Tax Affecting S Corporations and Other Pass-Through Entities

Tax treatment is different for S corporations and C corporations. The latter pay taxes on corporate-level income at corporate tax rates up to 40% (actual tax rates may be much less) and may distribute some, all or none of these earnings dividends to shareholders. Shareholders, in turn, who receive dividends pay dividend tax rates of about 15% on what they receive.

Consequently, owners of a C corporation see two levels of taxation before obtaining cash in their pockets. S corporations, LLC structures, and other pass-through entities, in contrast, do not pay taxes on a corporate level, although all of the reported earnings pass proportionately to the corporate shareholders who pay ordinary income tax (actual rates vary according to the individual owner). As a result, S-corporation shareholders pay tax on an individual level on their pro-rata share of the S corporation's earnings, whether money is distributed or not. Accordingly, there is an advantage to the shareholder of the S corporation because there is no double taxation. In addition, an S corporation provides an increase in basis to its owners for all earnings retained in the business, which reduces the tax when the business is sold.

When using the income approach, the question is whether or not to apply tax affecting when valuing an S corporation. Two frequently used methods under the income approach are the capitalization of income method and the discounted cash flow method. Both methods begin with net income (before or after tax?) and then adjust for a variety of factors, including normalization adjustments, nonrecurring revenue and expense, capital structure and financing costs, appropriate capital investments, non-cash items, and other expected changes. When applying these methods, reducing the net income by the applicable income taxes is called tax affecting. Ultimately, tax affecting lowers the value of a business. Due to the tax advantages described above, should the earnings of an S Corporation be tax affected or not, when applying the capitalization of income and the discounted cash flow methods?

Tax Court Opinions to Ignore Tax-Affecting

During the years 1999-2002, four opinions were issued by the U.S. Tax Court regarding tax affecting earnings of S corporations to put them on a comparable basis with C corporations. All cases rejected tax affecting. (Gross v. Commissioner: T.C. Memo. 1999-254 No 4460-97(July 29,1999). Aff'd. 272 F.3d 333 (6th Cir. 2001); Wall v. Commissioner, T.C. Memo 2001-75, March 27, 2001; Estate of Heck v. Commissioner, T.C. Memo 2002-34, Jan. 30, 2002 and Estate of Adams v. Commissioner, T.C. Memo 2002-80, March 28, 2002. There have been other cases affirming the Internal Revenue Service position that S-Corporations, or other pass-through entities should not be tax affected.)

Arguments by the taxpayers included:

• Adjustments should be made to account for the risk that the corporation could lose its favorable S status.
• If an S Corporation distributes less than all of its income, the actual distributions might be insufficient to cover the shareholders tax obligations.
• S corporations have limited possible investors, due to ownership restrictions and adjustments, and should account for this limitation.

These opinions of the Tax Court are case-specific and, therefore, do not represent the opinion of the Tax Court as a whole. As Shannon Pratt has noted, “there seems to be a consensus in the business valuation community that the decisions generally do not comport to good economic theory.” (Shannon Pratt and Alina Nuculita, “Valuing a Business,” 5th Ed., McGraw-Hill, 2008, page 614.) There may be little difference when valuing 100% ownership because the owner can take out high compensation and perks to generally minimize the corporate tax issue. However, in the cases of buy-sell agreements that state no discounts for minority position are to be reflected, if the only possible buyers are other qualified holders of the S-corporation stock, than all of the benefit should be included. At the individual shareholder level, the different corporate structure may offer a benefit known as a “premium.”

Models of 'Premiums' for S-Corporation Structure

Four models for valuing S corporations and pass-through entities have been developed since the Tax Court decisions. (There is an excellent discussion of these issues in Chapter 8 “Valuation of S corporations and Other Pass-Through Tax Entities: Minority and Controlling Interests” in Business Valuation and Taxes,” by David Laro and Shannon Pratt, John Wiley and Sons, 2005.) All of these models have common theories:

• The appropriate standard of value is fair market value as defined in Revenue Ruling 59-60.
• The models recognize that the seller and buyer are hypothetical, not specific.
• The role of a business valuation analyst is to estimate the present value of an investor's future economic benefits.
• Cash flow generated may be retained by the company, is available for distribution to investors or may be partially retained and partially distributed to investors.

Roger Garbowski's model reflects that interests in C corporations may have a less value than an interest in identical S corporations and other pass-through entities. His theory is that a specific interest in an entity is being valued, not an abstract interest. The interest has characteristics inherent in the entity including tax. In valuing a specific interest, the hypothetical willing buyer is buying an interest subject to those characteristics and the hypothetical willing seller is selling an interest subject to those characteristics. (Roger J. Grabowski, “S Corporation Valuation in the Post-Gross World ' Updated,” Business Valuation Review (September 2004).

