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Does Your Business Have The Right Entity Structure Given The New Corporate Tax Rate?

Many business owners are inquiring whether they should convert their business from a pass-through entity (sole proprietorships, partnerships, S corporations and LLCs) to a C corporation now that the corporate tax rate has dropped from 35% to 21%. Alternatively, many business owners who were contemplating converting from a C corporation to a pass-through entity are wondering if it is still a good idea.

One of Quist’s clients who specializes in software development and is structured as a C corporation is struggling with this conundrum. A considerable amount of research about the benefits of converting to an S corporation had already been done, but now that the corporate tax rate dropped so dramatically the company is wondering if it economically still makes sense?

We focused our discussion with the client around three main questions:

Service vs. Non-Service Business

The confusion about entity choice is primarily due to the creation of a 20% deduction for “Qualified Business Income” (QBI) as part of the Tax Cut and Jobs Act. The effective tax rate on income earned on qualified pass-through business owners can be as low as 29.6% (37% x (1-20%) = 29.6%) when combined with the decrease in the top ordinary income tax rate for individuals to 37%. However, only certain pass-through business entities qualify. The definition of a “qualified trade or business” is somewhat elusive as it is defined as any business not in a “specified service”; namely, health, law, accounting, actuarial service, performing arts, consulting, athletics, financial and broker services. Additionally, any trade or business in which the principal asset is the reputation or skill of one or more of its employees would be considered a “specified service”.

QBI eligibility is not clear for our client who sells both products and services. Because of the proportion of revenues derived from services versus products, it was ultimately decided that they would not qualify for QBI; however, there is scant guidance at this point with the IRS as to what specific criteria they will use to determine eligibility.

Profit Distribution vs. Profit Retention

C corporation income is taxed at the entity level at a 21% tax rate and then the net income is taxed again at 20% when shareholders receive dividends. As such, the greater the distributions to shareholders, the more likely a pass-through entity structure may make sense. However, if a business does not intend to distribute profits, but instead plans to reinvest capital in the business, then a C corporation may make more sense.

Our client is fast growing and considered to be in an expansion phase. Outside of distributions made to shareholders to cover tax liabilities, all remaining profits would be retained in the business to fuel growth. On the surface, this would point toward remaining a C corporation.

Continue to run the Company vs. Planning for a Sale

Selling your business as a C corporation has the same double taxation implications as making distributions to shareholders. A business owner that is considering selling their business in the near to intermediate term would be better off as a pass-through entity. However, keep in mind that while there is generally no tax upon conversion from a C corporation to an S Corporation, if assets are disposed of within 5 years of conversion, there is a tax on built-in gains on appreciated assets that the C Corporation had upon conversion.

Conclusions: The business owner we worked with knew that within 5-7 years they were moving toward an internal or external ownership transition. In our discussions this became the driving factor. Ultimately, our client chose to convert to an S Corporation. For most business owners, it is vital to work closely with a professional advisor to understand all impacts of choosing your entity.

Have questions abouthow the new tax laws affect the value of your business? Quist Valuation can help. Let’s set a time for a free 30-minute consultation. We can discuss the specifics of your business and identify the next steps needed to assess the value of your company.

Schedule your free 30-minute consultation here.  

A family office approached Quist Valuation for assistance in managing the reporting that is necessary for their direct investing compliance. This office wanted to capture a higher return on their investment dollars through direct investmentsin private equity.

Should your family office move to a direct investing model?

Moving to a direct investing model has upsides. According to Barrons, “Direct investments returned 8% on average in 2016 compared to the private-equity industry’s 6% return for the same period.” If a family office is willing to manage direct investing, it becomes an option with superior returns.”

What strategies are there for going direct?

Be part of a network

Networks can be a formal club of investors with well-defined plans or a more loosely structured and informal group. Independent sponsors approach these networks when raising capital for a deal. This is a low-commitment model for a family office and may be a good start if your family office is looking into this strategy.

