Should I ignore taxes when modeling free cash flow?

September 14, 2021

by a searcher from Brigham Young University in Salt Lake City, UT, USA

When modeling the free cash flow for a business (LLC), is it right to ignore taxes? As the shareholders will pay income and/or capital gains tax once the profits are distributed (either as a salary for owner/manager or dividends/draw for shareholders), I assume there are no income tax cash flows that affect the LLC. Is that a correct assumption? Thanks for any help.

I.e.: Levered FCF = EBITDA - Net Interest Expense - Change in Working Capital - CapEx - Debt Repayments

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Reply by a professional
from Walsh College of Accountancy and Business Administration in Detroit, MI, USA

Yes taxes should be included in your free cash flow model. First, you should review the tax distribution section of your operating agreement that will dictate how much cash you're required to distribute to the members based on taxable income. Most operating agreements are written very broadly when it comes to tax rates and will say to use the highest federal/state tax rate in New York or California, regardless of where the member actually lives or where the company has nexus or they will leave the tax rate up to the Board to decide. Second, many states require non-resident withholding on member taxable income apportioned to their state. The operating agreement will tell you how to treat this withholding, which is generally treated as a tax distribution (or a loan). Third, there are entity level taxes in some states and cities for LLC's taxed as partnerships. A few examples include Ohio Commercial Activity Tax, Texas Franchise / Margin Tax, New York City, etc. Fourth, many states are adopting alternative state tax rules to get around the $10,000 itemized deduction limitation at the individual level. If the company elects into these tax rules or is required to follow them, this would be an entity level state tax expense. Fifth, yesterday the House Ways and Means Committee released a first draft of the tax provisions proposed to be included in the Build Back Better Act. Several of the provisions impact the current tax rates mentioned in earlier posts. If passed with the current language, some tax changes would be effective as of September 13, 2021 and others January 1, 2022.

Reply by an intermediary
from The University of Chicago in Chicago, IL, USA

You have not identified the purpose for your FCF.
1) If you want to calculate how much an owner will take home BEFORE salary, then you should not deduct salary and any taxes.
2) If you want to calculate how much an owner will take it home AFTER paying himself/herself a salary, then you should deduct salary. FICA taxes, etc. but not deduct income taxes.
3) If you are trying to calculate FCF (more precisely FCFE) the way accounting, finance and valuators define/use it, then you must deduct shareholder income taxes in addition to deductions described in #2, Tax rate should be that of the shareholder. Under current US tax laws that rate is either 37% or 29.6% (for businesses that can benefit from 199A deduction), plus state level taxes.

There is a school of thought (A) that pass-through-entities (PTE) like S Corp and LLC), have same value as C Corp. They use 21% as the tax rate in #3 above. Another view (B) is a court decision in Gross that said S Corp. should be valued w/o shareholder taxes. I disagree with both. However, between A and B, B is absolute garbage decision by the courts; A is closer to real value of PTE. Happy to discuss how to determine true PTE value. I have written few articles and have a software to do so.

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