Individual Tax Rates

Forbes magazine listed the following U.S. cities as having the highest 2012 state and local income taxes on $1 million of income:

1. New York, NY
2. Honolulu, HI
3. Los Angeles, CA
4. Portland, OR
5. Baltimore, MD
6. Washington, DC
7. Portland, ME
8. Burlingtion, VT
9. Minneapolis, MN
10. Wilmington, DE

In the United States (including Washington, DC) there is a wide range in state individual income tax rates. In addition, many states define taxable income differently than the federal government’s definition. Following is a summary of 2013 maximum individual state income tax rates

• Seven states have no individual income taxes: Alaska, Florida, Nevada, South Dakota, Texas,
• Washington, and Wyoming.
• Thirteen states have maximum individual income tax rates ranging from 1 to 5 percent: Alabama (5%), Arizona (4.54%), Colorado (4.63%), Illinois (5%), Indiana (3.4%), Kansas (4.9%), Michigan (4.25%), Mississippi (5%), North Dakota (3.99%), New Hampshire (5%), New Mexico (4.9%), Pennsylvania (3.07%), and Utah (5%).
• Nineteen states have maximum individual income tax rates ranging from 5.1 to 7.5 percent: Arkansas (7%), Connecticut (6.7%), Delaware (6.75%), Georgia (6%), Indiana (7.4%), Kentucky (6%), Louisiana (6%), Massachusetts (5.25%), Maryland (5.75%), Missouri (6%), Montana (6.9%), Nebraska (6.84%), Ohio (5.925%), Oklahoma (5.25%), Rhode Island (5.99%), South Carolina (7%), Tennessee (6%), Virginia (5.75%), and West Virginia (6.5%). Washington, DC, and nine states have maximum individual income tax rates ranging from 7.6 to 9.9 percent: Iowa (8.98%), Maine (7..95), Minnesota (7.85%), North Carolina (7.75%), New Jersey (8.97%), New York (8.82%), Oregon (9.9%), Vermont (8.95%), and Wisconsin (7.75%).
• Two states have maximum individual income tax rates of 10 percent or greater: California (12.3%) and Hawaii (11%).

Clearly, the business valuator should avoid applying the same combined federal, state, and local income tax rate to all valuations. To do so would effectively ignore the impact of such widely differing state tax rates.

Quantifying the Impact of State Rates

Let’s now analyze the impact of different state individual income tax rates, applying a “value to the holder” standard of value. The following example compares the after-tax returns of a New York City S corporation and a Florida S corporation, both generating $2 million of 2013 income after expenses, but before income taxes (i.e., pre-tax income). We further assume the following (the simplest possible scenario):

• The 100 percent shareholder of both companies maintains permanent residency in the city where the subject business is located.

• The shareholder’s tax status is married, filing joint, no children.

• There is no taxable income other than pass-through income from the S corporation.

• There are no itemized deductions other than state and local income taxes

Table 1 summarizes the total corporate and individual income taxes incurred under each scenario. The difference of $246,000 in Table 1 is the additional tax cost associated with locating a business in New York City versus Florida. What impact does this difference in total state and local income taxes have on the value of each business? Let’s apply the Modified Delaware MRI Model to find out (see Table 2). In our example, the owner of a New York City S corporation earning pre-tax income of $2 million nets approximately $1,019,000 after tax. The owner of a Florida S corporation earning the same $2 million of pre-tax income nets approximately $1,265,000 after tax, a difference of $246,000. The impact on business value is also material. The imputed corporation income tax rate for the New York City S Corporation is 22.4 percent in this example; the imputed corporation income tax rate for the Florida S Corporation is 17.0 percent. The difference between the two imputed corporation income tax rates yield a valuation benefit of 6.9 percent for the Florida business versus the New York City business.