Work with an Independent Sponsor

There are independent sponsors that are reliant on a specific family office as their equity partner. This way, family offices have someone handling their direct investing but without the overhead of hiring an internal staff. With a dedicated sponsor, there is the option of more reliable funding sources and less difficulty in closing transactions.

Hire Private Equity Professional Staff

A family office could expand the family office infrastructure to include in-house PE professionals. Becoming a professional operator is necessary to conducting proper due diligence and managing ongoing portfolio risk. According to Nextvest, the breakeven point of hiring a team of professionals is $100M in investment capital. “Among family offices leading direct investments, we see the high fixed costs of in-house expertise become cost-efficient when allocations grow north of $100M…”. Families want an advantage over market-rate investment management fees, and to capture that spread, scaleis required.”

If your family office is doing deals at this level, it could be a viable option.

Family offices that are willing to do the work of direct investing in private equity could see reduced management fees and above market returns. It’s also important to talk with your financial professionals about whether this strategy is a good one for your family office.

As for the family office investing directly in private equity but needing a bit of help with reporting, with the help of Quist’s expert staff a process was put in place to ease the challenge of tracking investments on an on-going basis and meeting the requirements of periodic compliance reports. Quist has the experience to help family offices understand and implement best practices in valuing private equity investments. In addition, Quist commonly acts as an extension of your back office to help interact with auditors. This family office is now well prepared to handle the reporting for their investments, providing peace of mind for stakeholders and investors.

If you need help understanding the private equity investing by your family office, Quist Valuation can help. Let’s set a time for a free 30-minute consultation. We can discuss the specifics of your business and identify the next steps needed to create a plan.

Schedule your free 30-minute consultation here.

Are you ready to value your business?

The Guideline Public Company method is a technique used to value a company based on the pricing multiples for similar companies (“Comps”).

What if there are no good Comps to use during your company valuation?

Comparing the size and scope of operations between companies is challenging. Problems with comparability arise when a company is atypical and operates in a niche segment offering unique products and services.

Here are three ways to value your company.

Cost approach

The cost approach to valuation is also known as the asset-based approach.

This approach involves understanding a company’s value through determining the market value of its assets. The cost approach serves as a floor to the valuation because a company’s assets are usually worth more while the company is running than if the company closes and liquidates its assets.

If your company is asset-intensive, however, this may be a better valuation technique with no need for a comparable analysis.

Market approach using transactions

Instead of Comps, a business may be valued using transaction data.

This method is also known as the Guideline Transaction method. It can include both private and public company transactions.

The valuation measure of companies sold can be a good proxy for a specific company. In certain industries, there are:

  • Large numbers of similar transactions
  • Many transactions occurring within a similar geographic region
  • Recently occurring transactions

Of course, this method is very dependent upon the transaction structure. Factors such as cash vs. debt, contingent earn outs, non-competition agreements, and employment agreements impact valuation. Given these, selecting the appropriate transaction multiple to apply to the subject company must be done carefully.

Discounted cash flow

An income approach converts future expected economic benefits to a present dollar amount.

Within this technique, a company’s after-tax cash flows are adjusted for changes in working capital, capital expenditures and outside capital needs. The most common methods used are Single Period Capitalization and Multi-Period Capitalization.

A Multi-Period Capitalization provides the greatest flexibility and is particularly useful for valuing high growth businesses.

On the other hand, a Single Period Capitalization of earnings often applies to established businesses with stable earnings.

The adjusted after-tax cash flows are then discounted to the present by a discount rate that is proportionate with the risk of investing in the subject company.

With so many different ways to value a company, the lack of close, peer company comparables is not a barrier to a good, comprehensive business valuation. Working closely with your valuation partner is the best way to get the most accurate assessment of your company.

If you need help understanding the value of your business, Quist Valuation can help. Let’s set a time for a free 30-minute consultation. We can discuss the specifics of your business and identify areas to focus on as you progress along the path of increased value for your business.

Schedule your free 30-minute consultation here.

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