Michael B. Lehner, CPA/ABV, CFE, ASA
732-412-3825
MLehner@zbtcpa.com
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3 questions to ask about tax reform when valuing a business

how tax reform will specifically affect the subject company’s cash flow

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In every business valuation assignment, the expert must consider the current regulatory environment. The recent tax reform legislation is the biggest change to the tax law in over 30 years. It will lower taxes for many businesses and is expected to provide various growth opportunities. When valuing a business under the new tax law, it’s important to ask these questions.

  1. How much tax will the company save?

The new tax law is known as the Tax Cuts and Jobs Act (TCJA) for a reason: It cuts the corporate tax rate to a flat 21% and eliminates the 20% corporate-level alternative minimum tax. Under prior law, C corporations and personal service corporations were taxed based on a graduated rate scale that topped out at 35%.

To help level the playing field, the new law also allows pass-through businesses — such as S corporations, limited liability companies, partnerships and sole proprietorships — to deduct 20% of qualified business income starting in 2018. This deduction is subject to various restrictions based on income levels and the entity’s W-2 wages. In addition, this break isn’t available for certain types of service businesses at higher income levels.

Experts must consider the full effects of reduced federal tax rates and other business-related tax law changes when valuing a business interest. (See “Beyond tax cuts.”) State taxes may also be affected by changes in the federal tax laws.

Most business owners have already discussed with their tax advisors how the new law will affect the company’s cash flow and the value of any deferred tax items. A business valuation expert probably will ask about these tax planning meetings and request any notes that were taken. This information is essential during the valuation process.

  1. How does management plan to use the savings?

Some businesses could be adversely affected by the tax law changes, such as those with substantial offshore assets and income. But most will pay less in federal taxes. Some companies will use their tax savings to repurchase shares, pay off debt, pay dividends or put money into savings. These options generally won’t add value over the long run. Others will pursue growth strategies by buying new equipment, investing in R&D or hiring new workers. These alternatives could potentially add value.

Management’s intentions about spending any tax savings are critical when valuing a minority interest. Shareholders who lack control of strategic decisions are at the mercy of controlling shareholders who may not pursue growth options.

Conversely, when valuing a controlling interest, an expert might assume that management has a fiduciary duty to pursue options that maximize shareholder value. However, it’s important to note that strategies that might expose stakeholders to excessive risks could adversely affect a company’s cost of capital.

Management’s spending plans could, in turn, affect other valuation assumptions. For example, if management plans to use tax savings to pay off debt, it could affect the company’s capital structure and the cost of capital your valuation expert uses in the income approach.

  1. Are management’s cash flow projections reasonable?

Experts often rely on cash flow projections prepared by management to value a business. Before using these estimates, an expert must consider whether the effects of tax reform have been factored in and whether management’s expectations appear reasonable.

For an added level of assurance, management can ask the company’s accountant to review in-house projections. Or, better yet, management can have an outside financial expert prepare them independently.

Valuation is a moving target

The new tax law brings massive changes to businesses. Experienced valuation experts stay atop the latest legislative developments, consider how the changes will affect a subject company’s earnings and adjust their methods accordingly.

 

Sidebar: Beyond tax cuts

When incorporating the effects of the Tax Cuts and Jobs Act (TCJA) into a business valuation, it’s critical to identify provisions that could potentially affect a subject company’s tax base (the amount to which new, lower tax rates will be applied). For example, the new law:

  • Reduces the deduction for corporate dividends that C corporations receive from other corporations,
  • Limits interest expense deductions for businesses with more than $25 million in annual revenue,
  • Reduces or eliminates deductions for certain employee fringe benefits and business-related meals and entertainment,
  • Imposes a new one-time repatriation tax on offshore earnings and profits for U.S. multinationals,
  • Accelerates depreciation deductions for new and used asset purchases (though the expanded bonus depreciation breaks are only temporary),
  • Eliminates the domestic production activities deduction or “manufacturers’ deduction” under Section 199,
  • Limits deductions for “excess business losses” incurred by noncorporate taxpayers and net operating losses (NOLs),
  • Liberalizes the eligibility rules for the cash method of accounting,
  • Restricts like-kind exchanges for personal property assets,
  • Limits compensation deductions for amounts paid to principal executive officers, and
  • Requires certain R&D expenses incurred after 2022 to be capitalized and amortized over five years (15 years if conducted outside the United States) instead of being deducted currently.

All these changes could potentially affect a company’s cash flow and long-term growth. But the effects will vary from company to company, so it’s important to have an in-depth understanding of the new tax law.

 

Michael Lehner


This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.