Fall 2002
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Recent Court Decisions Raise Key S Corporation Valuation Issues A series of recent court decisions directly confronts the
widespread practice of tax-affecting S corporation earnings in business
valuations. Cumulatively, the three cases — Gross v. CIR, 272 F. 3d 333 (6th Cir. 2001), Estate of Heck v. CIR, T.C. Memo. 2002-34, and Estate of This attack on the practice of tax-affecting S corporation
earnings is significant because the data most commonly used to develop the
discount rate when using the income approach is extracted from the after-tax
results of C corporations. Therefore, S corporation earnings must be adjusted
to an after-tax equivalent by tax affecting, or the discount rate must be
adjusted to a pre-tax equivalent. Otherwise, the resulting apples-to-oranges valuations
approach means that an S corporation will always have a higher value than an
otherwise identical C corporation.
This would inappropriately mean that the mere filing of an S corporation
tax election would significantly increase the value of a business. The concept of tax-affecting stems from the difference in
tax treatment of S and C corporations. C corporations pay tax on earnings at
the corporate level. S corporation earnings flow through to their
shareholders, who are taxed on those earnings through their personal returns. When C corporations are valued using the income approach,
earnings are reduced by the applicable corporate taxes to determine an
accurate value. Valuators usually also reduce S corporation earnings for
taxes. In some cases, valuators base that adjustment on an assumed personal
tax rate; more commonly, they base the adjustment on corporate tax rates. Why Tax
Affect? At first blush, the practice of using corporate tax rates
to reduce S corporation earnings may seem odd. There are a variety of reasons
for this practice, however. Keep in mind that fair market value is based on the price
a hypothetical willing buyer would pay for the entity, as well as the
hypothetical seller’s price. The
hypothetical buyer will be concerned with the tax liability on the business’s
earnings. Since the vast majority of buyers of controlling interests
in S corporations, especially mid-sized or larger S corporations, are C
corporations, valuators typically choose the corporate rate to reduce S
corporation earnings. Also, the flow-through treatment of S corporation earnings
makes tax-affecting by the personal rate tricky, since there are a variety of
personal rates and the rate that any specific individual shareholder will pay
depends on that shareholder’s personal circumstances. Using someone’s specific personal tax rate
gets away from the hypothetical parties contemplated under the fair market value concept. In addition, given the numerous limitations on S
corporation shareholders, many S corporations live with the threat that they
may have to switch to C corporation status at some point in the future. For all these reasons, most valuators of controlling
interests in S corporations choose to reduce earnings by the corporate tax
rate to best approximate the economic reality of a transaction between a
willing buyer and seller. In addition, while S corporations don’t pay taxes at the
corporate level, they almost universally distribute sufficient earnings to
their shareholders to pay the personal taxes associated with the S
corporation’s earnings. Thus, a C corporation pays taxes directly to the
government while an S corporation distributes funds to its shareholders, who
in turn pay those funds to the government. In broad economic terms, the
result is similar; thus, the valuation method used should be similar as well. Also, the data on rates of return that most valuators use
are based on public company C corporations.
Arbitrarily applying them to an S corporation without an adjustment
presents problems. Tax
Court’s Position If tax-affecting is such a common practice, and if the
reasons for tax-affecting S corporation earnings by the corporate tax rate
seem logical, why then this sudden spate of Tax Court rulings challenging the
practice? In Gross, the IRS expert argued that an after-tax discount
rate was appropriate because the earnings used were “after corporate taxes”
(which, because the company was an S corporation, were zero). The Tax Court agreed. Although the result in Gross may make sense when viewed in
light of the specific facts of that case (see sidebar), the IRS is attempting
to apply the same reasoning to other valuations involving S corporations.
Most in the valuation community vehemently disagree. Many valuation experts believe that the discount rate
achieved by the IRS expert is applicable to tax-affected earnings. Therefore, they believe, the earnings of
the entity in question should have been tax-affected and the Tax Court’s
findings are economically inaccurate. From the perspective of S corporation
owners, the entrenchment of the Tax Court’s position would be an all bad
news, no good news proposition. Valuations for estate and gift purposes — or
at least those valuations challenged by the IRS — likely would go up in the
neighborhood of 30 percent to 40 percent, increasing tax exposure. It’s unlikely, however, that valuations for sales of
companies, valuations used to secure financing, or valuations for other
transactions would follow suit, since the valuation community at large
doesn’t agree with the Tax Court’s economics. The Tax Court rulings do leave open the possibility of
considering S corporation taxes and other S corporation “weaknesses” when
calculating discounts for lack of marketability and minority interest. Given
the chasm between the opinion of the valuation community at large and the
position of the Tax Court, it seems certain that the issue of tax-affecting S
corporation earnings will continue to be addressed in court. To what extent
the position taken in Gross and other recent cases is hardened into case law
remains to be seen. |
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