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© 2018, by Daniel T. Jordan, ASA, CBA, CPA, MBA, and Martin M. Shenkman, Esq.

This article was published on July 26, 2018 in Financial and Estate Planning, Report 463.

Planning Impact of Possible Valuation Changes

Practitioners are well aware of the significant tax law changes to corporate tax rates enacted as part of the Tax Cuts and Jobs Act of 2017 (“TCJA”). The changes include, among many others, a reduction in C corporation tax rates to 21%, the 20% deduction for qualified business income (“QBI”) under new Code Section 199A, and so forth. These changes may have an impact on valuation of business entities which could impact:

• Matrimonial cases. For example, valuations are used in determining the value of a closely held business of one spouse when computing the values in a property settlement agreement.

• Buy sell agreements. Some formula clauses may be impacted if tax issues are integrated into them. For agreements that embody a fair value definition (whether fair market value or otherwise) the calculations may be affected by the changes.

• Estate planning transfer valuations may be affected. While the high exemptions make this irrelevant for most taxpayers, for the wealthy still affected by the estate tax, assumptions in valuation models that increase values may make planning more challenging. This is important as many ultra-high net worth taxpayers seek to shift wealth before the possibility of a change in tax laws under a future administration if there is a change in composition in Washington. For example, a client with $100 million business interest may view the current estate tax environment as a window of planning opportunity to act on before a different administration may enact harsher tax legislation. The impact on values of the TCJA may affect the structure of that transaction. For example, a larger value might trigger a need for a guarantee whereas at a lower valuation level that may not have been required. For more moderate wealth taxpayers seeking to take advantage of the current high temporary exemption (the new temporary exemptions decline in 2026 from a basic exclusion of $10 million to $5 million) may be affected by changes in valuations. It may be advantageous for only one spouse to make a gift to preserve the exemption of the other spouse.

• Post-mortem planning valuations. For estates that are not taxable, achieving the largest step-up in income tax basis will be a goal that will be free of estate tax cost. The tax law changes may make it feasible to increase these date of death values thereby maximizing basis step up.

Double Taxation for C-Corporations

A regular corporation (also known as a C-Corporation) is taxed as a separate entity unless it makes an election to be taxed as an S-Corporation. After the corporate income tax is paid on the business income, any distributions made to stockholders are taxed again at the stockholders’ tax rates as dividends. This is the often mentioned “double taxation”. However, there are ways to reduce or eliminate double taxation that a tax adviser can recommend.
Pass-through entities do not pay income taxes at the corporate level. Instead, the owners of the pass-through entity pay income taxes on the funds allocated to them personally on their personal income taxes. (For federal tax purposes, pass-through entities are sole proprietorships, partnerships, limited liability companies, and S corporations.)

Since pass-through entities do not have two levels of tax, pass-through entities have a tax benefit over C-Corporations. Thus, it is proper for business valuators to apply a pass-through entity adjustment either by applying a pass-through entity premium or by lowering the tax rate when tax-affecting the earnings of the pass-through entity.

Valuation Impact Prior to TCJA

How should an appraisal reflect the tax effect of a pass-through entity such as an S corporation? What C and S corporation tax rates should be used?

In computing the corporate taxes, we follow the same methodology based on the Delaware open MRI Associates, P.A. v. Howard B Kessler case in 2006. In rendering the Court’s decision, the Vice Chancellor applied a 29.4% effective tax rate to the earnings of the subject, treating the S Corporation shareholder as receiving the full benefit of untaxed dividends, but equating its after-tax return to the after-dividend return to a C corporation shareholder.¹  The Vice Chancellor compared the cash received by a C Corporation to that of an S Corporation to calculate the implied corporate income tax rate.

In the charts below, we use this model with modified tax rates and assume a high end taxpayer:

Corporate Income Tax Rate

Prior to January 1, 2018 the corporate income tax rate was 35%. Assume a state income tax rate of 8%. Companies deduct state and local tax expenses. The combined income tax rate for C corporations (federal and state) can be estimated at 40%, computed as follows:

35% + 8% – (35% x 8%)

Personal Dividends Income Tax Rate

The top federal rate on personal dividend income is 23.8% (20% top marginal tax rate plus a 3.8% net investment tax to fund the Affordable Care Act). In addition, taxpayer face personal dividend taxation at the state level that ranges from zero in states with no personal income tax to 13.3% in California. In this article, we assume an 8% state income tax rate. Taking into account the deductibility of state taxes against federal taxes, we estimate a 29.9% tax on personal dividend income.

Personal Income Tax Rate

Prior to 2018, non-corporate owners of pass-through entities and sole proprietors faced a maximum marginal tax rate of 39.6% (not including the 3.8% Medicare surtax).²  With the state income tax of 8% and taking into account the deductibility of state taxes, we estimate a 44.4% marginal income tax rate for individuals.

So, prior to 2018, the cash or revenue received by a C-Corporation would be evaluated as compared to that of an S-Corporation, as follows:

In other words, the appraisal might apply the effective tax rate of 20.2% to the earnings of an S-Corporation, treating the S-Corporation shareholder as receiving the full benefit of untaxed dividends, but equating its after-tax return to the after-dividend return to a C-Corporation shareholder.

Valuation Impact After TCJA

Now, after the passage of the TCJA, the corporate tax rate has been changed to a flat 21% starting January 1, 2018. Similar to the above, with an assumed state income tax rate of 8%, the combined income tax rate for C corporations (federal and state) can be estimated at 27.3% using the following equation:

21% + 8% – (21% x 8%)

Personal Dividends Income Tax Rate

We use the same 29.9% tax on personal dividend income as computed above.

