ESOP Valuations and the Effect Tax Reform Will Have

Late last year Congress passed the final version of the Tax Cuts and Jobs Act of 2017. Although the plan does not alter ESOP legislation, there are some indirect effects on ESOPs.  Some of the changes will impact the valuations of ESOP-owned companies.

Increased After-Tax Earnings

The Act effectively lowers national corporate income tax rates from 35% to 21%. As many appraisers tax affect earnings of both C and S Corporations for valuation purposes, this change will impact ESOP valuations of both corporate structures.

The lower income tax provision will boost after-tax earnings and implied cash flows, which will increase stock value.

Public stock market returns, on which valuations are also based, should likewise experience a boost from the lower corporate tax rates, providing another positive impact to stock value of ESOP-owned companies.

Increase in Repurchase Obligation

Improvements in stock value for ESOP-owned companies also means increases in repurchase obligation, an offsetting factor.

For S Corporations, which pay no corporate taxes in reality, there is no corresponding true increase in cash to cover the increase in repurchase obligation.

This negatively impacts the final stock value by means of a potential increase in the Discount for Lack of Marketability.

Considerations for Partially Owned ESOPs

Partially-owned ESOP companies may be impacted by the new tax plan in two ways.

Limitation of Net Interest

The Act limits net interest deductions to 20% of EBITDA for four years, after which the calculation of maximum deductible interest payments will be based on earnings after depreciation and amortization are subtracted.

New leveraged ESOPs may find that their deductible expenses will be lower and, therefore, their taxable income higher. This would offset some of the positive impacts of the lower tax rates.  (This will not affect 100% owned S Corporations that do not pay corporate taxes.)

Potential for Lower S Corporation Distributions

It is common practice for S Corporations that are owned less than 100% by an ESOP to pay distributions to cover the personal tax liabilities of non-ESOP owners. In those situations, the ESOP will receive its pro rata share of such distributions.

The Act, however, allows owners of S Corporations to now deduct 20% of their income. This translates to lower distributions to S Corporation ESOPs as the non-ESOP owners will now declare 20% less taxable income and, therefore, require a smaller distribution to cover their tax liabilities. This reduction in distributions could slow down the process of ESOP loan repayment and, therefore, negatively impact stock value.

The Bottom Line

As each ESOP-owned company is different (C Corporation versus S Corporation, leveraged versus non-leveraged, and various levels of ownership), it is impossible to generalize the net effects of the tax reform on ESOP-owned companies as a group.

The decrease in corporate income taxes will have a positive impact on valuation, but this may be mitigated by other impacts as discussed above, such as the lack of a corresponding increase in cash to cover the increase in repurchase obligation for an S Corporation.

It is important to note the potential impacts caused by the Act and discuss with your advisors.

If you have comments or questions about this article, or would like more information on this subject matter, please contact us.
Tracy Lamb

Valuation
tlamb@pcecompanies.com
Orlando Office

407-621-2100 (main)
407-621-2118 (direct)
407-621-2199 (fax)