On December 22, 2017, the Tax Cuts and Jobs Act (Tax Act) became law, resulting in significant changes to the treatment of corporate taxes, as well as gift and estate tax provisions. Interpretation of how these changes will impact valuations is evolving. The following is a Q&A addressing three general components:
- The impact of changes to corporate taxes on company value
- A go-forward approach to valuations
- Changes impacting gift and estate tax provisions
Impact on Company Value
Q: Do the provisions of the Tax Act increase or decrease values?
A: For the most part, the Tax Act will have an upward impact on company value. This effect of the Tax Act was evident in the 2017 stock market, where anticipated tax cuts helped drive up the market to record levels. The Dow closed the year at 24,719, up 25.1 percent, and the S&P 500 closed at 2,674, up 19.4 percent. Nonetheless, many factors are facts and circumstances specific. Companies that have historically incurred high effective tax rates and/or invested heavily in capital expenditures will pay less in taxes, thus likely contributing to an increase in business value. In the meantime, companies that have historically incurred low effective tax rates, operating at a loss for tax purposes, investing little in capital expenditures and are heavily leveraged, such that interest expense is greater than 30 percent of EBITDA, will be negatively impacted by the Tax Act, thus potentially contributing to a decline in value. It is important to note that the Tax Act also allows for the repatriation of cash at lower interest rates, so although taxes will now be paid on that cash, the taxes are at a lower rate than previously stated. This should enhance a company’s liquidity and allow for stock buybacks, acquisitions and other corporate activities, which may also augment a company’s value. For many companies, the factors move in opposite directions; however, as stated previously, on a net basis we expect the Tax Act to be value accretive.
Q: How does the Tax Act impact corporate taxes paid in individual states?
A: There are 45 states, including the District of Columbia, with a corporate state income tax. Only Nevada, Ohio, South Dakota, Texas, Washington and Wyoming do not have a corporate state income tax. The following table presents examples of the combined statutory corporate tax rates in the nine states where VRC has an office:
As can be seen in this table, the combined corporate tax rates in these states range between 25 percent and 29 percent, and the decline in overall tax rate ranges between 12.6 percent and 14 percent. However, the state tax impact has increased in materiality due to the reduction of the corporate tax rate from 35 percent to 21 percent.
Our readers should note that these tax rates do not take into account local taxes or the impact of new rules regarding interest expense deductibility and capital expenditures, and assume that the source of income is domestic.
Q: What factors of the Tax Act have an upward impact on business value?
A: Two – a lower corporate tax rate and accelerated depreciation.
A decline in the C-corporation statutory (vs. effective) tax rate from a high of 35 percent (based on graduated corporate tax brackets) to a flat rate of 21 percent and the repeal of the corporate alternative minimum tax (AMT) for tax years beginning after December 31, 2017, have a material upward impact on business value. In short, lower taxes means more cash flow and more cash flow typically results in higher values. Unlike many other factors of the Tax Act discussed herein, the 21 percent rate does not sunset.
Concerning accelerated depreciation, businesses can now deduct 100 percent of qualified property, plant and equipment (PP&E) acquired and placed in service between September 28, 2017, and December 31, 2022. There is a gradual phase-out beginning in 2023 through the end of 2026. Up to $1 million can be deducted under §179 for the cost of PP&E acquired and placed into service starting in 2018. This means that if a company makes a taxable asset acquisition or makes a §338 election in a stock transaction on September 28, 2017 or after, it can expense the entire purchase price allocable to the PP&E for tax purposes.
Q: Which factors have a downward impact?
A: In most instances, the above two factors collectively have a more significant upward impact than the following five, which have a downward effect:
- Pass-through entities
- Interest expense deduction for highly leveraged companies
- Net operating loss deduction limitation
- Repatriation tax
- R&D amortization
Under prior tax regimes, C-corporation shareholders bore a more substantial tax burden than those who held interests in pass-through entities (PTEs) such as S-corporations, LLCs and LPs. The Tax Act changes for PTEs are complicated, but the benefit of holding an equity interest in a PTE is materially reduced because of the smaller gap between the two types of tax rates resulting from the Tax Act.
Interest expense deductions are limited for companies with average annual revenues over $25 million to the sum of business interest income, and 30 percent of adjusted taxable income (defined as EBITDA for the four tax years between 2018 and 2021, and EBIT thereafter); thus having a downward impact on value for highly leveraged firms. For example, the tax benefits from utilizing debt financing by a $50 million or $500 million capital-intensive business will decline in 2018 and drop even further in 2022. Not impacted are smaller companies, defined as those with average annual revenues under $25 million.
The Tax Act limits net operating loss (NOL) carryforwards to 80 percent of taxable income and eliminates the ability to carryback NOLs (with some exceptions related to select farming and insurance company losses) for NOLs generated in tax years beginning on January 1, 2018. The carryforward period changed from 20 years to indefinite. Note that pre-2018 NOLs are not subject to the 80 percent limitation.
