On September 27, 2017, the Republican led congress in conjunction with the White House released its long-awaited framework (the Framework) outlining the current legislative effort on comprehensive tax reform. Although many significant details have yet to be defined, major provisions such as a lower corporate tax rate for both C corporations and pass-through entities (S corporations, LLC’s and partnerships) will have a significant impact on the cash flow capacity and valuation of these entities.
According to the Framework, the top marginal tax rate for C corps could be reduced significantly from 35% to 20%. The pass-through entity tax rate (S corporations, LLC’s and partnerships) would be reduced to 25%, with some restrictions. Currently, income generated by such entities are taxed at the individual shareholder’s personal tax rate. If voted into law, the Trump Administration’s version of tax reform will likely have a significant impact in the following key areas:
• Corporate Cash Flow – In general, cash flow is generally defined as the amount of cash a business has left over at the end of the year after collecting revenue and payment of all expenses. Expenses typically include items such as cost of purchases, salaries and wages, and rent among others. Other cash expenses include interest, taxes, and capital expenditures. Unlike certain cash investments that offer a return on investment, such as a new plant or equipment, cash outlays for taxes offer zero return on investment. Therefore, a reduction in the amount of corporate taxes paid will result in a direct enhancement of cash flow, allowing companies more cushion to fund productive investments such as hiring new employees, funding capital expenditures, paying off debt, or making dividend payments to stockholders.
• Corporate Valuation – In the valuation of a business, it is often said that cash flow (after taxes) is king. This is because when applying the income approach, the value of a business is estimated by projecting future cash flow (after taxes) and discounting those cash flows by an appropriate rate of return (discount rate). As discussed above, since corporate taxes are a subtraction in the cash flow formula, as well as a non-productive use of funds, any reduction in corporate taxes paid will increase cash flow available to the enterprise resulting in a higher valuation under the income approach.
• Value of Tax Benefits – Since tax benefits such as net operating loss carryforwards (NOLs) and deductions for intangible amortization and interest expense derive their value by shielding taxable income, it follows that a reduction in the corporate tax rate would reduce the value of these tax benefits. A lower tax rate means less tax can be shielded during any given year. Therefore, the present value of the future tax benefits is reduced accordingly.
Although there are still many uncertainties regarding tax reform legislation and offsetting impacts, the reduction in the corporate taxes should result in increased corporate valuations. Valuation professionals and CFO’s will need to monitor these changes and modify their pricing models and forecasts accordingly.