How the New Tax Law Affects Your Company's Value
Mike Metzler, CPA, ABV, CMA, CGMA, ASA
New federal tax regulation was signed into law on December 22, 2017 (the “Law”) by the president and since taxes are a component of cash flow, the amount of taxes paid has a material impact on your company’s value. We will first provide a high-level explanation of the Law and then discuss its impact on value. Below are a few highlights for each legal entity:
S Corporations, partnerships + sole proprietorships
For this article, S Corporations, partnerships and sole proprietorships will each be referred to as a pass-through entity (PTE). The law is complex for PTEs. First, it separates PTEs into two categories:
- specified service trade or business, and
- qualified business
The Law defines a specified service trade or business as, ‘any trade or business where the principal asset of the business is the reputation or skill of one or more of its employees’. Examples of specified service trades or businesses include:
- Heath care providers
- Law firms
- Accounting firms
- Consulting firms
- Brokerage services
- Financial services
All other businesses fall into the qualified business bucket.
The law impacts PTEs based on the level of income of the taxpayer. Remember, PTEs do not pay income taxes at the corporate level; the income passes through to the individual’s personal tax return. For purposes of our valuations, we assume the only income of the taxpayer is from the ownership interest in a PTE. Both specified service trade and business and qualified business income falls into one of three tiers.1 Below is an example of a single and married filing jointly (MFJ) taxpayer.
|Single||MFJ||Specified service can:||Qualified business can:|
|Deduct 20% of QBI from pre-tax income||Deduct 20% of QBI from pre-tax income|
|Deduct the lesser of 20% of QBI multiplied by a phase out % or 50% of W-2 wages paid by the Company multiplied by a phase out %||Deduct the lesser of 20% of QBI multiplied by a phase out % or 50% of W-2 wages paid by the Company multiplied by a phase out %|
|Income>||$207,501||$415,001||No deductions||Deduct the lesser of 20% of QBI or 50% of W-2 wages paid by the company|
As appraisers, we noticed that specified service trades and business do not receive any tax breaks when their income reaches Tier 3, except for the reduction in the highest individual tax rate from 39.6 to 37%. Even at the highest personal tax rate of 37% versus 21% for C Corporations, our calculations still indicate a cash flow benefit to a PTE over a C Corporation due to the dividend tax (which is anywhere from 15 to 23.8% for high income earners).
By far, the changes for C Corporations under the law are the simplest to understand. The law removed the seven tax brackets and the seven different tax rates and replaced it with one bracket with one rate – 21% (federal only). There is still a dividend tax which is determined by the investor’s individual tax bracket.
So, what does this mean in black and white? Let us look at the results of the law for a C Corporation and PTE that has $500,000 of pre-tax income and pays $200,000 in W-2 wages.
|C Corp||Qualified business||Specified service business|
|Earnings before tax||$500,000||$500,000||$500,000|
|Effective statutory corporate rate||26.5%||0.0%||0.0%|
|Corporate net income||$367,500||$500,000||$500,000|
|Assumed dividend rate||15.0%||0.0%||0.0%|
|Effective statutory individual rate||0.0%||26.3%||33.0%|
|Cash flow to the investor||$312,375||$368,500||$335,000|
|Cash flow premium over a C Corp||18%||7.2%|
|*Assumption: $200,000 in W-2 wages|
As expected, the PTE that is a qualified business has the lowest effective tax rate2 (26.3%) and the highest cash flow to the investor ($368,500). Next, is the specified service and trade business with a 33% effective tax rate and $335,000 of cash flow. The C Corporation still has the double taxation of profits issue which produces a 37.5% effective tax to the shareholder or $312,375 of cash flow. Please note, for shareholders of PTEs, the shareholder’s global income and deductions have a material impact on the actual taxes paid.
All things being equal, this should leave more capital in the business to assist in growth. For example, CFOs have historically distributed approximately 40% of earnings as a proxy for quarterly income tax payments of the shareholders. That percentage is expected to drop to approximately 30% for a qualified business.
In conclusion, we expect privately-owned companies that are C Corporations and qualified PTEs to increase in value due to the increase in cash flow. Specified trade and service businesses will experience a slight increase in value due to the decrease in the individual federal income tax brackets.