Tax Affecting Privately Held Companies – It’s Not as Simple as Yes or No
When valuing a privately-held company it is common to consider the effect of income taxes on cash flows. One would think this is nothing more than a simple mathematical calculation. However, the entity type, the valuation purpose and the industry in which the company operates may all have bearing on not only the tax rate but also the appropriate level of taxable income, making the tax calculation a bit more challenging.
Traditional C corporations pay taxes directly at the corporate level and these tax calculations are fairly straightforward thanks to the Tax Cuts and Jobs Act of 2017. The current federal tax rate for C corporations that is applied to taxable income is a flat 21%. This would seem simple enough, however consideration of possible tax credits, tax deferrals, and accelerated deductions for depreciation, can make the calculation a bit more complex. A company may also be subject to certain deduction limitations based on the type of expense or the industry. For example, interest expense paid to related parties may be limited if the debt does not meet certain IRS criteria. Companies operating in the cannabis industry may be subject to Section 280E of the Internal Revenue Code which prohibits the deduction of otherwise ordinary business expenses from gross income. As a result, businesses in this industry can have an effective tax rate as high as 80%
Pass-through entities have even more complexity.1 Prior to Gross v. Commissioner (“Gross”), it was common for business appraisers to tax-affect the earnings of privately-held businesses at C corporation rates, regardless of the entity type under the argument that potential buyers would be C corporations and investors would consider taxes in determining the purchase price of a company. Since the Gross decision, many business appraisers continue to argue that pass-through earnings should be tax-affected, but the methods of tax-affecting are not universally agreed upon. First, which tax rate should an appraiser use: C corporation rates or personal income tax rates? It is not a simple answer and could vary when valuing a controlling and noncontrolling interests.
Arguments for using C corporation rates include a C corporation is the most likely buyer in that particular industry, which would be a relevant consideration when valuing a controlling interest, or that using C corporation tax rates allows for better comparison to other companies in the industry. Alternatively, valuation purpose might dictate this decision, as Employee Stock Ownership Plans (“ESOP”) valuations are typically taxed as C Corporations regardless of the entity structure.
Those appraisers using personal income tax rates argue that these are the tax rates currently being paid by the owner(s) or will most likely be paid by the purchaser. However, the use of these tax rates is also not without issue. While some business appraisers believe that the actual income tax rates for the business owner should be used, in doing so, an assumption is made that a hypothetical buyer of the company will be in the same tax bracket as the current owners and will incur the same income taxes. This may or may not be true.
The use of personal rates becomes even more complicated when the pass-through entity has multiple owners. The appraiser may not have access to the tax information of each of the owners to determine their tax brackets or it may be found that each owner is in a different tax bracket. In such instances, the appraiser is faced with the challenge of either using one owner’s tax rate or a blended rate of all the owners. Because of these complexities and potential unknowns, some appraisers believe that the tax rates of a hypothetical pool of buyers should be used.
Another complexity in using personal tax rates is that the current tax rates, which were lowered by the Tax Cuts and Jobs Act, are set to increase December 31, 2025 when the tax bill expires. Therefore, consideration as to the impact of potential tax increases may have to be considered in valuation.
Finally, if using personal income tax rates, consideration must be given to the Qualified Business Income Deduction (“QBI Deduction”). When the Tax Cuts and Jobs Act reduced the C corporation tax rate to 21%, Congress created the QBI Deduction as to not disadvantage owners of pass-through entities by leaving them with a substantially higher tax liability than C corporations. The deduction allows taxpayers to deduct up to 20 percent of their qualified business income (QBI) but is subject to limitations based on income thresholds of the taxpayer, the type of trade or business and the amount of W-2 wages paid by the company, just to name a few. Therefore, the decision to use personal income tax rates comes with quite of number of challenges that an appraiser must consider and support.
Whether tax affecting at a C corporation rate or an individual rate, state and local taxes should also be considered. Depending on the type of business state and local taxes could be based on the company’s current location, or a more hypothetical blend of state and local tax rates. For companies located in high tax areas such as California or New York City, these rates can have a more significant impact on value.
Tax rates, level of control, ownership structure, industries, location, and all the specific facts and circumstances of the company being valued and the engagement type must be considered by an appraiser to arrive a supportable conclusion. While the Gross case brought change to the way valuation professionals view income taxes of pass-through entities, the debate goes beyond whether or not to tax affect.
1. A pass-through entity is any entity whose profits are taxed at the shareholder level, not the entity level. Common pass-through entities include Subchapter S corporations, Partnerships and Limited Liability Companies.
2. The Tax Court ruled in this 1999 case that tax-affecting the earnings of the pass-through entity owned by the estate was not appropriate.