Foreign-sourced income previously held overseas is now deemed repatriated (i.e., subject to tax). Cash and equivalents are to be taxed at 15.5 percent, while illiquid assets will be taxed at eight percent. Taxpayers would be able to elect to pay over eight years with the first installment due with the 2017 income tax return. In addition, no interest will be incurred if paying over eight years. The addition of this tax liability will have a downward impact on the value of companies with foreign-sourced income.
Finally, the Tax Act amends §174 to disallow research and experimental (R&E) expenditures beginning in 2022. While the Tax Act maintains the R&E credit, these expenditures are amortized over five years for R&E expenditures incurred domestically and over 15 years for research done outside the U.S.
Q: Are there any other factors to consider?
A: We do not anticipate any impact on the discounts for lack of marketability or lack of control for investment holding companies (including family LPs and LLCs) due to the Tax Act. We also do not anticipate any changes in the valuation of carried interests with holding periods over three years (but there is a negative impact on those held for less than three years due to the reclassification of the capital gains for such interests from long-term to short-term).
Effect on Valuation Approaches
Q: How is this all affecting approaches to valuing a business?
A: The most significant impact will be in the application of the income approach concerning how valuation specialists and other market participants tax-affect cash flows and adjust discount rates (cost of capital).
There are also considerations in the application of the market and cost approaches. With regard to the guideline public company (GPC) method, tax change has already been reflected in stock prices and resulting multiples. To the extent that there is a statistically significant sample of M&A transactions as time passes, valuation specialists will have to assess the impact on our transaction multiple method. Finally, within the cost approach, as valuation specialists apply an adjusted book value methodology, we will need to adjust the estimated taxes on the difference between the appraised value and tax basis of the assets.
Q: How are discounted cash flow models changing?
A: As we analyze client transactions over the next few months, we expect we will need to modify our thoughts and approaches. Based on provisions in the Tax Act, a discounted cash flow (DCF) analysis would, at a minimum, need to be adjusted for changes in taxes, including the new 21 percent statutory Federal tax rate, the deductibility of state taxes and the ability to immediately expense purchases of certain fixed assets. In addition, in the short term, it may be appropriate to sensitize the DCF to better understand:
(i) Uncertainty as to whether this lower Federal statutory corporate tax rate will be sustainable in perpetuity,
(ii) The fact that market data for the equity risk premiums used to build up this discount rate were determined under a higher tax regime, and
(iii) Uncertainty in how the lower tax rates will influence M&A activity and related transaction prices.
Also, as valuation specialists assess subject company forecasts, a discussion will be needed with management about their plans to use increased cash resulting from reduced taxes for investment in capital expenditures or other initiatives to grow or improve efficiencies.
Q: How does this affect the cost of capital?
A: The components of cost of equity include the risk-free rate, equity risk premiums from the public markets, and company-specific risk premiums. The components of cost of debt include the effective borrowing rate and the applicable corporate income tax rate.
We do not foresee any material change in the risk-free rate or equity risk premiums. However, we may see an impact in cost of equity after consideration of the three factors outlined in response to the previous question, as well as the contemplation of questions such as:
- Will market forces, in the long run, bring prices down to the point where competitive forces offset tax savings?
- How will businesses respond to changes in the treatment of interest expenses and capital expenditures?
- How will the cap on interest rate deductibility impact private equity firms that use debt to finance transactions?
- Will heavily leveraged companies try to lower their debt burden?
- What is the risk that a future Congress will change the rate through a new bill due to change in political control, an economic downturn, a financial crisis, and so on?
With regard to the cost of debt, the Tax Act increases the after-tax cost of debt due to the reduction in the deductibility of interest expense resulting from a lower corporate tax rate. This has an incremental effect on highly leveraged firms that will be subject to the new interest expense deduction limitation.
Q: Is this VRC’s final position?
A: Probably not, like all professionals at this time, our thoughts and interpretations are evolving through further study of the Tax Act, discussions with other professionals, and observations of our clients’ M&A transactions. Each of our valuation analyses will continue to be based on our current interpretation on how hypothetical willing buyers and sellers will apply these changes to their transaction-related due diligence.
Gift and Estate Planning
Q: What did the Tax Act change that would impact estate planning?
A: The estate and gift unified credit exclusion (i.e., lifetime exemption) and generation-skipping tax exemption doubled to $10 million per individual. With inflation indexing, this amount works out to approximately $11.2 million per individual and $22.4 million per married couple for 2018 (marital portability is preserved). These amounts will sunset (revert to $5 million for individuals and $10 million for married couples) at the end of 2025. The tax rate remains at a flat 40 percent.
Q: What happens to the step-up in tax basis?
A: The step-up in the tax basis (i.e., the readjustment of the cost basis of an appreciated asset for tax purposes upon inheritance) of assets to fair market value at death is maintained. With the higher lifetime exemptions, some families with assets not expected to reach the new limits may consider reversing prior estate planning transactions to bring assets back into the gross estate of certain taxpayers upon review with their legal, tax and/or wealth advisors.