Every quality business appraisal considers how the United States economy, the state economy, and the local economy impact the company being valued. Small business owners are acutely aware that taxes are one of the largest “economic burdens,” and tax bills can vary based on the state where a business operates. But, how do taxes impact a small business’s value? And when appraising businesses in Minnesota, is there a way to balance tax bills with business value? Let’s find out!
Minnesota’s Economic Rankings
The 2023 Rich States Poor States guide provides some great statistics about each state’s economy. The economic factors that it calculates and ranks are some of the same economic factors that can impact a business valuation. According to the Rich States Poor States’ guide to Minnesota for 2023, overall, Minnesota ranks 48th in the United States for economic outlook and 27th for economic performance.[1] These rankings consider the following statistics (and more) to as far back as 2008:[2]
The Top Marginal State Personal Income Tax Rate is 9.85%, which ranks 45th in the United States.
Minnesota has held the 45th position for the Top Marginal State Personal Income Tax Rate since 2017.
The Top Marginal State Corporate Income Tax Rate is 9.80%, which ranks 45th in the United States.
Except for 2019 and 2020 when Minnesota ranked 44th, Minnesota has held the 45th position for the Top Marginal State Corporate Income Tax Rate since 2008.
Minnesota has held the 50th place rank for estate and inheritance taxes since 2008.
In one of its more positive rankings, Minnesota’s Debt Service as a Share of Tax Revenue is 16th out of 50 in the U.S. This metric measures interest paid by the state on its state and local debt.
Between 2009 and 2014, Minnesota ranked #1 out of all states for its minimum wage. However, after changes made to the state minimum wage since then, Minnesota currently ranks 27th on this metric.
The impact of most of these metrics will show up on each individual company’s financial statements and tax returns. For example, the impact of Minnesota’s minimum wage indirectly shows up in each business’s Salaries and Wages expense on its profit and loss statement. However, the impact of taxes paid on a business often do not appear until, well, after the tax return is filed and the business owner receives an unpleasant bill.
Minnesota versus California
To illustrate the severity of taxes to a small business in Minnesota, let’s explore a hypothetical scenario. Imagine a small business owner, who in 2019, made $52,316 in corporate profits. According to the SBA, that is the average income of a Minnesota small business.[3] Let’s also assume that the business is structured as a pass-through entity (such as an LLC or S-corporation), is owned by only one person, and that one business owner has a single (or unmarried) tax status.
In Minnesota, that hypothetical business owner may wind up paying as much as $13,168 in taxes,[4] or about 25% of its corporate profits.[5] This includes federal personal income taxes, state personal income taxes, Social Security, and Medicare taxes. Comparatively, if that same business were in California, with identical earnings and structure, the tax burden may be slightly lower. In this case, the owner may be paying around $12,261 in taxes,[6] or about 23% of its corporate profits.[7]
So, while California may have a reputation for some of the highest tax bills in the United States, California actually has a more favorable tax structure than Minnesota for those in the lower tax brackets: i.e., the average small business owner.
A silver lining to this (in either state) is that, as a pass-through entity, at least the business owner is avoiding “double taxation,” which is another issue unique to companies structured as C-corporations. C-corporations are subject to federal corporate income taxes and state corporate income taxes in addition to the federal personal income taxes, state personal income taxes, Social Security, and Medicare taxes calculated above.
How Do Taxes Impact A Business’s Value?
Well, in some cases, they do, and in other cases, they don’t. Understanding the impact of taxes on business valuation involves considering not just the tax burden itself but also how valuation methods incorporate tax bills. Common valuation methods, such as Discounted Cash Flow (DCF) analysis or Earnings Multiples, often use pre-tax metrics, so arguably, the tax bill has a minimal impact (if any) on the resulting value. But logically, a potential buyer is going to consider how much of the business’s profits have to be paid via taxes - unique to their own situation - and this can impact the buyer’s perceived value of the business.
In DCF analysis, future cash flows are estimated and then discounted back to their present value using a discount rate. This discount rate reflects the riskiness of the cash flows and is usually calculated on a pre-tax basis. This approach assumes that the tax environment, and thus the tax burden, will remain constant over the forecast period. However, changes in tax laws can significantly alter these projections, impacting the resulting value.
Similarly, when using Earnings Multiples - such as Market Value to EBIT - appraisers often work with pre-tax earnings to account for differences across different tax jurisdictions and periods. This approach helps in comparing businesses in different tax environments on a more equal footing. However, this is an area where the application of business valuation theory is disputed between experts.
Think back to the Minnesota versus California example for a minute – which business is more valuable to you? The Minnesota business with the higher tax bill, or the same business but with its lower California tax bill? Common sense would tell us that the company with the lower tax bill is more valuable to a buyer. However, with the ability for any business owner to utilize tax planning strategies, the resulting tax bill is arguably nothing more than a standalone measure of the business owner’s (or potential buyer’s) knowledge of and ability to effectively use tax planning strategies.
