while burgers and tacos were lagging a little bit.

You get into June. A lot of our deals had frozen. We just took all of our clients and said, "Hey, let's pause. Let's stop. Let's increase due diligence periods. Let's stop the APA negotiations on our assignments for a couple weeks." We were just trying to create time and space to see what was happening. In June, our deals started kind of coming back. We thought at first that it was going to be one of these situations where you would have the re-trading happening. A $20 million business we were selling would all of a sudden get re-traded to 16 million, but it wasn't happening. It was because sales and profits were up and there were enough lenders that were stepping back into the space seeing the strength of QSR and the buyers saying that these businesses look like they're COVID proof that lead to prices staying strong and deals actually continuing to happen that were in process.

We got into kind of the July/August timeframe, and QSR sales continued to strengthen. Dining rooms were still largely closed, as many are today. So, profits were up even more than the flow through on the dollar increase in sales would justify. You had this mushrooming effect on the bottom of the P&L. On the causal dining side, you started seeing bankruptcies. We started seeing clients generally start ask the question, "Is it maybe time to sell? I was a little afraid coming out of this pandemic, but my business is up. I'm willing to take what I was willing to take before, maybe a little less. Is now the time to do this?"

If there's anything that you hear about the M&A market from me today, it's going to be that the impact of supply and demand is probably more powerful than just EBITDA or any other little driver. At the time in July, August and September, there weren't any deals on the market. We put like five or six deals on the market. When we did that, we had way more interest than I thought. It was because there was plenty of demand. If there had been 10 buyers on the average deal, maybe now there's eight. A couple of them went away. Some family offices and private equity firms are investing in airline industries and other places that were in trouble, so they had to cover their losses and they didn't want to expand.

A lot of those folks wanted to come back into the restaurant business because of its stability on the QSR side, and you didn't have any businesses for sale. So, we put these business on the market, and lo and behold, had a lot of interest and prices were up. The multiple stayed about the same, but the actual EBITDA, these businesses, really was increasing and the marketplace was recognizing the that strength of the industry was leading to higher prices. So, a really smart move by some of these guys to jump out and get in front of it when the supply was low and the demand was still there.

We now trail into November and December. Things are a little bit quiet. This is where we find ourselves today. I know I've been rambling, but I thought it would be a good time to give you the past year as we go, "Woo," and we count our blessings for still being here even amidst all the fear we felt in March. We find ourselves here now in November and December. We're looking at a political change. We're going to have a new president. We're looking at still some continued craziness in Congress. We don't know what the Senate will do. We're going to opine today on what potential ranges of legislation and tax changes could be in play and how that might not only impact the sale or financing of a company but also, like I said earlier, impact the supply/demand curve of M&A in early 2021.

That's all I've got, guys. Let me say, before I move on, the punchline is going to be this for me. Then I'll let these gentlemen speak. If your horizon to sell your company is within the next five years or less, say the next two or three or four years, I'm here to tell you that you do not do yourself any favor to wait any longer. If your goal is to continue to build a perfect P&L until May of 2021 on a TTM or trailing 12-month basis, I'm here to tell you that when your deal goes into due diligence, unless you can lap last year's sales, you're going to be re-traded. You're going to be re-traded if you have significant sales declines during due diligence. It's going to be like catching a falling knife. So, don't hold out for the very last dollar of EBITDA in your P&L.

In my mind, there's so much murkiness with tax increases and minimum wage increases on the horizon that you would be unwise, I think, to not heavily consider selling soon or now if you have a horizon that's small. If you have a longer horizon, then it doesn't matter. You'll see another upside and downside and a couple valleys and peaks between now and then. You should be thinking today instead on legacy and estate plan, which we'll touch and talk about.

Okay. Here we go. Shifting political landscape. Gentlemen, I want you guys to just kind of weigh in. Now I'm going to talk a lot less. Go for it. Tell me what you think as you guys look at the tax and legislative changes.

Go on, Jim. You go first, brother.

Obviously we don't know what's going to happen with the Senate. So, all of this stuff that we're talking about today that we think could happen, certainly that Mr. Biden would like to have happen, you've got to take it all with a shaker of salt because there's no way he's going to get everything that he wants. We're going to lay out what it is that he's talked about over the last several years and more recently in terms of what he would like to see in terms of changes in the tax law. Whether he's going to get those things or not, because some of them are pretty darn drastic, and even some Democrats like Senator Manchin of West Virginia, had indicated that [inaudible 00:14:02] with some of the more drastic stuff.

