Valuation Implications of the Tax Cuts and Jobs Act of 2017

Value = Earnings x Multiple

Value = Income/Risk – Growth

In the first instance, all a business appraiser needs to do is to determine the relevant Earnings, and then multiply those earnings by the relevant Multiple to arrive at Value. In the second instance, the appraiser must first determine the relevant and sustainable Income stream, the Risk associated with that stream of economic benefit and the Growth it will achieve over time. Of course, the devil is in the details particularly with respect to the application of these fundamental valuation concepts to closely held business interests.

Until now, we have typically relied on historical trends and simply verified and normalized prior period activity to estimate the Earnings or Income expected to be obtained in the prospective period, together with the use of a mix of empirically grounded data and a strong dose of professional judgment when determining market Multiples, Risk, or cost of capital, and sustainable Growth. Using a historical perspective may no longer be relevant given the magnitude of the economic impact of the TCJA.

C Corporation Earnings

We know that the federal corporate marginal tax rate was lowered from 35% to 21%. Figure 1 shows the change in corporate income tax rates, pre and post TCJA. It is noteworthy to recognize that the tax brackets, starting at 15% of the first $50,000 of federal corporate taxable income, have now all been replaced with a flat 21% tax effective Jan. 1, 2018. At the same time, the flat 35% federal income tax applicable to professional service corporations has also been rescinded, which will create significant planning opportunities and valuation challenges for many of these legacy C corporation entities, beyond the scope of what can be discussed in this article. See Figure 1 below.

For comparative purposes, take note of the changes to the federal individual income tax brackets that have generally been reduced, with the exception of one bracket which actually increased slightly. The new 2018 rate brackets applicable to long term capital gains and dividend income is also provided in Figure 2 below.

Along with the TCJA rate reductions for both corporate and individual income taxes, came a myriad of changes to itemized deductions and other aspects that will be critically important for many business and individual taxpayers to be cognizant of as they progress into 2018 and beyond. In selected instances, these changes will also impact the valuation proposition for closely held businesses due to the actual and perceived impact on after tax cash flows available to owners and investors of closely held businesses and professional practices. Figure 3, below, summarizes several of these key changes:

Certain aspects, such as no longer being able to deduct entertainment expenses, including college and professional sporting events, cultural events, and golf outings with clients and prospects, and a strict 50% deductible limitation on all meal expenses will impact many small businesses and professional practices. Limitations on the deduction of state and local taxes, as an itemized deduction, to no more than $10,000, will impact many taxpayers in states with high state income taxes, such as California, New York, New Jersey, Illinois, and the like. No longer being able to deduct interest expense on home equity lines of credit used for other than home improvements will also impact many taxpayers, as will the lower overall threshold on deductible mortgage interest when in play. These are just a few of the key changes that reach well beyond the changes in business and individual income tax rates. These changes will be critical to assess in dissolution proceedings when available after-tax cash flows are evaluated for establishing alimony and child support. The fact that many of these changes sunset in 2025 with a return to prior tax law and limits in 2026.

The loss of a deduction for alimony for decrees entered into after Dec. 31, 2018 has sent shock waves through much of the family law bar. Understanding the caveats on post-2018 alimony modifications, the increased value of child credits and IRC Section 529 plans, coupled with the loss of personal exemptions and increased standard deduction thresholds are all key aspects of the TCJA reform but beyond the scope of this article. Expanded information if readily available on these issues for those seeking more detailed guidance here.

Another significant and incredibly complex area of the new law is the 20% deduction provided to the owners of certain pass through entities of what is called Qualified Business Income. The intent of this cornerstone provision of the TCJA is to allow an approximate parity between the significant reduction of C corporate tax rates from 35% to 21% and the taxation of flow through business income coming from pass through entities, including Subchapter S corporations, LLCs and LLPs being taxed as partnerships and sole proprietorships. Figure 4 below provides a very basic framework for how the 20% deduction applies and the exceptions to it.

