The Tax Cut and Jobs Act: What’s In It For Home Care Owners?

When the Tax Cut and Jobs Act of 2017 was signed into law on December 22nd , the most significant change to the US tax code in more than thirty years, I expected a collective rejoicing among home care owners who stand to benefit. Instead, confusion prevailed.

It is clear that home care companies organized as “C” corporations will be benefactors of the corporate tax rate reduction from 35% to 21%. Less clear is how home care companies organized as “S” corporations, LLCs, sole proprietors and partnerships will be affected by the new 20% tax deduction on Qualified Business Income that flows through to the owner’s personal tax returns.

Since pass-thru entities make up most of the approximately 20,000 US home care providers, I will endeavor to eliminate the confusion and provide clarity. As I do, if you have any noisemakers left over from your New Year’s Eve party kits, you may want to keep one handy while I report some good news.

My disclaimer though is that I’m not a Certified Public Accountant. However, my team and I work closely with them in executing home care acquisition transactions across the US. My personal interpretation of the new law will need to be verified and validated by a CPA.

As our ownership succession planning clients know, the final return on their home care investment is the sum total of the after tax income achieved during ownership and the net capital gain earned upon the sale of the business. Although the nuances of the law are subject to further interpretation and clarification, my opinion is this. The vast majority of home care owners stand to substantially benefit from the new law in the form of lower tax rates and higher business valuations.

Specified Service Businesses: The confusion began when it was widely reported that certain service companies would not be eligible for the tax cuts. The law defines a Specified Service Business as health, law, consulting, athletics, financial services, brokerage services or any business where the principal asset is the reputation of one or more of its employees or owners. The underlined portion of this definition certainly appears to apply to home care providers. But even if it eventually becomes interpreted as such, most home care providers would not be excluded. Rather, they would be limited on a means tested basis. Only a minority wouldn’t benefit at all.

Qualified Business Income (QBI): The 20% tax deduction applies to the net income of S corporations, LLCs, sole proprietors and partnerships. If such entities are categorized as Specified Service Businesses, the full tax deduction is limited to those owners with taxable income of less than $315,000 if married filing jointly or $157,500 for single filers. The deduction does not apply to reasonable W-2 wages that S Corporations or partnership owners pay themselves as compensation for running their companies.

If the home care industry is caught by the Specified Service Business net, it would only impact owners with taxable incomes that exceed these thresholds. Otherwise, the tax deduction is limited to 50% of the home care company’s W-2 payroll. Given the labor intensive nature of the home care industry in which provider payrolls average more than 65% of revenue, the tax deduction would in essence be limitless if home care providers as currently interpreted fall outside of the Specified Service Business designation.

Example: To illustrate how it works, I pulled the 2017 tax returns of one of our sale clients formerly operating in the great Hawkeye State. The key figures are as follows.

Total Income (Line 6): $2,000,000

Compensation of Officer (Line 7): $72,000

Salaries and Wages (Line 8) $1,228,000

Ordinary Business Income (Line 21) $200,000

The $272,000 of compensation and ordinary business income this former home care owner earned was subject to a 33% tax rate based on 2017 household adjusted gross income of $300,000. Therefore, the home care owner compensation and business income net of the $89,760 tax bill was $182,240.

Under the identical scenario in 2018, the $89,760 tax obligation would be reduced to $55,680 for a reduced tax bill of more than $34,000. That’s because the W-2 compensation in 2018 is taxed at the lower rate of 24% and the business income at a 19.2% rate net of the 20% tax deduction (24% tax bracket minus 4.8 = 19.2%).

With a reduced tax bill of $34,000, the owner could either increase his ordinary business income by 17%, reinvest it back in the business or a combination of the two. Increased caregiver wages to top performers is certainly one way to invest the tax savings. But keep in mind, most caregivers just got a big tax cut in the form of the doubling of the standard deduction to $24,000 and an increase in the child tax credit to $2,000. That’s because the law was designed to benefit those at the lower end of the tax scale and job creators. So in this scenario, it’s a net win for the owner and her caregivers.

If the tax savings is applied to her business income, the value of her business using an after tax targeted rate of return of 15% would have increased from approximately $900,000 at the 33% tax rate to $1,077,000 at the 19.2% tax rate. That’s a valuation increase of 20%! And if this particular home care company stays outside of the Specified Service Provider designation, the cap on the deduction would be $650,000 (half of the company’s W-2 payroll.) So as the company grows, the deduction grows with it.

But before you blow too hard into that noisemaker, keep in mind there are some offsets to the tax savings such as the $10,000 cap on deductions for state income and property taxes. That means in high tax states like California and New York, the effective state tax rate on compensation and business income is going up. But the overall effect on the home care industry is a net positive.

The call to action is this. Now is the time to meet with your CPA to determine the following.

1. Am I organized in the most tax efficient manner possible?

2. Are my W-2 wages for services performed fair and reasonable?

3. Am I subject to deduction limitations?

4. Am I one of the many benefactors under the new tax law?

Since the Tax Cut and Jobs Act was designed to benefit business owners, job producers, and investors, the primary enablers of a growing economy, I expect corporate managers and executives who aspire to acquire and run their own business to take a closer look. They now have a considerable tax incentive to do so.

Industry Consolidators Seek To Build Marketing Muscle

Ready or not, here it comes – fewer agencies, bigger brands, better providers.

As a national practice solely involved in initiating confidential sales, acquisition searches and strategic successions within the US home care industry, we enjoy a front row view of the entry and exit moves among investors and owners.

