Monday, September 1, 2014

The Tax Dance: To Pass Through or Not to Pass Through Income?

I started last month by looking at US tax law and how it induces bad corporate behavior  and in this one, I want to expand the discussion to look at how the tax structuring of a business can affect its value. In particular, I would like to look at the differences between taxable entities (public corporations, private C-Corps) and pass-through entities (MLPs, REITs and private S-Corps), both on taxes and other aspects of doing business, and the trade off that determines why companies in one group may try to move to the other. I use the framework to look at Kinder Morgan’s decision to bring its master limited partnerships under the corporate umbrella and the value effects of that decision.

The Evolution of Different Tax Entities
For most of the last century, publicly listed firms in the United States followed the corporate model, where the earnings made by a company were first taxed at the corporate level, and investors in the company were then taxed again, often at different rates depending on whether the income was paid out as dividend or allowed to accumulate in the firm to generate capital gains. In its spasmodic attempts to use the tax code to encourage the "right kind" of investments, Congressional legislation created two entities that were allowed to escape entity-level taxes: real estate investment trusts (REITs) in 1960 and master limited partnerships (MLPS) in 1987, the former obviously for investments in real estate and the latter directed towards energy investments.

Across the privately owned business spectrum, the vast majority of businesses are structured as sole proprietorships, but among private businesses that choose to incorporate (to get the benefits of limited liability), the choice is between C-Corps, which resemble publicly traded companies in tax treatment and S-Corps, which are pass-through entities. While the original rationale for these pass-through structures may have been long forgotten, a CBO report in 2012 noted an undeniable trend towards pass-through entities in the last three decades:
Source: Congressional Budget Office
Not only has the percentage of income reported by taxable corporations dropped from almost 90% in 1981 to less than 60% in 2007, but the proportion of firms organized a pass-through entities has climbed from 83% to 94%. While the CBO report stopped in 2007, there are signs that the movement towards pass-through entities has continued in the years since. In particular, not only have we seen dozens of MLPs go public in the last few years, driven by the energy boom in the United States, but we have also seen increasingly creative REIT issuances, such as the one by Windstream, a telecom company, which classified its phone lines as real estate. In the private business space, the S-Corp form, which was generally used by smaller firms, has been embraced by some larger entities as well; Bechtel is one example of a large private business structured as an S-Corp.

The Trade Off
As pass-through entities grow in popularity, we are not only faced with the question of why this shift is occurring but also pragmatic questions about how best to value or price these entities. In this section, I will start with a discussion of the tax differences that are not unexpectedly at the center of the story and then look at the rest of the story (which does muddle the trade off somewhat), with the intent of answering these questions.

The Tax Story
Not surprisingly, most of the news stories that I have read about the growth in pass-through entities emphasize the tax angle. They argue that replacing the double taxation that is inherent in a conventional corporation (C-Corp), where the entity first pays taxes and equity investors are then taxed again, with a pass-through model, where income is taxed only at the investor level only, saves taxes. That may be true, in a general sense, but the story is a little more complicated. To understand the difference, I have outlined how taxes work at taxable corporations versus a pass-through entity (S-Corp or MLP) in the figure below:

