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Congress has passed the largest piece of tax reform legislation in more than three decades. The new tax reform act (H.R. 1) (the “Act”), signed into law by President Trump on December 22, 2017, reduces marginal tax rates and makes other policy improvements. This article summarizes the most important changes and its impact on the valuation of businesses.

Changes to Corporate Tax Rate

The C corporation statutory tax rate has been reduced from a high of 35% to a flat rate of 21%, and the corporate alternative minimum tax has been repealed. All else being equal, this will increase the value of the business because after-tax cash flows will be higher.

However, if one is performing a discounted cash flow (“DCF”) analysis, this increase in expected future after-tax cash flows may be somewhat offset by a slight increase in the cost of capital.

The weighted average cost of capital (WACC) is commonly used to determine the required returns for a company. It is made up of two components: the cost of equity and the cost of debt. It is not yet clear whether the tax reform changes will directly impact the cost of equity. However, there will be an increase in the after-tax cost of debt, due to the reduction in the deductibility of interest expense resulting from a lower corporate tax rate. The increase in a company’s required return would negatively impact value. This negative impact would be even greater for highly leveraged entities that are subject to the new interest expense deduction limitation (see below).

Despite the increase in the cost of capital, we expect the impact of a lower corporate tax rate will generally result in higher valuations as corroborated by the equity markets’ strong positive response to the tax reform.

Changes to Interest Deductibility

Under the new law, the deduction for business interest expense may not exceed the sum of business interest income plus 30% of adjusted taxable income. Adjusted taxable income is determined as tax-basis earnings before interest, depreciation, and amortization (EBITDA) for the first five years (2018-2021). This limitation applies to both C corporations and pass-through entities, but small businesses with less than $25 million in average annual gross receipts for the prior three years are exempt from the limitation. Therefore, companies that cannot take full advantage of interest deductibility would be negatively impacted by this change.

Changes to Depreciation of Qualified Property

The cost of most equipment purchased by businesses can now be expensed (i.e. immediately deducted in full rather than depreciated) for five years. This 100% bonus depreciation is available for purchases of both new and used property. Beginning in 2023, these rules phase-out and by 2027 normal cost recovery rules will apply. The legislation also increases the Section 179 threshold to $1 million, so small businesses will be able to deduct the cost of equipment purchases.

This change will allow businesses to use depreciation tax benefits sooner than under the old tax law, increasing their upfront cash flows. Given that a dollar today is worth more than a dollar tomorrow, being able to accelerate these tax benefits will give business value a boost.

Since most valuation models contain both discrete and residual year projection periods, caution is needed to avoid capitalizing a certain level of cash flow that remains subject to shifting tax attributes. For this reason, discrete projection periods may need to be extended in many valuation models to accommodate this variability.

Changes to Pass-Through Entities

Until the passage of the Act, there was an obvious valuation advantage for most closely-held companies to be organized as pass-through entities, especially when the corporation distributed cash dividends to shareholders. (For federal tax purposes, pass-through entities are sole proprietorships, partnerships, limited liability companies, and S corporations.)

A regular corporation (also known as a C-Corporation) is taxed as a separate entity unless it makes an election to be taxed as an S-Corporation. After the corporate income tax is paid on the business income, any distributions made to stockholders are taxed again at the stockholders’ tax rates as dividends. This is the often mentioned “double taxation”.
Pass-through entities do not pay income taxes at the corporate level. Instead, the owners of the pass-through entity pay income taxes on the funds allocated to them personally on their personal income taxes. Since pass-through entities do not have two levels of tax, pass-through entities have a tax benefit over C-Corporations.

Under the Act, C corporations that were previously taxed at the 35% federal tax rate will now be taxed at 21%, while dividends to shareholders are taxed at an effective rate of 23.8% if certain income thresholds are reached. In contrast, S corporations will continue to be effectively taxed at individual tax rates, which will be temporarily lower through the end of 2025.

Under the new Code Section 199A, the Act allows certain S corporation shareholders, LLC members, and partners to deduct 20% of their qualified business income (“QBI”) in arriving at their taxable income.

The phase out threshold is $157,500 for single filers or $315,000 for married filing jointly taxpayers for income from a specified service business (“SSB”). SSBs include businesses where the principal asset is the reputation or skill of one or more of its employees or owners (such as in the field of health, law, accounting, consulting, athletics, financial services, brokerage services, etc.), except for engineering and architectures services where were specifically exempted. For non-SSB income the deduction is not necessarily phased out but the limitation rules will apply, i.e. the 20% deduction cannot exceed the greater of (a) 50% of W-2 wages with respect to the business or (b) the sum of 25% of W-2 wages plus 2.5% of the unadjusted basis, immediately after acquisition of depreciable property).

In performing a valuation of a pass-through entity, the analyst needs to consider whether the 20% deduction applies and be aware that both the lower individual income tax rates and the QBI deduction expire after 2025. This is of particular importance when estimating the terminal value of a pass-through entity using an income approach.

It is apparent that the relative valuation advantage for pass-through entities will diminish. This will trigger a change in the debate over S corp valuations and the pass-through entity premium.

Conclusion

The new legislation lowers marginal tax rates for businesses, allows the expensing for equipment and improves international tax. We will likely see an increase in M&A activity. The Act may result in enhanced economic growth resulting from unleashing foreign and domestic capital and rising wages.

Valuation analysts need to revisit their financial projections to ensure that they properly reflect the direct impacts of changes in the tax law (such as changes in the capital expenditures) and changes in the economy due to enhanced economic growth.