Litigation + Valuation Perspectives

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What is an S Corporation worth? The IRS fight continues

s corporation, valuation, business valuation, pass through entityWhen it comes to the valuation of non-controlling interests in pass-through entities (PTEs) such as a Subchapter S corporation, there have been ongoing disagreements between business valuators and the IRS. The issue is whether and to what extent to offset PTE earnings for income taxes (often termed “tax-affecting”). Doing so reduces the value under the income approach to value.

The IRS position is that the earnings stream should not be adjusted for income tax expense. Since the income is passed through to the owners and taxed in their personal tax returns, PTEs don’t pay income taxes. Business valuators argue that investors in the real world consider income taxes in the valuation of the PTE.

This difference can have a significant impact on value as illustrated in the simplified example below:

 IRS PositionTaxpayer Position
Earnings$1,000$1,000
Less Income Taxes (at 40%)0(400)
Adjusted Earnings$1,000$600
Divided by Capitalization Rate20%20%
Value$5,000$3,000

As you can see, the impact is significant.

The U.S. Tax Court ruled in the IRS’s favor on this issue in the Gross case.1 That case was followed by Tax Court rulings in 6 more cases, all of which disallowed imputing income tax expense in the valuation of non-controlling interests in PTEs. In spite of those cases, many business appraisers adjust the earnings stream for taxes in the valuation of PTEs. Arguments in favor of tax-affecting may include the following:

  • C-corporations operate in the same economic environment as PTEs;
  • PTEs may lose their pass-through status in the future and convert to C-corporations;
  • Most measures of corporate performance used in valuation models, such as growth and discount rates, are derived from C-corporations; therefore, PTEs should be valued as C-corporations to maintain consistency with these measures;2
  • Free cash flow to equity holders should be the cash flow that investors receive and can use unrestrictedly for any purpose they choose. If part of the cash flow must be used to pay what are effectively corporate taxes, rational investors will not consider the pass-through profits to be true free cash flow without consideration of the tax thereon. Accordingly, this portion of taxes should be deducted from the cash flow to value the company; and,
  • According to the IRS, PTEs lend themselves readily to valuation approaches comparable to those used in valuing closely held C-corporations.3

In a case currently pending with the U.S. Tax Court, Cecil v. Commissioner, both the taxpayer’s and the IRS’s expert appraisers have prepared appraisal reports using the same method of tax-affecting the earnings stream in their valuations. The case involves gifts of minority interests in a PTE that owns the famous Biltmore estate. It will be interesting to see how the court rules in this case. We may have additional insight on the tax-affecting issue. Also of interest to business appraisers will be the Tax Court’s reaction to the specific tax-affecting model utilized by both experts.

Stephen E. Koons, CPA, ABV, ASA, CFF

  1. Gross v Commissioner, T.C. Memo 1999-254, aff’d 272 F 3d. 333 (6th Cir 2001) 78 TCM.
  2. William E. Simpson and Peter D. Wrobel, “Income Tax Issues in Valuing S Corporation,” CPA Expert, Spring 1996, pp.1-2.
  3. IRS Valuation Training for Appeals Officers (Chicago: CCH Incorporated, 1998), pp. 7-12.

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