So, he's going to have to, regards to what's going to happen with the Senate, he's going to have to pull in all the senators from the other side at least. I think we have to assume that there's going to be some of these changes. We don't know what's going to happen in Georgia until what happens in Georgia. It looks like even though there's still some little battles going on, it looks pretty much written on the wall that Mr. Biden's going to be the President on January 20th. We know what his intentions are. We just don't know what he's going to be able to get through.

I would echo that too, Jim. I mean, I think the main thing that you have to be concerned about is being a little bit flexible as you're going through this. You've got to know what the potential is. Taxes are probably at the lowest you're going to see in the next few years. They can't go any lower. I don't think that's going to happen. I think you go back and you think about what happened when Trump was elected, and he was going to make all these drastic changes. It took him a couple years to actually get that through.

You've got the same thing that's going to happen for Biden. A lot of Democrats are going to be up on the midterm elections. What's going to happen to Congress at that time? Folks are going to be a little bit more conservative than all out. That's important, but as we're going through this, think about what makes sense. Don't let the tax tail wag the dog. Rick, your comment about getting calls after they called the election for Biden, I got the same call. I got a dozen of them and, "Hey, we need to close the transaction." I've got $100 million transaction and a couple others going on, and they're like, "We're done. We're going to close it right now."

So, that put you in a very quick maneuver. Sometimes it's hard to recover from that from a tax standpoint. When you look at it, don't let the tax tail wag the dog, but be very tax mindful as you're going these things. If you have a little bit of advice there that you can spend your money wisely, it makes a lot of sense and you get a little bit of return on that. That's it. That's what I wanted you to show, Rick.

Yeah, I thought this was a pretty interesting thing. I mean, the election betting odds, it's kind of a funny thing. That's way better than listening to the stupid news channels, because they're so wrong. I mean, I don't know. What do you think?

Yeah. I'm still impressed that Donald's got a 9.3% chance. Right?

Yeah.

I don't know where that chance comes from. The real important thing is what happens in the Senate. If the Republicans can hold and pick up one seat, they sit at 51. So, right now we're going into this 46 Democrats, two ultra-Democrats, Bernie Sanders and Augustus King on the Left. Just call them ultra-Democrats. So, you've got 48 to 50. We've got two seats up. Right? If the Republicans, and it looks like on the betting odds it's 71%. Interesting, last time we were looking at these things, they were changing as we were just talking. Weren't they?

Yeah.

So, they'll move again. Watching that, how many friends do you have that moved to Georgia to get in on the election, right? That throws that out as an important issue. The concern was that Biden's going to automatically raise capital gains tax to 40%. Is that a reality? Maybe. We're looking at that. He wants the means test, that is when you have over a million dollars. Any transaction that we're talking about is going to be over a million dollars and it's going to be potentially at that higher rate.

How quickly is that going to come? If you're looking at ... I think you're wise. If it's a five year time horizon, he probably gets tax reform done in four years, but I don't know that it's going to be tomorrow. It's probably not going to be five years from. You've got to weight that in your decision. Again, it's a tax tail wagging the dog. If the tax tail goes double, that's a pretty big tail.

Yeah. That's not a tail, that's ... I don't know, man. What is that?

Extra appendage, right?

Yeah. I mean, that's like the torso or something. I don't know.

Right, right.

Like a kangaroo tail maybe. Kangaroo tail.

Yeah. Really well said. Let's ask this question, because I hear this question a lot. No one has the final opinion on this, but a couple of things. What do you think the likelihood of tax increases is retroactively, number one? Number two, we've had a couple of franchisees who are very well connected politically that say some of the blue dog Democrats are going to vote against tax increases potentially, especially I keep hearing Joe Manchin in West Virginia. I keep hearing that name over and over again. Any comments on either of those two? Those things impact people's transactions, so everyone here is listening ears.

I mean, the media told us that it was going to be a blue tsunami. Looking at the polls prior to the election, it was going to be a landslide 10 or 15 percentage points. We didn't get that. The appetite maybe wasn't what they portrayed it to be. I say they as the media. I'm against the media, not to pick a political side, but they kind of lead us in a direction. Will it change? Will it be drastic? I don't know. We were talking about conspiracy theories at that time. We've talked about that. Were going to read something into the law during this lame duck and then come back and make the tax as retroactive? I don't know that that's a high risk right now.

It really has a lot to do what happens in January. On January 5th is really the tell. If they hold the seat, then we can feel pretty good that they can't pass tax legislation without Senate approval. So, that's a big holdout. Jim, I know you've got some more comments about the specific senators and the West Virginia and what not. So, your shot there.

