How the Tax Cut and Jobs Act (TCJA) Impacts Business Value

When valuing a private business interest, experts try to think like prospective investors. If you were buying a private business interest, would taxes affect how much you’d be willing to pay? Of course, investors consider a wide range of tax issues — such as expected federal and state income tax rates, deferred tax assets and liabilities, and built-in capital gains taxes — when evaluating investment options.

Quantifying future returns

Business valuation analysts often use economic returns as the basis for valuing a business interest under the income or market approaches. Rarely does a valuation analyst consider the cost approach as it is mostly applied to non-operating businesses, such as asset holding companies – think of a real estate holding company as an example.

Ultimately, the one variable that needs to be present for investors is the expectation of cash flows, either currently or in the future. And the one variable that potentially increases or decreases cash flow is the applicable tax rates. To state the obvious, higher tax rates, lower cash flow; the lower the tax rates, the higher expected cash flows to owners.

And as mentioned above while historical returns or cash flows may be important it is the ability to create and sustain cash flow that ultimately matter! Investors want to know how much a company expects to earn in the future. Predicting a company’s future tax rate can be somewhat tricky, however and has been made “interesting” by the TCJA.

To the extent that a business has net operating losses and other deferred tax assets, the company’s effective tax rate may be lower than published income tax rates. Conversely, deferred tax liabilities may cause the company to incur higher-than-expected effective income tax rates in the future.

We present below a summary of the changes and the potential impact on business value – we have also prepared a more detailed presentation that dives deeper into the various implications of the TCJA for business owners and how it impacts value.

For a copy of the presentation please forward your request to Valuation@uhy-us.com

The Changes Enacted Under TCJA That Impact Business Value

The significant changes to the past tax regime can be simplified to the following:

  • Lower Federal Corporate Tax Rate from a maximum rate of 39% to 21%
  • Limitations on interest deductibility
  • Limitations on the deductibility of operating losses
  • Increased deductions for Section 179 and Bonus Depreciation
  • The introduction of the Qualified Business Income Deduction

All these provisions will have both a positive and potentially negative impact on business value.

The Obvious – a Reduction in the Federal Corporate Tax Rate from 39% to 21%

The TCJA reduced the graduated system of taxes for C Corporations (versus Sub Chapter S Corporations) from a max rate of 39% to 21%. By this change owners would logically think their businesses are more valuable. The result of change will be more cash flow available at the corporate level for more investment and hiring, which in turn would lead to further increase in value.

As we know there is always a “but for” and we will address each of the changes we describe above in the TCJA and their impact on business value.

Valuation impact – for many C Corporations the Act reduces taxes and increases value. However, the impact of many of the other provisions that follow can impact the overall increase in value.

Business Interest Limitations

Simply stated the TCJA has created a bias against borrowing and the deductibility of interest expense. To limit the impact of borrowing to maximize deductions under the liberalized Section 179 and Bonus Depreciation rules, the Act limits the deduction of interest expense to 30% of a taxpayer’s “adjusted taxable income”.

Many of the definitions and the application of certain sections of the Act are beyond the scope of this article but are available in our more comprehensive presentation as noted above. Clearly, the implications are that future borrowing needs to be considered more carefully as the cost of debt will be higher than the stated interest rate because some of the interest expense may not be deductible.

Valuation impact – for smaller entities, those with less than $25M in revenues the limitation will not be applied. For those entities whose interest deductions exceed the threshold a further analysis is necessary from a valuation perspective to determine if the interest limitation will continue and if the deduction can be used in the future.

Section 179 and Bonus Depreciation

A significant change has been enacted for Bonus Depreciation in that 100% of property “placed into service” before January 1, 2023 is deductible immediately and perhaps very important for certain taxpayers, it is not limited to “new” property. All these terms have very specific meanings in the tax law and need to be understood before action.

Section 179 deprecation has increased the dollar limitation to $1M for “qualifying equipment” and there are other conditions and planning possibilities.

The impact for value is that it may increase cash flow because of greater deductibility but it does raise the point, is the level of capital investment sustainable and what impact will that have on value?