Not long ago, the entry and exit doors were few. The primary entry door was start-up offices. The main exit door was change of owner-operator transactions. Private equity investors and industry consolidators were largely on the sidelines. They have recently moved to the playing field opening new doors and windows of opportunity.

The relatively young home care industry has achieved a key maturation point. Yet few if any other mature industries can match its growth prospects driven by durable, expanding demand. Case in point, of the 56 million US citizens who will be age 65 or older by 2020, an estimated 70% will be unable to care for themselves. About a third will be in situations that require them or their loved ones to pay out of pocket for needed care.

With these families expected to purchase an average of twenty hours of weekly living assistance, their annual household expenditures for care would be more than $20,000. That’s an emerging private duty market size of more than $25 billion in just three years expected to generate more than $3.5 billion of pre-tax earnings.

That’s just the first and smaller wave of the “Silver Tsunami.” Between 2020 and 2050, driven by the largest segment of the US population- Baby Boomers, the 65 and over crowd will balloon 50% to more than 84 million. With increased life expectancies, more than 20 million will be over the age of 85.

These trends have certainly not gone unnoticed by opportunistic private equity investors. Despite the rising cost of care, emerging lower cost alternatives and caregiver recruiting and retention challenges, the growth outlook is exceptional, fueled by an aging US population with an unwavering desire to age in place with grace.

With these growth prospects, why have private equity investors until recently remained largely on the sidelines? We know their investment criteria includes earnings predictability and scalability, both of which have given them cause for pause in the home care industry.

Earnings predictability is undermined by revenue volatility, the nature of the home care beast given the transitory nature of clients that inevitably “age out” by passing away or moving to facility based care. Scalability is also a challenge due to the uniquely local and highly personal nature of home care. Families want to do business with locally owned agencies yet they long for a trusted national brand. That explains the high industry fragmentation made up of approximately 20,000 US agencies, 7,000 of which are franchise offices more than half operating within the top ten nationally branded franchise networks.

It also explains Home Hero’s recent withdrawal from the industry. Having raised $23M dollars, they sought growth through lower pricing enabled by their independent contractor model, higher caregiver pay, greater speed, and improved efficiencies through proprietary technology. Instead, they underestimated the market entrenchment and regulatory advantages of brick and mortar, community oriented agencies that directly employ their caregivers. These agencies are primarily managed by hands on, owner-operators.

This year’s private duty benchmark leaders have developed high performance office teams of purpose driven managers who understand delivering a common service uncommonly well is knowing the little things make a big difference. Things like community involvement, impassioned, around the clock responsiveness, genuine compassion, personal communication, high touch and going the extra mile. Things that technology cannot replace.

As such, the key strategic consideration among private equity investors is how to achieve a competitive advantage from the marketing muscle and recruiting edge that comes from size, scale and national brand status while maintaining family’s preferences for locally owned agencies. The solution? Acquire the franchisors and fill the national “map gaps” by acquiring and converting non-franchise agencies.

The industry is on the cusp of this initiative creating new exit doors for owners of independent home care agencies many of whom are finding it increasingly difficult to compete with national brand power. These well-capitalized nationally branded networks have the financial means to invest in national advertising and top of the page internet marketing, two growing client/caregiver inquiry sources according to this year’s benchmark study.

Not long ago, there was only one franchise home care network investing in national television advertising. Today, most of the top ten do with more on the way. It’s an effective yet highly expensive medium that builds brand awareness and trust while driving considerable web site traffic. Access to it requires size and scale, precisely what the national networks have achieved and what the private equity investors seek. Marketing muscle matters especially in a high client turnover business.

With a flurry of recent investments, the private equity backed, franchise networks today include Senior Helpers, Right at Home, Home Care Assistance, Home Helpers, Always Best Care and Interim Healthcare. The private equity investors respectively are Altaris Capital, Investors Management Corporation, Summit Partners, Linsalata Capital Partners, Plenary Partners/Gemini Investors and Levine Leichtman Capital Partners.

Each will bring their own scalability initiatives designed to create marketing muscle, recruiting/retention advantages, economies of scope, and back office efficiencies from cutting edge technology. Some of the national franchise networks are establishing company operations to run the acquired agencies. Others plan to sell the acquired agencies to aspiring franchisees upon rebranding. In some cases, existing franchisees in select markets are being acquired by the franchisors. In others, under-performing franchisees are being transitioned out.

Meanwhile, the remaining technology driven players, including Honor, Home Team and Kindly Care, are fine tuning their investor backed business models in preparation for national expansion. They too are likely to target independent agencies to convert to their platforms as a speedier and more viable alternative to start ups. They have a new appreciation for established assets like brick and mortar, reputation, a client acquisition apparatus, a proven office team, a caregiver workforce and market knowledge. In a mature industry, these assets have become difficult to build from scratch.

As the evolution towards fewer agencies, bigger brands, and better operators accelerates, perhaps there’s no better time than now to use this benchmark study to do some serious self-assessment. If you’ve been operating for ten or more years yet you’re not a “leader,” why? What are your prospects of becoming one amid industry consolidation? If you can’t beat the national brands, should you join them? If so, how sustainable is your historical financial performance under new ownership? How transferable are your intangible assets? How convertible is your business to a national brand?

One might say the home care industry is being divided into the hunters and the hunted. Survival of the fittest will determine the winners and losers. We believe the powerful combination of a national brand and local ownership will be among the distinct winners creating expansion and exit payday opportunities for investors and owners. Like most windows of opportunity, knowledge, planning and preparation are key.