Actually, I wanted to touch a little bit more specifically on tax changes being retroactive. In the past, and you all have probably seen this and wondered about it, you'd see some law that's effective July 23rd, 1984. You're like, how in the world did they come up with that date? Somebody must have known somebody and they had a transaction that occurred on the 22nd, so they wanted it exempt from that tax. In reality generally, and it's just a bearance issue really, it's unfair to make a tax change that's unfavorable to the taxpayer without them having notice, because let's say you're selling a franchise or any other business deal and you're doing it based on what you know the law to be. Then they change the law back to the date before you made the deal. If you had notice of that, you might have done the deal different or not done it at all.

So, it's always been the standard to not make a disadvantageous tax law retroactive to a date prior to some date when the public is deemed to have notice, for example, when it's first read in committee. That goes to Dan's comment. Even during the lame duck session here, they could introduce a tax bill that they think could maybe be passed next year. Therefore, let's say they do that on December 15th just to pick a day, they could maybe make it retroactive or make it effective on December 15th. Then they go a step farther and set not a lot but often enough, make it effective for that entire year.

So, there's a chance that they can make a law retroactive to 2000 to cover anything in 2020. I don think that would ever happen. There's too many of those middle of the road Democrats. You don't have a lot of middle of the road either party anymore, but there are several who would not permit that to happen, I think. I don't see anything being effected in 2020.

That gives us a little bit of a window of opportunity, potentially. I like Dan's comments too. I don't like them, but I ... I don't like them at all actually, but Dan's comments are that we're probably looking at a higher tax environment at some point. So, there is a window of opportunity here, and maybe we'll go to the next slide and just chat about that and let you guys opine about what is on the table, whether it's today, tomorrow, next week or next year. What are we talking about here? Conceptualize this for folks.

The main thing that you're looking at is, what are the rates? The conversation that Biden's having, and it was a conversation that everybody was having, is 20% corporate too low? He's thinking 27, 28%. It's kind of flat. There's no graduated tax in his belief. Then you come back to the individual side of things, and you look at a rate increase for those over a million dollars back to 39.6, which we're just calling 40%. What are the chances of that happening? I don't know if they move exactly back to those same things, but they probably change. They don't change for the better. They change for the worse if you're a taxpayer. It depends on which side you're on. Right?

A big important issue is, there is a break point on some of this. Five percent of wage earners in the United States make over 150,000, and they pay 85% of the tax. It's easy to pick on those guys. It's easy to pick on a franchise owner that's employing 100 and some employees. It's easy to pick on them, because they're making all kinds of money. I mean, that's the problem and that's the issue that's out there. Bernie Sanders loves that issue, doesn't he? I mean, he was beating up on that the whole time.

Biden shared some of that. When it's over a million dollars, we're going to put that into play. That might play. There's some Democrats that don't subscribe to that, some more moderate that we hope that stay on the correct side of the aisle and don't subscribe to that. The chances of the taxes going up I think are pretty high. It's hard not to think that they won't go up in the near term. Just the question is when. It's not the question of if. It's more of a question of when.

Some of the taxes you're talking about, corporate income taxes would be one that's definitely probably on the table, right? That is less probably ... I mean, not entirely inapplicable to the franchise community for speaking to a 30 or 50 franchisee in Des Moines, Iowa. Largely speaking, they're going to be operating through S corporations and LLC's taxed as S corporations. So, they're thinking probably, "Okay, corporate income tax doesn't apply to me as much. Income taxes are going from the top-right potentially of 37 1/2 to 39.6. Is that right? So, we've got a two-point move maybe, 210 basis point move, which is significant but not earth shattering.

There's really, as we look at this, probably a couple of others that really hit you in the tail. One of them is capital gains taxes. Maybe the other one is payroll taxes too, the deductibility of payroll taxes. You want to speak to those a little bit? I've got a little simple Rick Ormsby kind of calculating it up on a $30 million sale, $15 million allocated to real estate, 15 million allocated to the business value. We've got to make assumptions on what the basis is. Let's say of that $15 million in business value, it's not unheard of. It's pretty normal to see the FF&E allocation being around 40% of the business valuation, and maybe the goodwill allocation being nine million dollars. So, maybe you've got a $30 million transaction that's $15 million in real estate, nine million dollars in goodwill and six million dollars of FF&E.

If you roll through capital gains tax increases from 23.8% to potentially as high as 39.6%, then you guys got to tell me how you feel about all this. I come up with just the old back of the envelope potential tax being anywhere from currently on the federal side, seven to eight million and it could be 11 to 12 million if it goes all the way to the highest that's been discussed throughout the election process. So, that is, guy's got 30 million, got no debt, got no transaction fees, which is always never the case. But if he doesn't, he walks away with 22 million maybe now. Two years from now, maybe he walks away with 18 million or something like this. Pretty big potential difference there I suppose. What do you guys think? Comments?