TABLE 1: EFFECTIVE INDIVIDUAL INCOME TAX RATES, NYC & FL ($2M OF PRE-TAX PTE INCOME) ($000s omitted)

		NYC	FLORIDA
Gross income (taxable to shareholder
S corp pre-tax income		$2,000	$2,000
Less: S Corp’s NYC income taxes		(177)	-
Adjusted gross income (AGI)		1,823	2,000
Deductions and exemptions
State income taxes		$ 193
Less: 3% AGI floor		(46)
Standard deduction		-	12
Personal exemptions		-	-
		147	12
Federal taxable income		$1,676	$1,988

Income taxes (shareholder and S Corp)
S corp’s NYC income taxes		$ 177	$ -
Individual federal income taxes		611	735
Individual state income taxes		193	-
Total income taxes		$ 981	735
Difference			$ 246

Income taxes as a percent of AGI
Individual federal income taxes		33.52%	36.75%
Individual state income taxes		10.59%	0.0%
		44.10%	36.75%
	Difference		7.35%

TABLE 2: COMBINED FEDERAL, STATE & LOCAL ENTITY INCOME TAXES, NYC & FL

($2m OF PRE-TAX PTE INCOME) ($000s omitted)

	NYC				Florida
	PTE & Individual Rates	Derivation of C Corp Tax Rate			PTE & Individual Rates	Derivation of C Corp Tax Rate
Normalized pre-tax cash basis income	$2,000	$2,000			$2,000	$2,000
NYC S corporation taxes	8.85%	N/A			0.00%	N/A
Income before federal corporation income taxes	1,823	2,000			2,000	2,000
Combined federal and state C corp tax rate	N/A	22.35%[5]			N/A	16.99%[5]
Available company earnings	1,823	1,553			2,000	1,660
Available company earnings	1,823	1,553			2,000	1,660
Pre-tax earnings retained % [1]	0.00%	0.00%			0.00%	0.00%
Distributable company earnings	1,823	1,553			2,000	1,660
State & local income taxes - individual	10.59%[2]	10.59%[4]			0.00%[2]	0.00%[4]
Federal income taxes	$804	$534			$735	$395
Available to owner after corporation & individual income taxes	1,019	1,019			1,265	1,265

Notes:

[1] Assumed -0- in this example

[2] See Table 1

[3] 20 % maximum dividend tax rate plus 3.8% Medicare tax surcharge

[4] Same as table 1 state and local tax rate

[5] Derived from model

Quantifying the Tax Impact

How is the 6.9 percent valuation benefit derived in the preceding paragraph impacted by the level of income? If 2013 pre-tax income is $200,000 and not $2 million in our example, would the valuation benefit for the Florida business have been greater or less? Table 3 summarizes the total corporate and individual income taxes incurred under each $200,000 pre-tax income scenario. We again assume a “value to the holder” standard of value. The difference of $29,000 in Table 3 is the additional tax cost associated with locating a business in New York City versus Florida. By applying the Modified Delaware MRI Model, we derive the imputed corporation income tax rate for the Florida and New York City S corporations assuming $200,000 of pre-tax income (see page 16 for Table 4). In this example, the owner of a New York City S corporation earning pre-tax income of $200,000 nets about $133,000 after tax. The owner of a Florida S corporation earning the same $200,000 of pre-tax income nets about $162,000 after tax. That’s also a substantial difference as a percent of S corporation income, as is its impact on valuation. The imputed corporation income tax rate for the New York City S Corporation is 7.46 percent in this example; the imputed corporation income tax rate for the Florida S Corporation is 0.25 percent. The difference between the two imputed corporation income tax rates yield a valuation benefit of 7.8 percent for the Florida S Corporation versus the New York City S Corporation. Table 5 (page 16) summarizes the imputed corporation income tax rates in the two examples. One would expect as our examples confirm, that the greater the pretax income, the greater the imputed corporate income tax rate. The New York City imputed corporate income tax rate increases from 7.46 percent ($200,000 pre-tax income example) to 22.35 percent ($2 million pre-tax income example), and the Florida imputed corporate income tax rate increases from 0.25 percent ($200,000 pre-tax income example) to 16.99 percent ($2 million pre-tax income example). The valuation benefit of being a Florida S corporation versus a New York City S corporation remains approximately the same: 7.8 percent ($200,000 pre-tax income example) versus 6.9 percent ($2 million pre-tax example).

