Whether it be a business or an individual, we are taxed on the income earned. One main way the value of a business is determined is by understanding the amount of income the business will generate. To do this properly, the valuation analyst must consider the taxes that would be paid on the income generated, also known as tax affecting. When effective tax rates increase, the value of the business essentially falls. Why? The “after tax” income the company can generate would be less because of the increase in the income tax that it pays on that income. Inversely, as effective income tax rates decrease, the value of a business increases because the “after-tax” income would be higher. In other words, the net present value of expected future “after tax” corporate profits are more which is one method by which the value of a business can be determined under the Income Approach to valuation.
2018 Tax Year Reform
Under the Tax Cuts and Jobs Act of 2017, one of the significant provisions that changed for 2018 and future tax years is that “C” Corporations will be taxed at a flat rate of 21% regardless of income level, instead of graduated rates between 15% and 35% for tax years prior to 2018 (Unlike a Subchapter “S” corporation that passes through corporate earnings to its shareholders who pay the tax on corporate earnings, a C corporation pays corporate income tax on its earnings). For a larger company with annual taxable income over $75,000, this can mean a significant decrease in its effective tax rate. Further, increases in “after tax” income can mean more funds available to pay dividends to shareholders or reinvestment into the company.
Consideration of the changes in corporate tax rates and effective tax rates of the company in a business valuation are key factors for the valuation analyst to consider, but the more important input to the valuation is the estimated future “effective tax rate” and not the present corporate tax rate. The estimated “effective rate” is a true measure of the future amount of taxes the corporation pays on its earned income and accounts for tax benefits, such as, allowable business deductions and credits.
The business valuation community is still waiting to judge the full impact of the 2018 Tax Cuts and Jobs Act. It is too early to answer the question of exactly how much business values will go up based on how much future “effective tax rates” of the companies being valued will decrease with the new flat Corporate Tax Rate of 21% for “C” Corporations. However, for a profitable company that is expected to remain profitable for the foreseeable future, the value is higher.
Business valuation is not an exact science. It’s based on judgment, experience and relevant information. It’s important to select a well-qualified professional with extensive experience in evaluating all types of organizations and who are up-to-date on current tax legislation. When facing a potential buyout or other change in business ownership, you need a qualified business valuator to protect your interests. As a full-service CPA Firm, TDT CPAs and Advisors can not only assist you with those challenges related to Business Valuation, but also provide services related to your accounting and tax needs.