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How the Tax Cuts and Jobs Act of 2017 Impacts Business Valuation

03.23.2018

Though the winners and losers of the Tax Cuts and Jobs Act of 2017 (TCJA) won’t be fully evident for several years, one thing is certain today: all other factors constant, the TCJA that was signed into law on Dec. 22, 2017, increased the value of many businesses. 

We know this because we know that taxes affect shareholder value. A business has greater cash flow available to distribute to its owners when it pays less taxes – in the same way an employee has more money in her pocket when less of her wages go to taxes. The value of any investment, including companies, is often considered as the present value of its future economic benefits (typically net cash flow). Therefore, there is a direct link between future net cash flow and a business’s value. The TCJA in most cases will increase a business’s future after-tax cash flow.

At the end of January 2018, the S&P 500 index had increased 12 percent since late September 2017, when President Donald Trump’s administration turned its attention to tax reform. We believe this increase was driven, at least partially, by the market’s anticipation of lower taxes on American public companies. The market seems to understand the link between taxes, net cash flow, and value. As such, a similar impact should be noticeable in privately held businesses, although the value increase may be less immediately observable.

It would be an oversimplification to suggest that the only impact of the TCJA is to increase a business’s after-tax cash flow. A lower tax rate also modestly increases the cost of debt, which could offset some of the value gains on the cash flow side. Additionally, the TCJA places certain limitations on the deductibility of interest expense. Companies with higher debt levels may see a further increase in the cost of debt, making equity financing increasingly more attractive.

Impact on business value of C corporations

The new flat corporate tax rate of 21 percent is intended to be permanent and is a significant decrease as compared to the 35 percent tax rate paid on income over $10 million under the previous tax law. Given the permanent nature of this decrease, many companies currently with negative taxable income should realize an (albeit smaller) increase in value as long as the business anticipates becoming profitable in the future (and paying the lower tax rate on those future earnings).

Impact on business value of pass-through entities

Pass-through entities will generally increase in value from the cuts made to the individual tax rates, although the individual tax rate cuts were modest compared to the corporate rate cuts. The real value driver with respect to pass-through entities is the 20 percent qualified business income (QBI) tax deduction, which generally allows non-service businesses to pay taxes on only 80 percent of their income. Unfortunately, this deduction won’t be available to all pass-through entities. Also, the 20 percent QBI deduction and the individual tax rate cuts are only provided through 2025, as opposed to the C corporation’s permanent tax reform structure. The uncertainty surrounding an extension of these tax cuts past 2025 increases the risk of the projected after-tax cash flows and likely tempers the increase in value experienced by pass-through entities, as compared to C corporations.

C corporations are likely to see a more universal and consistent increase in value from recent tax reform. Pass-through entities should see increases in value but with a higher variance depending on the type of business and its manner of operation.

Team

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