Well, in terms of the kind of gains taxes, there's something that's really interesting in what Mr. Biden has proposed. That is this flipping of the capital gains tax would actually be more than ordinary income tax, because his preference is to do away with capital gains discount, if you want to call it that, and just make everything ordinary income. But the 3.8% Obamacare Tax would still be there, and that would apply, at least the way it's written out, to your capital gains. So, you could have potentially 43.4 capital gains tax.

I think like Dan said, it's much more likely to have capital gains go to 27, 28%. It was 28 for some time. Just like I think corporate tax probably won't go to 35, it'll probably go to a flat 28, which is halfway there which is kind of what's he's proposed anyway. Yeah, your taxes there is going to be extremely, it's not certain, but considerably higher. My biggest concern I think with that, or maybe we should put that off in terms of talking about it, is state tax-

Yeah, we've got another slide, because I want to spend some time on that. That's something that's itching ears will want to hear, because it's such a massive issue. What about if you're a ... I mean, look, it's one thing to be selling a company. I harp on this all the time about valuations and timing and capital gains taxes. People who know me on this webinar hear me say this stuff a lot, but what about if you're just operating a franchise company and you're thinking about the social security tax, number one, how that applies to you, if that changes? Also, maybe at the local level and the state level, what do you think about property tax increases? I mean, these are just negligible things.

You guys know I'm a Florida resident now. I got out of dodge. In Kentucky, man, in the City of Louisville, I wouldn't be surprised to see property taxes increase by 20 or 30%, because revenue's crumbling as people move away. Comments on any of that stuff?

I see two things with property tax. I'll let Dan talk today. He's more in tune with that. One is, capital gains tax is going to affect you generally when you sell your business one time. [inaudible 00:29:04] increase property taxes every single year. The next thing that happens is that depresses your EBITDA, which depresses your ultimate sale price. It hits you a couple of ways.

That's the problem with the franchise. You're trying to be where the people are. These metropolitan areas know that. There's a cost, in their theory, there's a cost for you to be in the City of Louisville or the City of Atlanta or DC or wherever you're at, Des Moines, Iowa. I mean, there's a cost for being in there. They want to pick up that revenue. Look, one of the things we remember from COVID, and this is not exactly germane to your audience per say, but people are going to work remotely. They're going to flock out of these cities. That's where a little bit of that drain is coming from.

We experienced the problems in Downtown Louisville. Nobody's going down there. It's a ghost town. They've got to replace that revenue. Where are people moving? People are moving outside of major population centers, so they've got to build that revenue back up. The problem is, franchises restaurants, the quick casual, I want to be there. I want to be where the people are. That's where the revenue's going to be.

Yeah, they're going to have to replace that revenue. Property tax is an automatic. It's an easy one. I mean, expect those things to go up. It is going to impact the EBITDA. You also have the increase of minimum wage and those considerations that are out there, places that are moving in that direction. Social security tax, look, we can fix ... You know we have a problem with social security, right Rick?

Yeah.

[crosstalk 00:30:47] How many times have we had this conversation? We can fix social security underfunding real quick, remove the cap. Is that going to go up? Potentially. I mean, those are sources to raise revenue.

What does that mean to the casual listener here, we can remove the cap? I mean, put that into an example. Let's say a franchisee makes a million dollars. Easy math. Now there's-

Now we're always dealing with reasonable comp, right? In an S corporation, you can't just take 100% of your profits out as S corp distributions. You do have to have some compensation. Somebody typically has some compensation. Normally we try to stay below or at that social security cap, unless we have a retirement plan or something in place that we're trying to maximize a different benefit. So, the social security cap stops at the 132, 136,000 range. If you remove the cap and you have a W2 of 300,000, which is probably reasonable if you're making a million bucks. Your exec's making 250, 300,000. Well, you pick up that 6.2% on him up and the company's going to match that. So, you've got this stealth tax that's going to be 12.4%. If you do that on executives, then boom, we fix social security problem really fast, but it's at a cost.

The larger franchisees who are listening who might have a structure that's franchisee and partner here and then maybe four or five region coaches and maybe 50 restaurants that have area coaches and restaurant managers, I mean, you're talking up here, especially if you've got a guy who's making 150, $175,000 a year. Let's say he's making 200,000 with bonus and everything else and he's managing a significant portion of your business. What Dan's describing could, for that one employee, could potentially mean another seven or 8,000 a year in tax or for both you and the company. So, you multiply that out across multiple folks and it could be substantial, but even bigger obviously for the owner himself or herself.

