Abstract: The Tax Cuts and Jobs Act (TCJA) — enacted in late 2017 — will fundamentally alter the tax rules for businesses. This article explains some of the favorable and unfavorable provisions that valuation professionals must evaluate when they estimate the value of business interests.
Tax Cuts and Jobs Act
Factoring tax reform into the valuation equation
The Tax Cuts and Jobs Act (TCJA) — enacted in late 2017 — will fundamentally alter the tax rules for businesses. While most of the changes affecting businesses are permanent starting in 2018, they’re not all favorable. The effects of the TCJA will vary from business to business. But one thing is certain: Valuation professionals will need to evaluate the effects of the changes when they estimate the value of business interests.
How might cash flows increase?
Most businesses and owners are expected to owe less federal income taxes under the TCJA than under prior law. Three major changes that will likely increase business cash flows starting in 2018 are:
- Lower tax rates. C corporations and personal service companies are now subject to a flat 21% federal income tax rate. Under prior law, these entities were subject to graduated tax rates as high as 35%. The corporate alternative minimum tax (AMT) has also been eliminated.
Likewise, pass-through entities (sole proprietorships, partnerships, S corporations and limited liability companies) received a tax cut under the TCJA. In addition to lower individual tax rates, owners of these entities may be eligible for a deduction on qualified business income (QBI) of up to 20%. Eligibility for the QBI deduction depends on the nature of the business and the owner’s share of 1) W-2 wages, 2) basis in qualified property, and 3) pass-through income. The QBI deduction is only available through 2025, unless Congress extends it.
The QBI deduction is intended to help achieve tax-rate parity between C corporations and pass-throughs. This provision may cause valuation experts to rethink their position in the so-called “tax-affecting” debate. However, it’s important to note that C corporations are still subject to double taxation under the TCJA — once at the entity level and again when dividends are paid or a sale results in capital gains.
- Expanded first-year deductions for fixed asset purchases. The Section 179 deduction has increased to $1 million, and the phaseout threshold has increased to $2.5 million. These changes are permanent, and the amounts will be adjusted annually for inflation.
In addition, first-year bonus depreciation on qualifying new and used property increases to 100% for assets placed in service between September 28, 2017, and December 31, 2022. Thereafter, the percentages generally fall to 80% in 2023, 60% in 2024, 40% in 2025, and 20% in 2026. The program expires at the end of 2026, unless Congress extends it.
- Liberalized tax accounting rules for small businesses. More small businesses (with average annual gross receipts for the three previous tax years of $25 million or less) will qualify for cash-basis accounting rules and simplified inventory reporting methods under the TCJA. These changes could provide opportunities for small businesses to defer future tax obligations.
Which changes are unfavorable to business?
The TCJA includes some provisions that could offset business tax cuts. For example, it establishes new limits on deductions for business entertainment, certain transportation-related employee benefits, interest expense deductions, executive compensation deductions and net operating losses.
The TCJA also repeals like-kind exchanges (except for real estate exchanges) and the Sec. 199 deduction (also known as the manufacturers’ deduction or the domestic production activities deduction). What’s more, companies will be required to capitalize specified research or experimental expenditures, rather than to expense them as incurred, starting in 2022.
Beyond tax cuts
The TCJA is expected to result in sweeping changes as businesses adjust their daily operations and long-term strategies. Experienced valuation professionals must evaluate how tax law changes will affect the expected future earnings and capital structure of each unique subject company.