Valuation impact – for smaller entities the liberalized deductions may have an intoxicating effect on business decisions causing a “lumpiness” of capital expenditures and of depreciation expense. Key to the valuation process will be determining the extent to which the intoxication leads to bad decision making resulting future cash flow that is penalized in the form of unsustainable principal payments or of interest payments and an inability to generate an adequate return on overall investment.

Larger entities will have to decide whether to take advantage of the enhanced deductibility of depreciation after considering their future capital expenditures needs, the potential for interest deduction limitations, the borrowing capacity and the related cost of borrowing and finally the impact over time of lumpy capital expenditures and aggressive depreciation policies and their collective impact on overall taxes as well as return on investment.  

Net Operating Loss Limitations

The importance of these provisions will be forward looking for companies having operating losses which will be limited to 80% of “taxable income”. The impact is obvious, a full absorption of the tax loss in a prior year is not possible – a measure of tax will be assessed. Interestingly, prior law allowed a carry-back of losses, the new Act provides for an unlimited carry-forward of losses, subject to the above limitation.

The impact on value will be on a case-by-case basis, arguably the ability to use net operation losses in the future will impact value. Losses created, for example, in one year can be used to offset income in future years which should lead to important decisions on both Section 179 and Bonus Depreciation decisions and when and how to utilize the “new and improved” deductions.

Further, consider that decisions relating to a depreciation strategy are now impacted by the net operating loss rules and the interest deductibility rules.

Valuation impact – as indicated above the impact of a net operating loss benefit will be determined on a case-by-case basis; what is interesting will be some of the elections made under the liberalized depreciation rules and their impact on reported losses for tax purposes. While financial policy, tax planning and strategy have always been strange bedfellows, the need to coordinate overall strategy is more important under the new regime.

Section 199A – Qualified Business Income Deduction

For tax years beginning after December 31, 2017 and before January 1, 2026 a deduction will be available for owners of Sub Chapter S corporations, partners, members and sole proprietors equal to 20% of the taxable income of a “pass-through” entity.

This is perhaps the most complex and unclear section of the Act. Let’s start with some basic information:

C corporations are subject to two levels of taxation: once at the corporate level and again when income is distributed to shareholders, usually in the form of dividends. To help reduce taxes, many private businesses are organized as pass-through entities, such as S corporations, limited liability companies, partnerships and sole proprietorships. Importantly, pass-through entities aren’t taxed at the entity level.

Under prior law the tax advantages of owning an interest in a pass-through entity may have warranted a higher selling price than if the investor owned an interest in an otherwise identical C corporation because of the tax avoided by a pass-through entity.

Under the new law, if the shareholder, partner, member or sole proprietor participates in a qualified business then a deduction of 20% of the taxable income for the entity may be deductible from the taxpayer’s income. There are many unknowns in the determination of this deduction and as Accounting Today in its March 13, 2018 article notes:

“The Challenge ahead for the IRS …is that it must write coherent rules, and then be able to make judgments on every business in the US. …the IRS can be challenged by taxpayers and second- guessed by courts, a process that could take years to play out.”

Based on a recent tax conference the IRS has indicated it will be providing more detailed rules and regulations on how to determine the deduction. As noted above, our presentation titled “Valuation Implications of the TCJA” can provide more detailed information on the deduction from what is known as of this writing.

Valuation impact – if a pass-through entity can utilize the 20% deduction when coupled with the highest individual tax rate of 37%, the effective tax rate is reduced to 29.6%. Let’s now look at C Corporations where the flat tax rate is 21%, is this an apparent advantage? Perhaps not, the C Corporation must make a distribution to its shareholder in the form of a dividend which is taxed at a 20% tax rate. The effective tax rate, not assuming state or local taxes is 36.8% for any dividend distribution from a C Corporation to a shareholder. While at first blush the advantage appears to be with the pass-through entity, however there are many other decisions that will impact the overall effective tax rate and the creation of value for both C Corporations and pass-through entities. Simply stated each scenario or type of entity will need to be evaluated to determine the true impact on value for the new tax regime.

 

Categories: Valuation

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