Absolutely.

Obama, we've had a view of what Biden's done, right? He was the number two guy for eight years. Obama brought this up, this topic of the social security thing every year that he was in office. It's something that if we're predicting what's going to happen, that's probably one that goes away or gets attacked. Let's put it that way. Jim, your thoughts?

One thing that Biden just said is, he would like to, and maybe it still stays at 137, but if you make over $400,000 in compensation, there's not going to be a cap above that. In other words, everything that you, of 137 and everything you make above 400 is going to be subject to [inaudible 00:33:40] and you're going to have that doughnut hole in the middle. What I expect to happen is ... I mean, that may happen. There's a lot of people who would vote for that just because those are the super rich people, but I think also you're going to see more than a creep up but a pretty substantial increase in the 137 cap that we have now.

For example, you might have the first 200 is subject to other tax. Then you've got the doughnut hole, and then everything over 400 is subject to tax. We don't know how it's going to come out, but those are the proposals that have been out there.

Now after hearing all this, I feel like I want to jump off a cliff. Thanks guys. I really appreciate that. I've got one other piece of bad news. When I got those dozen phone calls, the Monday after Saturday Biden is declared or self-declared or whatever as President in waiting, most of the calls were not as concerned on taxes, believe it or not, as they were on minimum wage increases. Almost all of those dozen calls were large franchisees in the Southeastern United States.

It's probably because of the glorious State of Florida passing a graduated minimum wage increase to $15 through 2026. I heard that over and over again. I mean, I've personally seen in our Unbridled business what the impact of minimum wage increases means to people's P&Ls. I'll say this, if you're in the Southern United States, a lot of people are paying an average wage that's eight or nine dollars an hour. I think nationally, if you're not in a high minimum wage state, a lot of people are having to compete for labor and paying at least ten bucks an hour.

I don't know what your particular situation is if you're a franchisee. What I can tell you is, in 2018, we had a deal in Seattle. In the middle of the transaction, it went to $15 an hour minimum wage. I watched, no kidding, over the course of almost overnight it seemed, maybe it was over 60 to 90 days, but the person's EBITDA dropped 70 to 80%. It was shocking. It was shocking. It was almost like half of the stores when unprofitable immediately. Franchisee ended up in bankruptcy. I mean, it was just shocking.

I think the learning from that is a lot of states are going to put in graduated increases to get to $15. If Florida can turn, the other states are probably, in the South, are going to be somewhat behind it. You cannot price your way out of minimum wage increases. I mean, you can't do it immediately. You'll lose your customers. They're not that elastic with their pricing. They're not going to come and order a three dollar taco tomorrow if they paid $1.50 for it yesterday. So, you have to do it over time and you have to be patient. Those are some of the learnings I think I've had there. Any comments on that, guys? That's clearly the biggest one, because I think you're going to find EBITDA on an operating business, especially one that operates with relatively low wage employees, it's going to be hit pretty hard. There's been a lot of rhetoric at the presidential campaign level about $15 minimum wage being a living wage.

The difficulty with all that rhetoric is that, even if that doesn't happen, it immediately affects the value of your business just because banks are going to be a little bit more hesitant to lend not knowing what the future's going to hold, not knowing whether that borrower is going to be able fund that loan over time if the government takes 80% and 70% of the profits of it. I think it's going to affect people's businesses regardless of how it actually comes out in terms of pricing the sale.

As always, if you're a franchisee, you want to be operating the best brands and be the best operator. If you do those things, you're going to be fine. I've always believed that the cream always rises to the top. You know what I mean? The best always gets better. The ones that struggle are the ones that were marginal to begin with. If you're operating a brand that's a legacy brand that hasn't performed well historically or it's kind of languished along, those are the brands that tell you you need to be cognizant of operating into 2022 and '3.

Let's talk a little bit about PPP and loan forgiveness. It's maybe a little bit apart from ... Well, it involved taxation. You guys have done a lot of good work related to this. We got a lot of new news coming out. Could you kind of give us a little update on what you think the ... just what's going on, how to prepare for paying for a possible tax in 2021, how to think about all this stuff?

I love your screen. You've got it laid out there. The first question and the most looming question is, is the triple-P going to be taxable? Right now, as the code stands as Mnuchin and the IRS have said, "Hey, it's taxable." It's taxable whenever you get it forgiven. Now, you're probably not going to get it forgiven in 2020, last part of this year, because nobody's accepting applications really. None of the big banks are accepting applications. Under 50,000, they're taking those applications, and then everybody else is pretty much stalled.