What Personal Tax Rate Should be Used?

The issue arises as to what rate should be used to estimate the personal income tax rate? The personal rates that are applicable to income generated by pass through entities is more difficult to determine as it is subject to a number of factors based on each individual owner’s personal tax profile. The new maximum personal income tax rate for 2018 is 37%. However, income generated by a pass-through entity may qualify for a 20% deduction with a phase out threshold of $315,000 for married filing jointly taxpayers for income from a specified service business (“SSB”). SSBs include businesses where the principal asset is the reputation or skill of one or more of its employees or owners, except for engineering and architectures services which were specifically exempted. For non-SSB income the deduction is not necessarily phased out but the limitation rules (50% of W-2 wages or 25% of W-2 wages and 2.5% of the unadjusted basis, immediately after acquisition of tangible asset values) will apply.

In valuing pass-through entities, the following federal tax rates are considered for use in the valuation analysis:

• Specified Service Business Entities – federal tax rate of 37%.
• If Shareholder’s Taxable Income under $315,000– federal tax rate of 37% less 20% deduction resulting in a tax rate of 29.6%.
• If Shareholder’s Taxable Income over $315,000– federal tax rate of 37%.

Next, reconsider the above chart for two scenarios: an S corporation shareholder who qualifies for the 20% QBI deduction, and an S corporation shareholder that does not qualify for the deduction. If the S-Corp shareholder qualifies, use a federal tax rate of 29.6%. This is the 37% individual tax rate, less the 20% deduction. With the state income tax of 8% and taking into account the deductibility of state taxes, we estimate a 35.2% marginal income tax rate for this individual.

If the S-Corp shareholder does not qualify, use the maximum 37% individual tax rate. With the state income tax of 8% and taking into account the deductibility of state taxes, we estimate a 42.0% marginal income tax rate for this individual.

The new table starting for 2018 should be as follows:

Scenario I:
Assuming the S-Corp Shareholder qualifies for the Code Sec. 199A deduction:

In this instance we apply the effective tax rate of 7.3% to the earnings of the S corporation. In other words, there is a material S corporation benefit over the C corporation (even more than prior to the TCJA changes).

Scenario II:
Assuming the S-Corp Shareholder does not qualify for the 199A deduction:

In this instance it would seem appropriate to apply the effective tax rate of 17.3% to the earnings of the S corporation. In other words, the S corporation benefit over the C corporation is materially lower than in Scenario I (and lower than prior to the TCJA changes).

Based on the above, we can also quantify the S-Corp premium by comparing the available earnings after applying the corporate income tax of 27.3% for the C-Corp vs. the effective tax rate of 7.3% (Scenario I) and 17.3% (Scenario II) for the S-Corp.

Scenario I:
Assuming the S-Corp Shareholder qualifies for the 199A deduction:

Scenario II:
Assuming the S-Corp Shareholder does not qualify for the 199A deduction:

The above charts calculate the S-Corp Premium at 27.6% for Scenario I (with 199A deduction) and 13.8% for Scenario II (without the 199A deduction).

Scenario II will be the most relevant one because we typically perform valuations for medium and large businesses whose shareholders are most of the time high end individuals. Also, the S-Corp premium of 27.6% in Scenario I seems large. The S-Corp premium of 13.8% in Scenario II is more reasonable. Thus, we are more comfortable with the results from Scenario II.

Conclusion

Based on the above analysis, we conclude that after the passage of the TCJA, the S corporation still has a tax benefit over the C-Corporation. The tax benefit is greater when the S corporation shareholder qualifies for the 20% QBI deduction, and lower when the S corporation shareholder does not qualify for the 20% QBI deduction.

From the valuation perspective, it is more reasonable to assume that the S-Corp shareholder does not qualify for the 199A deduction for two reasons:

(a) We mostly value successful businesses and our clients are frequently high net individuals.
(b) The S-Corp premium seems more reasonable and in line with the premium we used prior to TCJA.

Having said this, the C-Corporation may still be a better option than the S-Corporation in some instances.

In our analysis above, we applied the highest rate of corporate tax. However, prior to TCJA, few corporations paid tax at the 35% rate because of existing loopholes. Absent the new tax law, companies in 2018 would pay at an effective rate of 21.2%. With the new tax breaks, though, that rate will drop to an average of 9.2% across all industries, according to the University of Pennsylvania’s Penn Wharton budget model.

Moreover, above we discussed that the reason for the S-Corporation Premium is the avoidance of the double taxation.

However, there are ways to reduce or eliminate double taxation, such as:
1. Pay higher salaries to shareholders.
2. Lease property from shareholders.
3. Defer or eliminate dividend payments.
4. Defer capital gains taxes on shares by making lifetime gifts of appreciated stock.

In other words, corporations could structure their affairs to ensure that a portion of their earnings is paid out to shareholders as compensation, rents, or some other such deductible expense. However, the payments must be reasonable (Reg. § 1.162-7). Otherwise such payments will be recast as dividends. (Reg. § 1.162-8) Alternatively, the corporation could retain its earnings if the shareholders had no need for distributions and the corporation avoids the imposition of the accumulated earnings tax or the personal holding company tax. (Code Sec. 531 et seq).
Thus, good tax planning can often minimize the impact of double taxation, while leveraging the corporate structure to provide other benefits. Plus, with the top individual rate now higher than the top corporate rate and with the ability of a C corporation to retain earnings rather than passing the entire amount through to the shareholders, a regular corporation may be the better choice in some cases.