The Tax Cut and Jobs Act has had a significant impact on business value and its effect is still being dissected in the business valuation community. As someone who has been a forensic analyst and business valuation professional for nearly a decade, I needed to know more about the effects of the Tax Cut and Jobs Act on business value and decided to take matters into my own hands. Based on the trends we observed, various stress models we conducted and our analysis of the new tax law, it is my opinion that business owners should anticipate an increase in business value. This is great news for Baltimore businesses, and I think it makes this a better time than ever to discuss the impact of the new tax plan with advisors and determine how the expected increase in business value affects tax position and financial planning.
There are a number of different elements in the Tax Cut and Jobs Act that are expected to impact business value. These elements include:
- Lowering the corporate tax rates
- Taxing pass-thru entities (PTE) rates lower than individual income tax rates
- The ability to expense capital investments in the year of purchase rather than depreciating them
- Changes to the interest deduction for businesses
Based on our models, each of these individual elements collectively increases the value of a business.
The corporate tax rate lowering to 21 percent has a significant impact on business valuations for C Corporations. Under the Income Approach, the present value of future cash flows is used to determine the value of a business. Lowering the corporate income tax rate to 21 percent is expected to increase cash flow since the corporation will pay less in taxes going forward. Increases in cash flow result in increases in business valuation. There are other elements under the Income Approach that may change, but ultimately, the value of the business is expected to increase.
The lower corporate tax rate is also expected to have an effect on the Market Approach, specifically the Guideline Merged and Acquired Company method (also known as the Transaction Method) in our valuation analysis. This method uses historical transactions of comparable acquired companies as a proxy to determine market multiples to use in the valuation of the subject company. Transactions that happened prior to the Tax Cut and Jobs Act have different tax structures than transactions that have occurred since the Tax Cut and Jobs Act. There is significant differentiation in tax structure in these transactions and we have determined that an adjustment needs to be applied to transactions that have occurred prior to the Tax Cut and Jobs Act. Based on our stress models, the adjustment tends to increase the value of a business based on the tax changes from the Tax Cut and Jobs Act.
The changes to PTEs are not as straightforward in the Tax Cut and Jobs Act. These business entities have historically had tax advantages over C Corporations since PTEs are taxed at the individual level only while C Corporations are taxed at the corporate and individual level. The Tax Cut and Jobs Act changes taxes for PTEs by introducing the qualified business income (QBI) deduction which may have a significant effect on the taxes for PTEs. There is also differentiation in the type of PTEs (such as service and non-service businesses) and the level of the QBI deduction that the PTE can take. In terms of business valuations, the results vary. The majority of our stress models indicate that non-service PTEs have favorable tax changes compared to service PTEs and thus see higher business value with all else being equal.
The other elements of the Tax Cut and Jobs Act— including the ability to expense all of, instead of a portion of, the capital investments in the year purchased — will allow businesses to lower their taxable income and thus lower the income taxes they must pay. In addition, there is a limit for the amount of interest expense that a business can deduct which could affect the cash flows of the business. These items have mixed result when it comes to the effect on business valuations.
There are many reasons it pays to know the value of a business, including tax planning purposes, corporate planning purposes, transaction purposes, domestic purposes and financial reporting purposes. Regardless of the reasons, business owners and their professional advisors need to be aware of the expected increase in business value in the near future. Getting a valuation completed in order to learn about the potential increase in value to a business is an important decision because knowing the value of the business allows the owner and advisors to plan strategically in the future.