You're going to get your forgiven notice. That's going to happen in 2021. That's going to revert back to your 2020 tax return. Remember that the conversation is, the loan itself is not taxable. The forgiveness of the loan itself is not taxable income. That's what they've said. Will they come back and make it taxable is those expenses that gave rise to the forgiveness. Those expenses are not deductible. I love how tax, we start getting into all these conversations, accountants and CPAs and lawyers. We really, "Well, the loan's not taxable, but the expenses that gave rise to it are not deductible-

I mean, that's confusing. Why not just make it easier? If I borrowed 100 bucks, I've got to pay 35 of it back. You know what I mean?

That's exactly what-

Make it understandable.

We double talk all the time. I mean, it's taxable income. What do you do with that right now? You have to prepare your tax projections under two scenarios I think. The current scenario is it's taxable. You have to recognize that fact. There's the potential ... We're hoping the lame duck fixes this. In everything that I've seen in the proposed laws are they do fix this. They just can't come together right now, because they're playing partisan politics right now. If we can get that, that would be the best Christmas present for a lot of clients. I got this relief loan, and now I'm going to have to pay tax on it. If it's two to five million dollars, that's a big number that I'm paying 35, 37% on. That really didn't help me. I appreciated it, but it didn't really help me in the longterm.

So, I got a three million dollar loan. It's basically all forgivable. I'm sitting here, and right now I've got a million dollars I've got to pay back under the current legislation. When do I have to pay this darn money back? Does it go against my 2020 tax return but I pay it in 2021?

Well, so that's an interesting point. We always want to be subject to safe harbor. We want to pay our tax based on the prior year or 90% of the current year. We're looking at clients right now under those scenarios, and we've got to run both scenarios. Then we have to flip a coin. If we've got you to prior safe harbor, then you're good. But who wanted to pay prior to safe harbor in March? When I was calling you and saying, "Hey, you got a first quarter estimate, and it's a large one," and you're going, "I don't know if my doors are going to stay open. What are you talking about I've got to write a check?"

That was the beauty of triple-P. It came out, I said, "Hey, this is going to be non-taxable money for you." Everybody said, "Hurray, that makes a lot of sense." That I think really helped the recovery, because we come in there, we flood the market with dollars and the stock market takes off. People get calm. It settled things. Then they come along and tell us, "Well, we were just kidding about the taxable part."

So, you've got a first quarter that you're underwater. Then what happened for your second and third quarter? I mean, we were all waiting for the surge again, right? Nobody's wanting to release extra capital, and let alone we don't want to give it to the government. A lot of people are coming in at the end of the year, and they're not on the prior safe harbor. Like you said on the quick serve, they picked back up. They're making a little bit more. I'm definitely not telling my staff people, "Hey, we're doing really well," because I'm beating the drum, "Man, this is a hard economy." It's a hard economy, right?

You're dropping dollars to the bottom line, but you don't know. I mean, yes, we have a vaccine. Who knows? The question to your point though, Rick, is January 15th, you want to make your fourth quarter estimate and get yourself caught up as much as you possibly can. Then the question is, is that air ball taxable? Look, all taxes are paid and due, if you're a corporation it's March 15th, if you're an individual, it's April 15th. So, you know you're going to have a payment event that's going to happen there.

Jim and I debate whether or not we can get a reasonable cause waive on a estimated tax penalty. Maybe you can, maybe you can't. The law says you should be paying it, but we are in a pandemic. I don't know if-

Yeah, it's an interesting point.

So, that's the question. April 15th for most of your S corp folks are going to have to pay a tax. Then heaven forbid, if we're going to safe harbor, you're paying 1/4 of 2020's taxes. Isn't that a scary thing to get to the safe harbor? I mean, that's a big, big issue. So, you've got to think about that. We hope they fix it. We're doing strategies that leave people pretty open. I'll be honest with you, if I have to pay the estimated tax penalty, I'll pay the estimated tax penalty rather than release the dollars. When I say that, I have to tell the client, "Hey, are you will to pay that 7% estimated tax penalty that's non-deductible?" They want to quantify it.

I've got a $5.5 million triple-P loan right now. Without the loan, it's a $1.8 million loss. With the loan, it's $3.5 million income. What's the estimated tax penalty? I mean, that's what they wanted to know, because we're trying to give as much time for liquidity purposes, because they need that money. They're not ready to write that check/

Yeah, yeah. I'm hopeful that that legislation gets fixed. Again, I made the comment today, I saw a point that they were talking about being able to issue a second round for 300 employees or less, if you had any quarter in 2020 your revenue was down 30% or more over last year, you could apply for a second round of money that could be fully forgiven. That may apply to second quarter, especially for a lot of our casual dining, fast casual clients, our gym clients. People who operate health and fitness businesses and auto businesses because their revenues were down a lot doesn't probably apply so much to the QSR franchisees. Keep note of that.