Pre and Post tax Income: The Tax Effect of Pass Through Entities
Using a company with $100 in pre-tax operating earnings, in conjunction with the top statutory tax rates on corporate income (35%), personal income (40%), dividends (20%) and capital gains (20%) today, and assuming that 40% of corporate earnings get paid out as dividends, the pass through entity delivers higher post-tax income to the investor.
Statutory tax rates and income
In particular, starting with pre-tax income of $100, the pass-through entity delivers after-tax income of $60, $8 higher than $52 you receive as an investor in the corporate entity, translating into an earnings and value premium of about 15.38%:
Earnings/Value Premium for pass-through = ($60/$52) -1 = .1538 or 15.38%
The story gets complicated when you consider two additional factors. The first is that corporations get more wiggle room that individuals do when it comes to taxes, both in terms of tax deductions/deferral and how foreign income is taxed, allowing them to lower the effective tax rate that they pay. The second is that the tax due on the capital gains portion of corporate income can be deferred by investors to future periods, since it is not collected until the stock is sold. In the example above, for instance, replacing the corporate statutory tax rate of 35% with the average effective tax rate of 27% (the weighted average tax rate across money-making US corporations in 2013) and allowing for the fact that about 25% of investors are tax exempt (thus reducing the tax rate that investors pay on dividends/capital gains to 15%), we get the result that  the collective taxes paid by a corporate entity is lower than that paid by a pass-through.
Actual taxes and Earnings
The pass through entity will trade at a discount of 3.30% on the taxable entity in this case and this example, though simplistic, illustrates the trade off between taxable and pass through entities depends on the following factors:
  1. The differential between corporate and personal taxes: The greater the the tax rate on pass-through investor income, relative to the corporate tax rate, the less incentive there should be to shift to a pass-through entity form. This may explain why more companies have shifted to the pass-through structure since 1986, when the individual tax rate was brought down to match the corporate tax rate.
  2. The proportion of earnings that gets paid out as dividends: The returns to investors from holding stock in a corporate entity can take the form of dividends or price appreciation. Until 2003, dividends were taxed at a much higher rate than capital gains, and the effective tax paid by investors on corporate income was therefore greater in high dividend paying stocks. While the tax rates have converged since, capital gains retain a tax-timing advantage, since investors don't have to pay until they sell the stock. 
  3. The make up of investors in the entity: As noted in the section above, investors in publicly traded companies can have very different tax profiles, from wealthy individuals who pay taxes on dividends/capital gains to corporations that are allowed to exempt 70-80% of their dividend income from taxes to tax-exempt investors (pension funds) that pay no taxes on any corporate income. Furthermore, the taxes paid by taxable investors on capital gains can vary depending on how long they hold the stock, with short term investors paying much higher taxes than investors who hold for longer than a year. In summary, companies with primarily wealthy, short-term, individual investors holding their shares have a greater benefit from shifting to pass-through status than companies with primarily tax-exempt or long term investors, holding their shares.
The Rest of the Story
If the only difference between pass-through entities and taxable entities were on taxes, the assessment that mattered for value would be whether you paid more or less in taxes with one form over the other. However, the laws that created the pass-through entities also created restrictions on other aspects of business behavior including where and how these businesses invest, how much they have to pay out in dividends and how they finance their operations. In the picture below, I have categorized business decisions into investing, financing and dividend pieces, to illustrate the restrictions that you face with the pass-through entities.

Investment Policy
Financing Policy
Dividend Policy
Pass Through
Pass Through
Pass Through
There are generally no investment constraints.REITs and MLPs are restricted in the businesses that they can invest in, the former in real estate and the latter in energy.
S-Corps face    no explicit investment constraints.
Can claim interest tax deduction on debt, giving it tax benefits from borrowing.No direct benefit from debt.
MLPs and REITs can issue new shares, but S-Corps cannot have more than 100 shareholders.

Managers have the discretion to set dividends, reinvest earnings in projects or just hold on to cash.
REITs are required to pay out 90% of their income as dividends, on which investors have to pay the ordinary income tax rate (rather than the dividend tax rate). MLPs and
S-Corps do not have explicit dividend payout requirements but MLPs generally return large portions of cash flows to investors.

(For those of you who commented on my MLP dividend policy restrictions, I updated the dividend policy description. I hope that I have got it right now).
In summary, choosing a pass-through tax-status for your business will narrow your investment choices (to real estate if you are a REIT, and to energy, if you are an MLP), require you to return much or all of your earnings as dividends and reduce your financing options (by restricting your capacity to attract new stockholders if you are a sub-chapter S corporation and by making the tax benefits of debt indirect). 

Will these restrictions make you a less valuable business? If you are a mature business with few growth opportunities and no desire to stray from your investment focus, the costs imposed by the pass through entity are minimal. In fact, the discipline of having to pay the cash out to investors may reduce the chances of hubris-driven growth and wasteful investment. If you are a business with good growth opportunities, the restrictions can reduce your value, either because you are unable or unwilling to issue new shares to cover your investment needs, or because you cannot take direct advantage of the tax subsidies offered by debt (to traditional corporations).

The valuation of pass through entities
Most of valuation practice and theory has been built around valuing publicly traded companies. In a typical public company valuation, we generally estimate cash flows after corporate but before personal taxes and discount it back at a cost of capital that is post-corporate taxes (with a tax benefit for debt) and pre-personal taxes. While the principles of valuation don't change when you value pass-through entities, it is easy for inconsistencies to enter valuations, especially if some of the inputs (margins, betas, costs of equity) come from looking at publicly traded, taxable entities. The process enters the danger zone, when appraisers create arbitrary rules of thumb (and legal systems enforce them), and attach premiums or discounts are attached to public company values (obtained either in intrinsic valuations or from multiples/comparable). To value pass through entities consistently, I would suggest the following steps:

