In previous articles, I have stated that all business valuations are forward looking. I still believe this is true. I also discussed the potential impact that the bonus depreciation provision of the Tax Cuts and Jobs Act can have on a business valuation by providing real tax dollar savings. Within these two topics lies a possible valuation minefield that can be easily overlooked. What happens if you are a new minority interest investor in a Company and you miss out on a big year of bonus depreciation? If the Company is a C Corporation and has financial statements prepared, there should be a deferred tax liability disclosed that could alert you to the situation. But if the Company is a pass-through entity (S Corporation or LLC for example), there is no requirement to disclose deferred tax liabilities to the shareholders in the financial statements of the Company. As a result, this possible future liability can be missed.
I believe that not only should you consider the possible bonus depreciation tax savings going forward, but you must also consider the internal/tax depreciation differences of past capital expenditures (the reversing impact of tax advantaged depreciation).
I can illustrate this using an example with the following assumptions: the Company is an S Corporation that makes capital expenditures eligible for bonus depreciation. Applicable tax rates are 33% through 2025 and 41.5% from 2026 on. The applicable discount rate is 20%.
In Exhibit 1, we show the impact in 2018 of bonus eligible capital expenditures that were $15,000,000 for 2018 and $1,000,000 every year after. The Valuation impact is $1.8 million in tax savings.
Click on the image above to view Exhibit 1 in PDF.
In Exhibit 2, we show the impact in 2019 on value but only consider the bonus depreciation effect of the $1,000,000 capital expenditures each year. The valuation impact is almost $377 thousand in tax savings.
Click on the image above to view Exhibit 2 in PDF.
In Exhibit 3, we show the same impact in 2019 on value as in Exhibit 2, but we also only consider differences between internal and tax depreciation from previous capital expenditures where bonus depreciation was taken (the $15 million from 2018). The valuation impact is dramatic with a tax cost of over $2.6 million. A total difference in value of over $3 million.
If you were a minority interest investor in the Company in 2019, which Exhibit would you want to consider? The impact of internal/tax depreciation differences resulting from past capital expenditures could be material to value. Every valuation situation is unique and must consider the specific facts and circumstances to determine the possible impact on value. An investor purchasing 100% of a Company may not need to worry about internal/tax depreciation differences because their basis in the assets will be reset on purchase, but a minority interest investor should consider the differences.
Should you have questions regarding the impact of bonus depreciation or internal/tax depreciation differences have on a business valuation, please contact me, T. Eric Blocher, Principal and Director of Business Valuation Services, at firstname.lastname@example.org.