Guys, we've got 11 minutes left, and so I wanted to make sure we hit the rest of it. So, Jim, you're on deck, buddy boy. What do you think about estate planning? This is something that really needs a little bit of attention, if you don't mind.

I think estate planning changes are low hanging fruit for Democrats in that because it affects only the filthy rich, as they see it. The proposal has been to go from the current exemption. I think it's 11,580 per person, basically 23 million per couple, to three and a half million per person. To the couple, the gift tax from that, the gift tax during your lifetime is one million. The really, really scary thing ... They want to raise the tax rate to maybe 45% from 40 to 45, which is not that big a deal, but reducing the exemption affects a lot of small business owners.

To me, the really scary part is what he's proposed with the [inaudible 00:45:55] basis when you die, whatever your assets were, that's what your heirs take. It's a tax basis, they can immediately sell that. The capital gains just gone. It dies with you. He's talking about doing away with that, number one. But worse than that, he's talking about making death a gain recognition event, which means when you die, not only do you have the estate tax, you have potentially a 43.4% income tax, which comes off first. Then whatever you've got, whatever they leave you after that is subject to the 45% estate tax.

You're talking about, run the numbers, and the government basically could get 68% of what you worked your whole life for, assuming that you had no tax basis. You know know how it is opposed to the old S corps, the tax basis is not that huge. So, assuming in a $10 million business, for example, the government can get 6.8 million of that, leaving your heirs 3.2%, just under a third of what you've worked your whole life for.

Then the bill is due within nine months after death too. So, what you're doing is you're putting a gun to the heads of your kids and saying, "The repercussions are dramatic of what happens next. I mean, they're dramatic." I don't have a family with any money, but if I did and all of a sudden a $10 million gain comes to me and I've got to pay 6.8 million in taxes that I don't have, that forces me to liquidate. Then when I liquidate, you talked about this earlier, I have to liquidate at a discount, don't I? I'm in a fire sale, daggonit. I got to get the darn money to pay the tax. Whatever that I get ahold of that's worth 10 million, unless it's stocks that I can liquid trade quickly, I've got to dump it for a discount. It's a fire sale to pay the taxes. I mean, it's almost criminal. I don't know.

You could be selling into a down market too.

That's true.

[crosstalk 00:47:48] We do have Section 6166 for wholesale of business to allow you to pay that tax over time. The best your kid's going to get is the 3.2 million of your estate. If you had to sell it quicker than you should because the market's not right, then they'll lose more than that because we'll sell it for less than its value.

Planning is critical. A lot of your clients I know are putting things in trusts now to cover their assets and plan for their legacy to avoid a possibility that this exemption will go way lower. What about insurance?

One thing on that, there is no clawback. For example, if you give $11 million to a trust today and then the law changes and reduces the exemption to 3.5 million, that 11 million is out. There's no clawing that back. If you're concerned about the exemption for estate tax going down dramatically next year, it's a good idea to make those gifts today if you can or before the 31st.

Yeah. Well said. Insurance becomes important too, right?

Insurance is a huge thing. We're starting those conversations again, putting it in an area of life insurance, looking at second to die policies, if it's taxed on the first death, the second to die is not. You need to have a first to die policy. Are you insurable? What are you doing with those? Making sure that you've got a reputable insurance company. I just had the conversation earlier this week on a five million dollar policy. You've got to have some liquidity, and that's what life insurance is for. I mean, that's really when it comes into the high net worth person is as a vehicle to help pay the estate tax and vehicle to make sure that you keep some amount of net worth in your family. So, you definitely have to consider it.

Isn't it just funny, here I am sitting here. I just started rubbing two nickels together selling chicken stores and taco stores and pizza stores. Simple, right? Make a phone call, get to know people. Why does this get so complicated, man? You know what I mean? Just listening to you guys, I'm like, oh my goodness, it hurts my brain. Thankfully you guys will lead into the next slide, because it hurts my brain and you guys are good advisors.

I do quarterly tax and legal planning meetings with these two gentleman. I mean, you should too. You've just got to trust good professionals. Then these two guys particularly are really good with creative ideas. I don't know if you have anything that you wanted to share, but you've got to think about revenue recognition, expense planning, borrowing against related companies. If you're trying to hedge yourself against tax increases in 2021, look at distributions, extended filings.

We've just got three or four minutes. I know there's a lot we could say about this slide, but let me do a little rapid fire Q&A. What do you think these guys, gentlemen, what do you think changes on the tax and legislative horizon? Which ones are most and least likely to occur, do you think?