Step 1: Take a post-personal tax view on cash flows
Broadly speaking, you can value a passthrough entity either on a pre-tax basis or on the basis of post-tax cash flows. If you decide to do your valuation on a  pre-tax basis, you estimate the cash flows generated by the entity, whereas on a post-tax basis, you will have to net out the taxes that investors have to pay on these cash flows. The rest of the inputs into cash flows, including growth and reinvestment, then have to be tailored appropriately. This choice, though, has value consequences and I would argue that, if valuing a pass through entity, you will get a fairer estimate of value using post-personal tax numbers for two reasons:

  1. If the rationale for shifting from one tax form to another is to save on taxes, it seems incongruous to be using pre-tax numbers. After all, it is the fact that you get to have higher cash flows, after personal taxes, that causes the shift in tax status in the first place.
  2. Some practitioners use the argument that if you are consistent, it should not matter whether you look at pre-tax or post-tax numbers, but that holds only if there is no growth in perpetuity in your entity earnings. If you introduce growth into your valuation, you do start to see a benefit that shows up only in the post-tax numbers and there is an intuitive explanation for that. The expected growth rate in an intrinsic valuation model is a measure of the value appreciation in the business, i.e., the capital gains component of return. Even though the income in a pass through entity is taxed in the year in which it is earned at the personal tax rate, the increase in value of a pass through entity (MLP, Subchapter S, REIT) is not taxed until the business is sold and qualifies for capital gains taxes, thus creating the premium in the post-tax value. It is precisely to counter this tax benefit that pass through structures are required to pay almost of their earnings out as dividends. As a result, the growth in earnings in a pass through entity has to be funded either with new equity issues (whose prices will reflect the value of growth) or new debt (without the direct tax benefit from interest expenses) and that growth has much smaller or no price appreciation effect.
Step 2: Estimate a tax-consistent discount rate
This is a key step, where the discount rate has to be estimated consistently with the cash flows, with pre-tax discount rates for pre-tax cash flows, and post-personal tax discount rates for post-tax cash flows. It is at this stage that inconsistencies can enter easily, since most of the public data that we have and use in estimating discount rates comes from taxable entities (publicly traded companies) and is post-corporate, but pre-personal taxes. Consider, for instance, the estimation of the cost of equity for a publicly traded real estate development company, where we use a risk free rate, a beta (say for real estate as a business) and an equity risk premium (either historical or implied). Using a 10-year T.Bond rate of 2.5% as the risk free rate in US dollars, a beta of 0.99 for real estate development and an equity risk premium of 5.5%, the cost of equity we obtain for this company is 7.95%:
Cost of equity of publicly traded real estate development firm = 2.5% + 0.99 (5.5%) = 7.95%
Using the average debt to capital ratio of 19.94% and an after-tax cost of debt of 3.30%, we estimate a cost of capital of 7.02% for the company:
Cost of debt = 5.50% (1-.40) = 3.30%
Cost of capital = 7.95% (.8006) + 3.30% (.1994) = 7.02%
Note, though, that this is a cost of equity and capital for a public company, post-corporate taxes and pre-personal tax.

To convert these numbers into pass through discount rates, you first have to take the tax benefit of debt out of the equation. Consequently, it is safest to work with an unleveled beta/cost of equity, on the assumption that the pass through does not use or at least does not benefit from the use of debt and then bring in the effect of personal taxes. The steps involved are as follows:
1. We start with the unlevered beta of 0.85 for a real estate development company and compute a cost of equity based not that beta.
Unlevered cost of equity = 2.5% + 0.85 (5.5%) = 7.18%
2. To convert this number into a pre-tax cost of equity that you can use to discount pre-tax cash flows on a pass-through real estate development company, you will need two additional inputs. The first is the tax rate that investors in the publicly traded entity pay on corporate returns (dividends & capital gains) and the second is the tax rate that investors in the passthrough entity pay on their income. If you assume that the investor tax rate on corporate income is 15% and the investor tax rate on pass-through income is 40%, the pre-tax cost of equity for a real estate development company is 10.17%.

The after-tax cost of equity will then be 6.10%, computed as follows:
Pass through aftertax cost of equity = 10.17% (1-.4) = 6.10%
Implicitly, we are assuming that investors demand the same return after personal taxes of 6.10% on an investment in real estate development, no matter how the entity is structured for tax purposes.

At the start of every year, I estimate costs of equity for publicly traded companies, classified by sector, on my website. I have updated that table to yield pre-tax and post-personal-tax costs of equity for pass through entities in each sector, using a tax rate of 15% for investors on corporate income and 40% for investors on passthrough income, but I give you the option of changing those numbers, if you feel that they are unrealistic for the sector that you are working with.