Readers are encouraged to consult their professional tax advisers for more detailed guidance on how the new 20% QBID rules apply, including the phase outs and limitations noted above. This one area of the new tax reform legislation has lots of land mines and issues to sort out, including an increased spotlight on what constitutes reasonable compensation and what businesses fall within the Service sector definition, which includes those enterprises where the primary source of income is based on the reputation of the owner.

A Hypothetical Example

Let's get back to an example of how the new TCJA tax rates will impact the value of a closely held business. For this example, assume a flat 6% state income tax rate and an enterprise that has sufficient taxable income pre-TCJA (2017 and prior) to be in the 35% federal top tax bracket. As you can see below, the combined federal and state effective tax rate drops from 38.9% to 25.7%, rounded to 39% and 26% for this example.

Now, let's apply these pre- and post-TCJA effective tax rates to a hypothetical example. Let's assume we start with a 20% cost of equity, a fixed debt interest rate of 5% prior to adjusting for the tax benefit of the interest deduction, and an optimal debt to equity capital structure of 65% to 35% before the enactment of TCJA and a modest change to 70% to 30% post-TCJA to allow for the debt burden being less attractive due to a lower tax benefit at the lower 21% federal rate. The overall impact on the weighted average cost of capital only shifts from 12% to 11%, but this component of our example shows how this must be considered.

Next, we assume Earnings Before Interest and Taxes (EBIT) of $100,000 and apply the effective tax rates outlined above to derive debt free net income. For simplicity of this example, we assume, in both scenarios, interest bearing debt of $250,000, capital expenditures will equal non-cash depreciation and a reasonable provision for working capital retention is $5,000.

Applying the 12% and 11% WACC capitalization rates to the debt free net income results in a calculated enterprise value of $575,000 versus $509,000, or a 13% increased value based on the impact of the new TCJA tax rates. The difference is even more pronounced once debt is deducted from enterprise value to get to the value of equity pre- and post TCJA, where a 25.5% increase is realized, based solely on the decrease in federal income taxes, resulting in increased cash flow to equity.

Keep in mind that this is a very simplistic example intended to explore how the TCJA reform will impact the value of closely held businesses. A broader look is required in actual practice to assess if a single period capitalized earnings method can be used, but we also know the reliability of historical market based transactional data under the market approach to value will be highly suspect given all pre-2018 transactions were based on prior larger income tax burdens and resulting lower net cash flows.

While it is certain that the new income tax hierarchy under TCJA will radically impact the value proposition for many public and privately held business enterprises, the bottom line is that there are no simple solutions to precisely how the TCJA tax reform will alter the proper appraisal of closely held businesses.

The focus of valuators will likely be an increased emphasis on prospective value methods, such as the discounted cash flow method under the income approach to value, coupled with the application of current market multiples and discount rates that embrace the lower tax rates and increased cash flows many entities will experience. At the same time, one should not lose sight of the sunset rules that apply to many of these changes, or the prospect that a change in political party control in Washington could easily bring repeal and a return to something close to what we have had in place for the past several decades.

Buckle up as the ride ahead for business appraisal will likely not get easier or less expensive undertake and the resulting conclusions may be more decipher and explain to our clients and triers of fact. This author sees an abundance of potential to further confuse and annoy jurists as we also have some complex new cost of capital alternatives on the immediate horizon to further confound the valuation community.

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Ron Seigneur, CPA/ABV, ASA, CVA, is managing partner of Seigneur Gustafson LLP located in Lakewood, CO. A member of this newsletter's Board of Editors, Ron is an adjunct professor at the University of Denver Sturm College of Law and Daniels College of Business where he teaches law firm leadership and business valuation courses. Ron is co-author of Financial Valuation: Applications and Models, 5^th edition, Wiley & Sons, 2017; and The Cannabis Industry Accounting and Appraisal Guide, published by LuLu. Ron can be reached at 303-080-1111 or [email protected]. This article is for informational purposes only and readers are reminded that any particular enterprise and related valuation situation is extremely fact specific.