Table 3: Effective Individual income tax rates, NYC & FL ($200K of pre-tax PTE income) ($000’s omitted)

	NYC	Florida
Gross income (taxable to shareholder)
S corp income	$200	$200
Less: S corp’s NYC income taxes	(18)	-
Adjusted gross income (AGI)	182	200
Deductions and exemptions
State income taxes	17
Less: 3% AGI floor	-	-
Standard deduction	-	12
Personal exemptions	8	8
	25	20
Federal taxable income	$157	$180
Income taxes (shareholder and S corp)
S corp’s NYC income taxes	$18	$-
Individual federal income taxes	32	38
Individual state income taxes	17	-
Total income taxes	$67	$38
Difference		$29
Income taxes as a percent of federal taxable income
Individual federal income taxes	17.58%	19.00%
Individual state income taxes	9.34%	0.00%
	26.92%	19.00%
Difference		7.92%

Table 4: Combined Federal, state and local entity income taxes, NYC & FL ($200K of pre-tax PTE income)

($000s omitted)

	NYC		Florida
	PTE & Individual Rates	Derivation of C Corp Tax Rate	PTE & Individual Rates	Derivation of C Corp Tax Rate
Normalized pre-tax cash basis income	$200	$200-	$200	$200
NYC S corporation taxes	8.85%	N/A	0.00%	N/A
Income before federal corporation income taxes	182	200	200	200
Combined federal and state C corporation tax rate	N/A	7.46%[5]	N/A	0.25%[5]
Available company earnings	182	185	200	200
Available company earnings	182	185	200	200
Pre-tax earnings retained % [1]	0.00%	0.00%	0.00%	0.00%
Distributable company earnings	192	195	200	200
State & local income taxes - individual	9.34%[2]	9.34%[4]	0.00%[2]	0.00%[4]
Federal income taxes-individual	17.58%[2]	18.80%[3]	19.00%[2]	18.80%[3]
Available to owner after corporation & individual income taxes	$133	$133	$162	$162

Notes:

[1] Assumed -0- in this example

[2] See Table 3

[3] 15% dividend tax rate plus 3.8% Medicare tax surcharge

[4] Same as table 3 state and local tax rate

[5] Derived from model

Table 5: Comparing combined federal, state & local entity income taxes, NYC & FL ($2M & $200K of pre-tax PTE income)

	Combined Federal and State C Corporation Tax Rate
Pre-tax S corporation income	NYC	Florida
$2,000,000	22.35%	16.99%
$200,000	7.46%	0.25%

Conclusion

This article explains how and why state income tax rates substantially impact after-tax income. High state and local income tax rates reduce the value of PTEs. The valuation consultant must consider the impact of the level of taxable income when valuing a PTE. Failing to properly consider these factors when applying the Modified Delaware MRI Model (or any PTE valuation model) and a “value to the holder” standard of value can result in a materially incorrect valuation conclusion.

A New York City hotel owner found himself planning a renovation of his property – as many owners have in the recent boom years. How do you prioritize the renovation? One obvious and appealing answer was to upgrade the hotel restaurant. A premium restaurant can do wonders for both the brand and the topline. With that in mind, the owner leased his restaurant to a prominent, well-regarded third-party operator.

“The Impact of State and Local Income Taxes on Pass Through Entity Valuations”, by Eric Barr, originally appeared in the July-August, 2013 issue of The Value Examiner. The Value Examiner is published by NACVA.

Contact Eric J. Barr:

Phone: (973) 630-5031

ebarr@markspaneth.com

This article originally appeared under the firm of Fischer, Barr & Wissinger LLC (FBW), now part of Marks Paneth LLP.