I think most likely to occur is some change in the estate planning exemptions. Maybe not as dramatic as he wants, but that's kind of an easy one for Congress to get together on.

Rick, we do have a question, S corp versus C corp. Do the potential income and estate tax touch the balance one way or the other? Yes, they do. C corp was in play for a little bit. C corp's not so much in play right now. It depends on what the tax rate, if we go back up to 28%. You've got to run the numbers. You've got to look at it. One thing that we didn't mention since we're in rapid fire, we're going to lose the SALT ... I mean, the SALT's $10,000, state and local income tax deduction. You're going to lose that. That's one of the things Biden wants to do. He wants to means test that again so it's almost an alternative minimum tax. You'll get 28% benefit of your itemized deduction and wants to keep the SALT.

Dan, sorry to interrupt you. That's a big deal. As simple as an old redneck could take it is this. If you're a charitable person and you're going to give away $100,000, stupid number, right, $100,000 to your church and you're expecting at your tax bracket to get a 40% deduction, what Biden is proposing is that that deduction only becomes 28% now?

That's right. That's right.

That sucks. That sucks for charities. That sucks for charities. It really does.

If we go back to your last slide. You don't have to go back, but in your last slide, you do need to have a conversation with good trusted professionals. You need to be crunching the numbers. You need to be looking at this prospectively of what's going on and what's your end game? My end game from my clients is to keep as much money as we can to find the strategies that make sense. If you have to put it in an S corporation or a C corporation and you do a conversion, you do those things when it makes sense, but you've got to run the numbers.u have to have those dialogues back and forth.

Yeah. That's great. Well said. We've got time for one more of these. I'll take a couple of questions here. I had one question come in, but I'll address the third one here is, "How will these tax changes affect valuations?" I mean, who knows. We're going into a tough winter before we have the vaccine rolled out. It's possible that we see consumer spending dip. I don't know. Maybe we get this big government stimulus and consumer spending comes back. I think when the vaccine comes out next summer, my opinion is you're going to see people out there spending money and probably spending it pretty forcefully.

So, you could see in your business your EBITDA going up potentially, but I think also the valuation, the multiple. EBITDA multiples and cap rates are going to get impaired as you have, number one, more supply in the market, which is going to happen in the first and second quarter of 2021. Like I said, you're not real bright if you're thinking of selling in the next three years and you don't consider it now or soon. As I said again, you're not real bright if you're doing that. That's going to cause a lot of clients and a lot of franchisees to consider selling. Supply's going to increase. Demand stays the same. Price, what happens? It goes down.

The other thing is, I think the tax regulations and the minimum wage impact is going to start creeping its way into the EBITDA multiple. In other words, someone might say, "Gee, I won't pay six times EBITDA or six and a half or seven times EBITDA for this business in Florida anymore knowing that in six years I've got to pay $15 minimum wage. I might now reduce my EBITDA and multiple to five and a half or six. You see?

These little things start filtering their way through the marketplace. I think what you might see is you might potentially EBITDA lifting but EBITDA multiples and cap rates getting worse. Then that effect could be that valuations probably stay close to where they are now. I mean, that might be just a guess, but then you've got higher taxes that you have to think about. The net-net is that I think we're running into an environment here where if you're looking to maximize the net proceeds in the sale of your company, I think the discussion here leads you to a negative place beyond the middle of next year is just kind of my commentary.

I want to thank everyone for their time today. Here's Dan and Jim's contact information. I'm sure any of the three of us would be honored to answer any of your questions at any time, any of them really. We're delighted that you're on the call. Check out the webinar. Watch for the email to come with a review of this ... replay of this webinar and also the podcast. Guys, do you have any final words that you want to share with folks listening here as they hang up here?

Well, thanks everybody for your time. Hopefully you have good advisors. You need to use them. Put the topics on the table. This is the time to be proactive. The next couple years, you want to be ahead not playing from behind.

That's great. Well said. Okay guys, many best wishes. Hey guys, everybody, Jim, Dan, everyone listening, Merry Christmas, man. [crosstalk 00:55:44] You know what I mean? Let's persevere. It hurts, doesn't it? You know what? There's a lot of the psychological pain and people are fatigued. We're sitting in our darn houses. Kids are not in school. We can't see our loved ones when they're sick and passing away. I mean, it isn't the easiest, but daggonit, we're resilient people. We have been for 200 and some odd years. We're going to get through it. Keep a positive attitude, man. Merry Christmas to both of you.

Absolutely.

[crosstalk 00:56:09] See you all later.

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