Step 3: Build in the constraints that come with pass-through form
As a final step in the valuation, you should bring in the effects of the constraints that come with pass-through entities. One reason that I scaled the cost of equity of publicly traded companies for the tax effects, rather than the cost of capital, is because taxable companies get a direct tax benefit from borrowing money (thus lowering cost of capital) and pass through entities do not get this debt benefit.  To capture the investment constraints, coupled with and perhaps caused by the forced dividend payout requirements, you have to either assume a lower growth in income (if the company chooses not to issue or cannot issue new equity) or equity dilution in future periods.

Step 4: Do the valuation
With pretax (post tax) cash flows matched up to pretax (post tax) discount rates, you can now complete the valuation of the pass through entity with that of an equivalent corporate entity. If you are consistent about following this process, the value of a business can go up, down or remain unchanged, when it shifts from a taxable form to a pass through entity, depending in large part on the tax characteristics of the investors involved and the growth potential of the company. In particular, you will be trading off any tax savings that may accrue from the shift to a pass through status against the lost value from the investment and financing constraints that accompany a pass through structure. Thus, the notions that a S-Corp is always worth more than a C-Corp or that converting to a MLP is always beneficial to investors are both fanciful and untrue.

To illustrate this with a simple example, assume that you have a real estate development business that generated pretax operating income of $100 million last year, on invested capital of $400 million, and expects this income to grow at 2.5% a year, in perpetuity. Assume that you are considering whether to  incorporate as a taxable corporation or as a pass through entity and that you are provided the corporate and investor tax rates on both corporate and pass through earnings. In the picture below, I value the effect for a given set of inputs.

In this case, the pass through entity has a slightly higher value than the taxable form, but reducing the corporate effective tax rate to 25% tips the scale and makes the taxable entity more valuable. In fact, using the average effective tax rate of 19.34% that was paid by companies in the real estate development sector last year gives the taxable form a decided benefit. You can use the spreadsheet yourself and change the inputs, to see the effects on value.

The Kinder Morgan Conversion
With the framework from the last two sections in place, let us look at the recent news out of Kinder Morgan. The company (KMI), one of the lead players in the MLP game, with its pipelines constructed as MLPs, announced recently that it planned to consolidate three of these MLPs (KMP, KMR and EPB) into its corporate structure, thus shifting them back from pass through entities to more traditional taxable form. 

The market reaction to the consolidation has been positive for all of these stocks, but is the market right? And if yes, where is the additional value coming from? Like other MLPs, the Kinder entities were trapped in a vicious payout cycle, where investors expected them to pay out ever increasing amounts of cash, which they funded with debt, on which they get no direct tax benefit (though their investors indirectly benefit). Thus, converting back to corporate form will release them from the vice grip of dividends, partly because they will not be obligated by law to pay out their earnings in dividends and partly because their investor base will shift. That release presumably will allow them to both pursue more growth and perhaps fund it more sensibly with equity (retained earnings) and tax-subsidized debt. This value creation story rests on the company being able to find value-enhancing growth investments and on good corporate stewardship.  

There is one final aspect of the Kinder Morgan deal that suggests that the net effect of this deal will be much more negative for partnership unit holders than it is for parent company stockholders. The partnership has deferred taxes on its income that will come due on the consolidation, estimated at $12 to $18 per partnership unit, depending on the investor's tax rate and how long he or she has held the unit, which is higher than the $10.77/unit that will be paid out as a distribution on the conversion. 

Since the prevailing wisdom seems to be that corporations and wealthy investors evade or avoid taxes, it is not surprising that any story on conversions to or from a pass through tax status becomes one about tax avoidance. Thus, we are told by journalists and analysts that the broad shift of businesses to pass through status (MLPs) is all about saving taxes and we are also then told that Kinder Morgan's conversion back from an MLP set up to a corporate entity is also about saving taxes. This borders dangerously close to  journalistic and analyst malpractice for two reasons. The first is that both pass through and taxable entities pay taxes and the tax savings are never as large as either critics or promoters of pass through entities make them out to be. The second is that if you compare the tax structures of traditional corporations and pass through entities, it strikes me that it is the former with its multiple layers of taxes (corporate, dividend, capital gains) that is convoluted, complex, and ripe for manipulation, and not the latter. In fact, if you wanted to make one tax system your standard one, it is the pass through version that seems to offer more promise.



Anonymous said...

