The Tax Act has a Significant Impact on 2018 Business Valuations

By Jay Sickler

I’m sure you’ve read a lot about the Tax Act’s impact on corporate and personal income taxes, but the 2017 Tax Cuts and Jobs Act is also throwing the business valuation profession into a bit of a frenzy.

Since 1993, business valuation practitioners have been able to utilize a consistent corporate income tax effective rate of 35%.  The new corporate tax rate of 21% is the lowest in the U.S. since 1939!

The Tax Act changes will impact valuations for both C corporations and S corporations.

C Corporation Valuation Impact

With all other things being equal within U.S. C corporations, an income tax decrease of 14% translates into a 14% increase in net income and potential cash flow for reinvestment and dividends.  Increased future cash flows have a direct impact on business value.

While it might be obvious that lower tax rates lead to higher cash flows, the decrease to the corporate tax rate also serves to increase the cost of debt. Cost of debt is the interest a company pays on its borrowings. Because interest expense is deductible for tax purposes, a higher tax rate leads to a greater benefit of taking on debt.

Assuming a company’s debt to equity ratio is fixed, an increased cost of debt produces an overall increase to cost of capital. This lowers the value of a company. As you can see, the decrease to the corporate tax rate not only increases available cash flow, but also increases cost of capital to those companies leveraged with debt.

Overall, we generally expect that C corporations’ business values will increase with the new Tax Act but the increase in cost of capital could mitigate the overall increase.

S Corporation Valuation Impact

You might be wondering: if I own an S corporation, how is my value affected?  Well, under tax rates in place prior to 2018, most appraisers around the country added what is known as an S corporation premium. This premium, as applied to the equivalent C corporation values, reflected the pass-through nature and income tax advantages of S corporations. However, with the C corporation rate now moving from 35% to 21%, this premium has disappeared in most cases.

Other Valuation Impacts of the Tax Act

In addition to the above changes in the tax law affecting corporate valuations, the following items will also impact value:

  • Limitation of business interest to 30% of adjusted taxable income
  • Bonus depreciation of 100% of qualified property until 2022 and then a step down in percentages from 80% to 0% between 2023 and 2027
  • The varying effect of 20% QBI deduction for S corporations depending on whether they are service or non-service businesses

Taxes matter because they directly impact cash flow to shareholders, and cash flow to shareholders impacts value.  If you are a closely held business owner, or are advising business owners, keep in mind that values are not what they were in 2017.