Christopher Mercer's model concludes that at the enterprise level, an S corporation has the same value as an otherwise identical C corporation. At the shareholder level, an S corporation interest may be worth somewhat more or somewhat less than an otherwise identical interest in an otherwise identical C corporation. (Z. Christopher Mercer, “Are S Corporations Worth More Than C Corporations?” Business Valuation Review (September 2004).)

But Chris Treharne's model recommends identifying the incremental cash flow differences between S-corporation and C-corporation minority interests. He would then determine their present values. He would do this by establishing the present value of retained cash flow by tax-affecting the S corporation's cash flow at C corporation income tax rates. Value attributed to the investor's cash flow is adjusted for tax benefits associated with the S corporation shareholder's not having to pay a second level of tax. The present value of the cash flow to the investor is adjusted for the income tax differences between the individuals and C corporations. (Monograph: “Valuation of Pass-Through Entities: Minority and Controlling Interests,” Chris D. Treharne, ASA, MCBA, BVAL, Gibraltar Business Appraisals, and Nancy J. Fannon, CPA, ABV, MCBA, submitted by the S corporation to the Treasury Department.)

Daniel Van Vleet's model has two basic premises. The first is that there are significant differences in the income tax treatment of S corporations, C corporations and their respective shareholders. The other premise is that capital markets are efficient, at least over the long term, therefore, equity security prices, price/earnings multiples and equity investment rates of returns of publicly traded C corporations reflect the income tax treatment of C corporations and their shareholders. Van Vleet developed the S corporation economic adjustment model (SEAM) to address the differences in net economic benefits between C corporation and S corporation shareholders. (Daniel R. Van Vleet, ASA, CBA, “The S Corporation Economic Adjustment Model,” Chapter 4, The Handbook of Business Valuation and Intellectual Property Analysis (New York: McGraw-Hill, 2004).)

Conclusion

In summary, all four models are based on reliable economic theory and market evidence. In valuing S corporations and other pass-through entities, the first step is to determine whether the interest being valued is a controlling or a minority interest. If the interest is a minority interest, one of the four models should be used, depending on the individual facts and circumstances of the valuation. If the interest is a controlling interest, many experts conclude that there may be little difference in value because of corporate structure.

However, a buy-sell agreement mandating “controlling interest attributes” may be distinguished if the relevant buyers are only other qualified holders of the pass-through entity's stock. In addition, the experts agree that the change in tax basis attributable to retained earnings of an S corporation can affect the value of an S corporation, but they disagree where in the valuation process this characteristic should be considered. Therefore, the business valuation appraiser should be evaluating the facts and circumstances of the specific situation and be knowledgeable of the various models summarized in the preceding paragraphs.

Expect your expert to wrestle with this issue in your next valuation assignment regarding S-corporation or LLC equity. Applying C-corporation tax rates to the earnings flow without application of some premium as calculated by one of the models discussed lessens the amount of the forecasted earnings and should find less marital equity value. Beware of the analyst who uses only a singular income-based method, ignoring market and cost approach perspectives, because these alternative methods offer a “sanity check” of the results from an income method. The advantage to appraising value using multiple methods and “reconciling” the indications is that the opinion is more robust and grounded.

Tax affecting is a perilous game, and many venues will question an automatic application of a tax rate when evidence shows that the subject company pays no corporate tax. Jack Bogdanski opined recently that “when valuing S-corporation stock, tweak the discount rate but don't call it tax affecting.” (Jack Bogdanski, “Tax Affecting Has Stalled in the Courts '” BV Wire, Dec. 21, 2011, issue #3, page 1.) Beware of the options your expert must consider!

Rob Schlegel, a member of this newsletter's Board of Editors, is an Accredited Senior Appraiser in Business Valuation by the American Society of Appraisers, and also holds the Master Certified Business Appraiser designation from the Institute of Business Appraisers. He is a Principal in the Indianapolis, IN, office of Houlihan Valuation Advisors. Penny Lutocka is a Certified Public Accountant and a Certified Fraud Examiner also practicing in Indianapolis.

Matrimonial attorneys are often confronted with equity in an S-corporation business that must be valued as a marital asset. Among the many methods an appraiser uses to analyze value, one of the most common is an income-based analysis where anticipated future earnings of the business are translated into “value.” In a single-period model, the basic equation reflects a type of earnings divided by a “Capitalization Rate.” In a multi-period model, the appraiser uses forecasts of future earnings in each year brought back to present value by a “Discount Rate.” These rates are generally determined by application of public market evidence from large C corporations that pay taxes and that the individual investor expects to pay a dividend tax. Since S corporations and other pass-through corporate structures carry no tax obligations, should the appraiser tax affect or not? Following four 1999-2002 tax court cases and subsequent similar cases, frenzy has gripped the business valuation community to develop a new theory for the valuation of S corporations and the interests in them. Expect to see some application of this theory to be employed by appraisers of S-corporation marital interests.

