Unlike “C” Corporations, who are taxed on their earned income at the entity level and then taxed again at the individual level on dividend distributions (distributed earnings), pass-through entities, such as “S” Corporations, Limited Liability Companies (LLC’s), and Partnerships, are taxed only at the individual owners or partners rate. However, with the implementation of the Tax Cuts and Jobs Act of 2017, the effective tax rates at which this income is taxed will change starting in 2018.

One of the significant provisions from the Tax Cuts and Jobs Act of 2017 – Section 199A that changed for 2018 and future tax years, at least until 2026, is that “S” Corporations and other pass through entities will be allowed a 20% deduction for qualified business income (QBI) if they meet certain requirements. This is where it gets tricky. Even the American Institute of Certified Public Accountants (AICPA) has urgently asked the Internal Revenue Service (IRS) for several clarifications regarding the definition of “qualified business income”. Due to the lack of specificity, valuation analysts are currently working with limited guidance on the tax changes when valuing pass-through entities.

Why is this Significant?

Depending on the size of the pass-through entity, the amount of tax savings resulting from a 20% deduction for qualified business income (QBI) can significantly impact the value of the business. Under the Income Approach in valuing a business, the valuation analyst determines the entities value based on the net present value of expected future “after tax” profits. To do this properly, the valuation analyst must consider the taxes that would be paid on the income generated, also known as tax affecting. Whether a 20% deduction is allowed or disallowed significantly impacts the value of the business, by 20% if all the income is considered QBI.

It should be noted, tax affecting pass through entities and whether it is appropriate or not is an area of intense discussion in the valuation community. The main source of contention is that pass-through entities are not taxed at the entity level, therefore; should not be tax affected. Others believe they should be tax affected to arrive at the true economic benefit to its owners. With that said, this topic is far beyond the scope of this article.

CPA’s and business valuation analysts alike are closely following guidance updates with respect to the Tax Cuts and Jobs Act of 2017 from the IRS and other sources including uncertainties related to the Section 199A 20% deduction for QBI. 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.