It is crucial to understand that pre-tax valuations do not disregard taxes altogether. Instead, they provide a baseline from which tax impacts can be individually evaluated and factored in. This allows for a more nuanced assessment of how different tax scenarios might affect the business's value for a specific buyer or seller.
The Trade-Off Between a Lower Tax Bill and Ease of Lending
Many business owners have experienced the frustration of going to a commercial lender and being told that their business’s earnings are too low for the loan they are requesting. However, many business owners try and reduce taxable income in order to minimize their tax bills. This creates a vicious Catch-22 where the business owner has to choose between their ability to get a business loan (i.e., show higher profitability), or minimize their tax bill (i.e., show lower profitability).
The key for business owners lies in finding a balance. Strategic financial planning and astute accounting practices can help navigate this dilemma. It involves not only smart tax management but also ensuring that the business's financial statements accurately reflect its operational health and growth potential. The decision between optimizing for tax savings or loan eligibility depends on the business's immediate needs, long-term goals, and the specific financial landscape it operates within.
The “Win-Win-Win” Business Strategy
The idea of finding a solution that allows a business to have a lower tax bill, show earnings sufficient to get a business loan when needed, and to receive a “good” appraised value seems impossible. However, there is a way to achieve all three of these goals without sacrificing any of them. Here it is:
Strategic Tax Planning. Utilize effective tax planning strategies such as entity structuring, maximizing deductions, and exploring passive investment opportunities. Resources like Mark Kohler’s website and his various channels (YouTube, Podcast, Social Media) provide some of the BEST guidance out there on these strategies.
Document Tax Planning Strategies. Maintain detailed records of expenses and accounting entries used in tax planning. In business appraisals, certain expenses can be adjusted through “normalizing entries,” potentially enhancing your business’s appraised value. These adjustments are purely for valuation purposes and do not affect actual tax liabilities.
Leveraging Tax Efficiency. Efficient tax planning not only reduces tax liabilities but also demonstrates strong business management. This can be a persuasive factor for your analyst to lower the risk profile during your appraisal. Since business value is influenced by both profitability and risk, decreasing risk while maintaining or enhancing profitability can positively impact the overall business valuation.
Implementing these strategies can create a “win-win-win” situation, allowing business owners to optimize tax savings, strengthen loan applications, and enhance their business’s valuation.
Conclusion
Navigating Minnesota's economic landscape requires a delicate balance between optimizing tax savings, maintaining loan eligibility, and enhancing business valuation. As we've explored, strategic tax planning, understanding valuation methods, and balancing profitability with loan requirements are crucial. Small business owners in Minnesota (as with any state) must stay informed and proactive in their financial strategies to ensure the best outcomes. But ultimately, with the right approach, it's possible to run a successful business in any economy.
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Miranda Kishel
Founder
Development Theory
Footnotes
[1] Rich States Poor States, “Minnesota (2023),” located at: https://www.richstatespoorstates.org/states/MN/#:~:text=,any%20effect%20of%20federal%20deductibility
[2] Rich States Poor States: Minnesota (2023). Located at: https://www.richstatespoorstates.org/states/MN/#:~:text=,any%20effect%20of%20federal%20deductibility
[3] According to the U.S. Small Business Administration, the average corporate profit of a Minnesota small business owner with their own incorporated business (such as an LLC, corporation, or formal partnership) was $52,316. Source: U.S. Small Business Administration Office of Advocacy, “2019 Small Business Profile,” located at https://advocacy.sba.gov/wp-content/uploads/2019/04/2019-Small-Business-Profiles-MN.pdf
[4] If a Minnesota business was a pass-through entity, owned by an unmarried person utilizing a $12,200 standard deduction (2019), made $52,316 (2019), with all profits being paid to the business owner as income, then the business owner could expect to pay as much as $13,168, comprised as follows:
Approximately $4,684 in federal taxes, with a marginal income tax rate of 22%.
Approximately $2,347 in Minnesota taxes, with a marginal income tax rate of 6.8%.
Approximately $4,974 in Social Security taxes, which is 12.4% of income up to $132,900.
Approximately $1,163 in Medicare taxes, which is 2.9% of all income.
[5] $13,168 / $52,316 = 25.2%
[6] If a California business was a pass-through entity, owned by an unmarried person utilizing a $12,200 standard deduction (2019), made $52,316 (2019), with all profits being paid to the business owner as income, then the business owner could expect to pay as much as $13,168, comprised as follows:
Approximately $4,684 in federal taxes, with a marginal income tax rate of 22%.
Approximately $1,440 in California taxes, with a marginal income tax rate of 6.00%.
Approximately $4,974 in Social Security taxes, which is 12.4% of income up to $132,900.
Approximately $1,163 in Medicare taxes, which is 2.9% of all income.
[7] $12,261 / $52,316 = 23.4%
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