Hi - if understand correctly, you suggest using an unlevered beta to compute the cost of equity when valuing the cash flows of a pass through entity. I understand where you're going with this, but would it not be better to use a pre-tax version of the WACC (no 1-d in the equation)? It seems like using the unlevered beta assumes a kind of Modigliani-Miller debt/equity equivalency, but in practice we usually assume a zero beta of debt in unlevering, so the pre-tax WACC doesn't really conform to the MM principle even without the tax shields of debt. Using a pre-tax WACC, you would capture the increased required return to equity from the leverage, ultimately leading to higher total required return. No?

Aswath Damodaran said...

I considered just scaling up the cost of capital for the tax benefit but here is the reason that I did not do this. Debt is a choice and it is a good choice for the taxable entity, because of the tax benefit. If you don't get a tax benefit, it is best not to borrow money and I think it makes more sense to focus on an unlevered cost of equity as your discount rate.
I see your point about unlevering betas and the debt beta of zero, but even assuming a debt beta does not change the unlevered beta much, at least at the sector level.
Starting next year, I plan to put this dataset on my website as well and report both the cost of equity and capital numbers.

Maria Clara said...

Hi Professor- Should the waccpassthrough.xls file have an extra column for the unlevered beta to be used when calculating the Post-personal tax cost of Equity and the Pre-tax cost of Equity for the pass through entities? Right now those cells are using the levered beta of 0.99 instead of the unlevered beta of 0.85 in the example you used for the real estate development company. Thanks!

Anonymous said...

Thanks for your response. One thing I've taken to doing lately which is kind of related is to use the pre-tax WACC to value cash flows that include the tax shields of debt. I've been doing this because I've never been completely comfortable with the simplicity of the (1-t) in the WACC equation and prefer to use actual tax forecasts. Previously, I used a compressed APV-like method, but that didn't scale up the implied cost of equity enough for the leverage (assuming a zero beta of debt). I used the pre-tax WACC on a couple of simple models including the debt tax shields and it checked out, but I'd be curious to hear your thoughts.

Aswath Damodaran said...

I think it is fixed now. It must have been an old version of the spreadsheet. Thank you for noticing it.

Aswath Damodaran said...

If you are worried about the the implicit assumptions of tax effecting your cost of capital, the best choice is to do an adjusted present value valuation of the company, where you use the unlevered cost of equity to first value the company and then bring in the effects of debt explicitly: by taking into account the tax benefits from interest expenses as a plus and the expected bankruptcy cost as a minus. I have a fuller explanation in my corporate finance & valuation books.

Tim Gaumer said...

Thank you for including your spreadsheet. Does this use cash taxes or the provision for income tax expenses (from the Income Statement)?

Aswath Damodaran said...

The taxes that I am using are accrual taxes, since it is easiest to work with, but the effective tax rate can be modified as a cash tax rate on cash income.

Igor Greenwald said...

MLPs are not in fact required to pay out 90% or any other fixed percentage of their income, unlike REITs.

Anonymous said...

Professor : I respect your valuation/s methodology a lot and you are doing a very great service to people in this space - Truely Commendable!

About Risks in stock= BABA : I am sure you may have spent lot of time to assess the risks but the Cayman Islands and the complex (= so so questionable) BABA IPO ownership structures and PR-China Citizenship ownership mandates so the variable-interest-entities etc have no precedence . Can you kindly please have a article and few examples ( may be dummy ) of valuations so that we can learn them ? I was reading URL = . I am not convinced that I have seen enough discussion in your previous articles about how to assign "calculated risk factors" to cater such cayman island deals while valuations . Can you kindly see that such out of blue complex structures are properly assessed while any valuation mathematics for any company which it is getting valuation. I can see only close comparable in ( approximately nearer to ) Software space that is Oracle=ORCL which has so many such non US corporations outside US. Was Oracle also valued correctly ? Somehow I always doubled the whole Oracle's stock price always.

Anonymous said...

Hi Professor,

So to clarify: In your valuation of a Pass Through Entity, you do not use a cost of debt because you're assuming a Pass Through Entity does not take on/benefit from debt. Instead, you use a modified cost of equity formula to discount cash flows?


Unknown said...

I would net option entitlements in calculating buy backs

Unknown said...

Dear Aswath,

My question is not related to tax complications under the pass through entity structure. I am looking for answer on how to go about valuation using pre-tax cash flows.

I have read many articles and all seem to suggest post-tax cash flows. If at all pre-tax WACC needs to be arrived at, it should be under an iterative process keeping the ultimate valuation same and putting a goal seek on the WACC using pre-tax cash flows.

Would highly appreciate if you could direct me to the right approach to arrive at the valuation using pre-tax WACC/ cash flows. In any of your publications, or any others have discussed this, kindly direct me to them.

highly appreciate your help, as always.

thank you!
Rishi Soni