TCJA Impact on Business Values
By Marissa Pepe Turrell, Director, Advisory Services
The most prominent impacts of the Tax Cuts and Jobs Act (TCJA), passed nearly one year ago, are the changing of the federal corporate tax rate from a graduated rate of 15%-35% to a flat rate of 21%, and the elimination of the corporate alternative minimum tax. What effect did the tax reduction have on corporate values? The simple answer is to say that cash flows went up; consequently, values also increased, and for the most part, that is probably true.
In fact, public companies, which often provide insight into private company markets, have seen a substantial increase in their per-share values in the past year. As of the writing of this article, the S&P 500 index was up nearly 10% from December 2017, when the law was passed; but it’s difficult to quantify how much, if any, of that increase was due to the tax law changes. Public company stock prices rose well in advance of the passage of the tax law, indicating that the market likely factored the expected tax savings into stock pricing once the discussion of potential tax cuts became meaningful.
To consider the impact on value of the TCJA, we need to understand the aspects of the TCJA that can impact business value. For C-corporations, notable changes include:
- Permanent change in the C-corporation federal tax rate to flat 21%.
- Interest deduction limitations of 30% of a business’s adjusted taxable income.
- Bonus depreciation – allowing immediate expensing of 100% of the cost of depreciable assets acquired after September 27, 2017, and before January 1, 2023. The allowable percentage expensed continues to reduce through 2026.
- Net operating loss (NOL) deduction limitations – NOLs created in 2018 and later are now limited to 80% of taxable income.
For many C-corporations, the federal tax rate reduction will have a direct effect on increasing cash flow. What, if anything, will corporations do with any extra cash? There are a few options. We’ve seen some public companies buying back shares of stock, though this does not necessarily create value. We’ve seen companies buy additional fixed assets in hopes of expansion, for example to increase production capacity. This takes advantage of lower tax rates and the temporary opportunity to accelerate depreciation offered in the TCJA. We’ve also seen some companies distribute tax savings to employees with bonuses or raises. The value impact from increased employment compensation is more questionable, as companies may feel pressured to do this in order to remain competitive by incentivizing employees who may have other employment options. This strategy may be more akin to maintaining value than increasing value. Finally, some companies have increased distributions, allowing owners to pocket the tax savings. This strategy elicits an increase in value from increased returns, but does not provide reinvestment and additional growth opportunities for a company.
The cap on interest deductions may also play a role in values. Highly leveraged companies that were once able to deduct all of their interest expense and benefit from low-cost debt may unload debt, as it is no longer as cost effective, and as interest rates rise. This may cause a shift in the company’s capital structure and its overall cost of capital, and ultimately may reduce valuations.
The value impact from the TCJA may be fairly straightforward for C-corporations, driven primarily by a simplified and decreased corporate tax rate, but for pass-through entities such as S corporations, partnerships, and limited liability companies, the TCJA is more complex.
For pass-through entities, all of the above changes to the TCJA can impact value, plus these additional factors:
- Change in personal tax brackets and rates (relevant to pass-through entity valuations).
- Qualified business income deduction (QBID) – allowing up to 20% deduction of qualified business income through 2025 for pass-through earnings from certain industries (relevant to pass-through entity valuations).
- Limitation on losses to a threshold of $500,000 for joint filers and $250,000 for others, with excess unused losses carried forward for years 2018 through 2025.
- Maximum deduction of $10,000 for state and local taxes.
Pass-through entities did not see the tax rate declines that corporations did, as these entities are taxed at the shareholder level, and personal tax rates did not see as significant a decline as corporate rates. There was only a slight decline for some brackets in individual tax rates. In order to somewhat equalize the impact of the decline on corporate rates, the TCJA includes a temporary benefit to pass-through entity holders — the QBID — that allows some owners of some pass-through entities to reduce taxable income from their pass-through entities by up to 20%. Entity owners who do benefit from the QBID must decide what to do with any savings — reinvest in the company through fixed asset purchases (and take advantage of bonus depreciation), business expansion, wage increases, or pocket the cash.
These options and the tax changes are far more complicated for pass-through entities, and not all business owners have had the time to factor in the nuances of the new tax law into their business planning. For example, many owners who could benefit from bonus depreciation have not yet made plans to do so. In addition, many business owners are contemplating whether maintaining their companies as pass-through entities makes sense, as the 20% tax break from the QBID expires after 2025, and in the long–term, pass-through entities will be taxed at a higher rate than C-corporations.
In order to determine what all of the above means for business values, we as appraisers are taking the opportunity to have more in-depth conversations with business owners about how they intend to modify operations and what the impact on cash flow will be. We must be particularly careful to consider temporary versus permanent changes to cash flows. In particular, the QBID is a temporary benefit, and we must be careful to not consider those savings in perpetuity. Despite the passage of nearly a year, the impact of the TCJA and changes to managements’ behavior is still unfolding. Ultimately, the impact on values will be company-specific.