In December 2017, the Tax Cuts and Jobs Act (TCJA) was signed into law, ushering in the largest overhaul to the tax code in three decades. It features sweeping reductions in tax rates – some permanent and some temporary – for corporations and individuals, as well as special deductions for pass-through entities. While it may be difficult to overstate how much the law has impacted taxes, its effect on business valuations cannot be ignored.
First, it helps to understand that businesses are typically valued using one of three approaches: income, market and asset. The income approach is based on a company’s ability to generate future economic benefit for its owners, while the market approach compares the company to historic sales of publicly traded and/or transacted companies. Finally, the asset approach looks at what the company’s net assets are worth.
It’s also important to understand how these tax law changes will impact your business valuation. In litigation, for instance, it could be a shareholder dispute, family law/divorce, or a commercial dispute that uses business valuation to measure damages. Whatever the case, experts need to be aware of these changes so they can assess the impact on the entity that’s being valued. Keep in mind that this is always handled on a case-by-case basis, with facts and circumstances driving the outcome.
With that in mind, let’s take a closer look at the main provisions impacting business valuation.
Change in the Tax Rates
The TCJA included big changes in both corporate and non-corporate taxes, with both expected to trickle down to the business valuation area. Individuals saw a reduction of the top rate from 39.6% to 37%, although this is a temporary change that will sunset in 2025. On the other hand, the rate for C-corporations was permanently reduced from a top rate of 35% to a flat rate of 21%.
Keep in mind that valuation is based on after-tax cash flows, which means that if tax rates change, after-tax cash flows change as well. Complications arise with the fact that corporate tax rates are a permanent change while individual tax rates are only temporary. It’s hard to reconcile the fact that the future is uncertain when valuation is forward-looking, which requires looking at future after-tax cash flows.
Qualified Business Income Deduction (QBI) (Section 199A)
The 20% qualified business income deduction is a tax break for owners of pass-through entities, such as sole proprietorships, S-corporations and partnerships. Limitations do not apply if taxable income is under $157,500 (single) or $315,000 (married filing jointly), and limitations are phased in over the next $50,000 ($100,000 joint) of taxable income. Over that threshold, there are limits to who can take the deduction. Keep in mind that the income method of valuation is based on after-tax cash flows. This is a complicated, year-to-year calculation, and it may apply to a business one year but not the next. It will also sunset in 2025, creating uncertainty for the future.
The law introduced additional benefits for the accelerated depreciation of used assets. The old law, which applies to assets acquired on or before September 27, 2017, provides a 50% first-year deduction, but it must be new assets. The new law, for assets acquired and placed in service after September 27, 2017, provides a 100% first-year deduction that can be taken on both new and used assets. It starts to phase-down by 20% a year in 2023.
Thanks to these changes, a company’s financials could look different in year-by-year comparisons. Due to additional tax benefits, the changes may also impact how a company behaves and invests in capital assets. When trying to project future cash flows, it will be necessary to consider differences in the company’s past and future capital expenditures. Large depreciation deductions can make it appear like a company lost more money than it did in prior years. For valuation or income purposes, it’s important to be aware of potential adjustments.
Net Operating Loss (NOL) Changes
The new tax law limits net operating loss carryforwards that were generated after December 31, 2017, to 80% of taxable income in each year. Unlike the pre-TCJA code, these net operating losses can be carried forward indefinitely. When it comes to valuation, certain financial decisions could be tax-motivated in an effort to tax advance net operating losses that were not historically included.
Interest Expense Limitation
The new limits on deductions for interest expense state that companies with three-year average revenues in excess of $25 million can only deduct business interest expense up to 30% of taxable income. If interest is potentially not deductible, it could have a significant impact on a company’s capital structure – whether they choose to get debt or equity – if they are a highly leveraged company or lost a tax deduction for interest they pay. To avoid this issue, it may be necessary to rely on equity to raise capital.
Navigating the Changes
These changes present some obvious challenges for valuators, especially in such a dynamic environment. They must represent the level of complexity in models while also remaining flexible for future changes. It begins with assessing the specific case and associated facts, as well as understanding the tax law changes, to address the company being valued. Valuators must continue to use acceptable valuation methods and current information about tax rates.
At this time, it doesn’t make sense to speculate about what will happen in 2025 when some of these provisions are scheduled to sunset. Things are going to change regardless, so any granular estimates will likely be incorrect. At least for now, the best course of action is to continue following standard practices.
If you’d like to learn more about the TCJA and how it impacts business valuation, contact your GBQ advisor.