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How do Tax Changes Affect the Value of my Business?

Valuations

February 7, 2018

The government has recently enacted a number of tax changes that impact the way small businesses pay tax and distribute income.  My colleague, Scott Rowland, and the rest of the Avail Tax Group has done some nice summaries of these changes and their impacts here and here.  This quick read will help you understand the impact of the changes on the value of your business.

1. Tax on Split Income

This change affects personal income taxes on distribution of corporate profits – it focuses on payments made to family members who aren’t involved in the business. Normally, this would not have an impact on the value of an incorporated business, because we do not consider personal income taxes when we do a valuation. 

In the long-term, this tax change may cause more business owners to retain profit within a corporation, which would normally increase the value of the business.

2. Tax on Passive Income

The second significant tax change is an increase on corporate taxes paid on passive income, such as interest, rent, or royalties.  This change will affect the value of many businesses, especially holding companies that have a large investment portfolio.  The underlying tax liability on any inherent gains in investments has increased substantially, which makes holding companies less valuable.

For example, if a corporation owns an investment with a $100,000 cost and a $500,000 fair market value, the potential tax liability in Alberta has increased from $40,000 to $100,000.  A buyer of the shares of this corporation acquires this tax liability, so the value of the shares has decreased.

In point 1, I suggested that the value of the company might increase if the owner chooses to retain more profit.  If the owner invests this profit into passive assets, that increase in value is reduced by the tax on passive income.  This change encourages business owners to either withdraw profits and pay personal tax immediately, or invest profits back into the existing business. 

3. Reduction in the Small Business Tax Rate

The last change seems to have received less attention.  The small business tax rate on income up to $500,000 has been reduced by 0.5% effective January 1, 2018, and will fall by another 1%, to 11%, on January 1, 2019. 

Since the value of an operating business is generally calculated based on after-tax cash flows, this change has a positive effect on value.  For a corporation earning $500,000, the 1.5% tax cut results in annual tax savings of $7,500.  In our experience, an annual tax savings of that amount would increase the business value by around $20,000 to $40,000. 

For businesses that do not get to claim the Small Business Deduction, this change has no impact.

Big changes like these can cause uncertainty about how your business is impacted.  In my last article, I wrote about Taylor Swift.  I only know two of her songs and they both come to mind here.  You can either “Shake it off”, accept these changes as part of your new reality, and work with your advisor to deal with them as best you can.  Or you can do something that doesn’t make sense, leaving you blaming the government for your problem and saying “Look what you made me do!”  

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