Moore Stephens North America is comprised of over 40 member firms that provide key services across a wide variety of industries and niches. This month’s “Moore Together” is a collaboration between Jason Buhlinger and Matt Byford with Brown Smith Wallace, and Thomas Grohs with Citrin Cooperman.
The enactment of the Tax Cuts and Jobs Act (“TCJA” or “Tax Reform”) has added a level of complexity to business valuation that did not exist before, at least as far as income taxes are concerned. The following addresses the effects of the TCJA, and the aspects that valuation analysts should consider when performing valuations of companies with valuation dates subsequent to the passing of the TCJA.
- Corporate Structure
According to Shannon Pratt, in the Fifth Edition of his book Valuing a Business, “…there is general consensus among appraisers that there is little or no difference in controlling interest market values between S corporations ("S-corps") and C corporations ("C-corps") under most circumstances, and that any difference depends on finding a buyer that can take advantage of certain potential tax savings.” Shannon’s point is further evidenced by the fact that historically we have not seen ample evidence of investors “flipping” C-Corps to S-Corps (or vice versa) to unlock value if one entity type was inherently worth more than another. However, with the passing of the TCJA this could very well change. It is possible that the TCJA has created an economic incentive to “flip” under certain circumstances, particularly among businesses not eligible for the Qualified Business Income (“QBI”) pass-through deduction.
C-Corps received a tax rate reduction across the board, while the QBI deduction offered to pass-through entities is much less straightforward. The TCJA has essentially forced valuation analysts to be much more knowledgeable about the tax effects of each type of legal structure. Should the valuation analyst now choose the optimal tax structure and assume this is what a hypothetical buyer would consider? Or assume a hypothetical buyer would choose not to “flip” the entity? Or continue to tax S-Corps and C-Corps similarly? The answer is currently uncertain.
- Projecting Cash Flow
When projecting cash flows under the income approach, it is imperative that analysts consider the following provisions of the Tax Reform:
- Ability to expense 100% of certain business assets for assets acquired and placed in service after September 27, 2017 and before January 2, 2023
- The use of net operating loss deduction being limited to 80% of taxable income for losses incurred after 2017
It is also important to consider the amount of tax savings that will immediately turn into increased cash flow. Will the tax savings be spent on capital expenditures, bonuses for employees, etc.? Also, if they are spent on capital expenditures and/or bonuses, are these essential to the operations of the business or are they driven by the company’s tax strategy?
- Depreciation
More analysis is necessary to forecast depreciation. C-Corps are eligible for bonus depreciation and S-Corps are eligible for increased levels of Section 179 depreciation.
- Capital Structure of Industry
A decrease in the tax rate increases the cost of debt. Certain industries, especially those that are highly leveraged, may be affected more because of the interest expense deduction limitation. Some industry capital structures may change rather abruptly (i.e. move toward less debt financing). Is it still appropriate to use historical figures as inputs into the calculation of the weighted average cost of capital?
- Equity Risk Premium
Analysts may contemplate making an adjustment to the equity risk premium. However an adjustment is tough to defend as the equity risk premium is typically calculated based on historical returns required by investors, which includes returns under several different tax regimes.
- Uncertainty of the Tax Rate Cuts in Perpetuity
The expiration of certain guidelines included in the TCJA (e.g. accelerated depreciation) has undermined the reliability of the capitalization of benefits method under the income approach. Similarly, when calculating the terminal value in the discounted future benefits method, the analyst must consider aspects of the Tax Reform that do not extend into perpetuity but are included in the discrete projection period. Should the discrete period forecast extend until the temporary portions of the TCJA expire? Is it acceptable to assume portions of the TCJA will be renewed?
There are certainly many more effects of the Tax Reform that will come to light as valuation analysts encounter them in practice. All the factors above are further compounded by whether the engagement call for the determination of fair market value, which contemplates a hypothetical, willing and able buyer and seller, and whether the subject interest is a control or minority interest.
To learn more about the impact the TCJA is having on business valuations, please contact
Jason Buhlinger or
Matt Byford with Brown Smith Wallace, or
Thomas Grohs with Citrin Cooperman.
We’re great alone, but we’re “Moore Together!” If you would like to collaborate with other members, or if you have a topic you would like to address, please contact
Laura Ponath.