The Tax Cuts and Jobs Act (TCJA) brings numerous changes that will affect businesses’ operating cash flows and values. One change in particular — referred to as the qualified business income (QBI) or the Section 199A deduction — is critical to understand when valuing pass-through entities (PTEs). For purposes of this article, PTEs include sole proprietorships, S corporations, limited liability companies (LLCs) and partnerships.
History of the tax-affecting debate
PTEs generally pay no entity-level income tax. Instead, income is passed through to their owners, who are taxed at their individual income tax rates.
Historically, this has given PTEs a tax advantage over C corporations, which are potentially subject to double taxation. That is, income is taxed once at the entity level and again when it’s distributed to shareholders as taxable dividends. As a result, the U.S. Tax Court generally has found that PTEs should be valued at a premium over comparable C corporations, to reflect the economic benefits of pass-through taxation.
Some valuation experts disagree with the Tax Court’s stance, arguing that earnings from PTEs should be “tax affected” based on an assumed corporate income tax rate. The theory is that tax-affecting reflects certain risks assumed by a hypothetical buyer, such as the risk that a PTE will lose its tax-favored status or that minority owners will owe tax on the PTE’s earnings — even when controlling owners fail to make distributions.
As a compromise between these two points of view, valuation experts may use sophisticated models that take into account personal taxes while reflecting a hypothetical buyer’s risk of entity-level taxes.
Unequal tax cuts for businesses
C corporations received several major tax breaks under the TCJA. Notably, their federal income tax rate has been permanently reduced to 21% and the corporate alternative minimum tax (AMT) has been eliminated.
But the top marginal federal income tax rate for individuals only decreased slightly under the TCJA, from 39.6% to 37%. And the individual AMT remains, although the exemption deductions and phaseout thresholds are now higher.
The deduction for QBI is intended to level the playing field between C corporations and PTEs. But it’s available only for tax years beginning in 2018 through 2025, and the deduction is subject to various restrictions and limitations.
To understand how the deduction for QBI affects the value of PTEs, it’s important to learn how it works. The deduction, which applies at the individual owner level, is generally equal to 20% of an owner’s QBI from the entity. (The deduction also can’t exceed 20% of an owner’s taxable income calculated before any QBI deduction, less net capital gains.)
In addition, QBI doesn’t include reasonable compensation received by S corporation shareholders or guaranteed payments for services received by partners.
The deduction is subject to two significant limitations:
- Wage limitation. Above the applicable taxable income threshold, the deduction is limited to either 1) 50% of an owner’s share of the entity’s W-2 wages, or 2) 25% of W-2 wages, plus 2.5% of the acquisition cost of certain depreciable property (including real estate) that’s used by the PTE during the tax year to produce QBI.
- Service business disallowance rule. Income from specified service businesses and businesses “whose principal asset is the reputation or skill of one or more of its employees or owners” is ineligible for the QBI deduction at higher income levels. (See “Which service firm owners may be ineligible for the QBI deduction?”)
These limitations apply only if an owner’s taxable income (calculated before any QBI deduction) is above $157,500, or $315,000 for married joint-filers. Above these thresholds, the limitations are phased in over a $50,000 taxable income range, or a $100,000 range for married joint-filers. The limitations are fully phased in when taxable income reaches $207,500, or $415,000 for married joint-filers.
Tax reform creates valuation challenges
It’s unclear whether PTEs are still advantageous from a tax perspective under the new law, especially after the deduction for QBI expires at the end of 2025. Generally speaking, it’s important for valuation experts to understand how the TCJA (and any future tax law changes) affect different types of businesses and factor company-specific effects of the changes into their valuation analyses.
Which service firm owners may be ineligible for the QBI deduction?
Owners of “specified service businesses” are ineligible for the qualified business income (QBI) deduction if their taxable income (calculated before any QBI deduction) exceeds $207,500, or $415,000 for married joint-filers. This disallowance rule potentially affects owners of pass-through businesses that perform services in these fields:
- Actuarial science,
- Performing arts,
- Financial services,
- Brokerage services, and
- Investing and investment management, trading, or dealing in securities, partnership interests or commodities.
The tax law specifically excludes architecture and engineering firms from the service business limitation, however. To determine whether this provision applies to a particular service business, contact a financial expert who’s familiar with the latest IRS guidance.