Corporate and Earnings Typologies

Pass-through entities such as S-corporations and LLCs are becoming more and more the entity of choice, while the number of C corporations continues to decrease. (Rules exist for entity structure in order for it to quality as an S corporation. For example, ownership cannot include foreign, partnership or other corporate owners; there can be only one class of stock, and the number of owners is limited to 100.) According to the Internal Revenue Service, approximately 69% of entities in 2008 were pass-through entities, up from approximately 24% in the late 1980s.

Tax treatment is different for S corporations and C corporations. The latter pay taxes on corporate-level income at corporate tax rates up to 40% (actual tax rates may be much less) and may distribute some, all or none of these earnings dividends to shareholders. Shareholders, in turn, who receive dividends pay dividend tax rates of about 15% on what they receive.

Consequently, owners of a C corporation see two levels of taxation before obtaining cash in their pockets. S corporations, LLC structures, and other pass-through entities, in contrast, do not pay taxes on a corporate level, although all of the reported earnings pass proportionately to the corporate shareholders who pay ordinary income tax (actual rates vary according to the individual owner). As a result, S-corporation shareholders pay tax on an individual level on their pro-rata share of the S corporation's earnings, whether money is distributed or not. Accordingly, there is an advantage to the shareholder of the S corporation because there is no double taxation. In addition, an S corporation provides an increase in basis to its owners for all earnings retained in the business, which reduces the tax when the business is sold.

When using the income approach, the question is whether or not to apply tax affecting when valuing an S corporation. Two frequently used methods under the income approach are the capitalization of income method and the discounted cash flow method. Both methods begin with net income (before or after tax?) and then adjust for a variety of factors, including normalization adjustments, nonrecurring revenue and expense, capital structure and financing costs, appropriate capital investments, non-cash items, and other expected changes. When applying these methods, reducing the net income by the applicable income taxes is called tax affecting. Ultimately, tax affecting lowers the value of a business. Due to the tax advantages described above, should the earnings of an S Corporation be tax affected or not, when applying the capitalization of income and the discounted cash flow methods?

Tax Court Opinions to Ignore Tax-Affecting

During the years 1999-2002, four opinions were issued by the U.S. Tax Court regarding tax affecting earnings of S corporations to put them on a comparable basis with C corporations. All cases rejected tax affecting. (Gross v. Commissioner: T.C. Memo. 1999-254 No 4460-97(July 29,1999). Aff'd. 272 F.3d 333 (6th Cir. 2001); Wall v. Commissioner, T.C. Memo 2001-75, March 27, 2001; Estate of Heck v. Commissioner, T.C. Memo 2002-34, Jan. 30, 2002 and Estate of Adams v. Commissioner, T.C. Memo 2002-80, March 28, 2002. There have been other cases affirming the Internal Revenue Service position that S-Corporations, or other pass-through entities should not be tax affected.)

Arguments by the taxpayers included:

• Adjustments should be made to account for the risk that the corporation could lose its favorable S status.
• If an S Corporation distributes less than all of its income, the actual distributions might be insufficient to cover the shareholders tax obligations.
• S corporations have limited possible investors, due to ownership restrictions and adjustments, and should account for this limitation.

These opinions of the Tax Court are case-specific and, therefore, do not represent the opinion of the Tax Court as a whole. As Shannon Pratt has noted, “there seems to be a consensus in the business valuation community that the decisions generally do not comport to good economic theory.” (Shannon Pratt and Alina Nuculita, “Valuing a Business,” 5th Ed., McGraw-Hill, 2008, page 614.) There may be little difference when valuing 100% ownership because the owner can take out high compensation and perks to generally minimize the corporate tax issue. However, in the cases of buy-sell agreements that state no discounts for minority position are to be reflected, if the only possible buyers are other qualified holders of the S-corporation stock, than all of the benefit should be included. At the individual shareholder level, the different corporate structure may offer a benefit known as a “premium.”

Models of 'Premiums' for S-Corporation Structure

Four models for valuing S corporations and pass-through entities have been developed since the Tax Court decisions. (There is an excellent discussion of these issues in Chapter 8 “Valuation of S corporations and Other Pass-Through Tax Entities: Minority and Controlling Interests” in Business Valuation and Taxes,” by David Laro and Shannon Pratt, John Wiley and Sons, 2005.) All of these models have common theories:

• The appropriate standard of value is fair market value as defined in Revenue Ruling 59-60.
• The models recognize that the seller and buyer are hypothetical, not specific.
• The role of a business valuation analyst is to estimate the present value of an investor's future economic benefits.
• Cash flow generated may be retained by the company, is available for distribution to investors or may be partially retained and partially distributed to investors.

Roger Garbowski's model reflects that interests in C corporations may have a less value than an interest in identical S corporations and other pass-through entities. His theory is that a specific interest in an entity is being valued, not an abstract interest. The interest has characteristics inherent in the entity including tax. In valuing a specific interest, the hypothetical willing buyer is buying an interest subject to those characteristics and the hypothetical willing seller is selling an interest subject to those characteristics. (Roger J. Grabowski, “S Corporation Valuation in the Post-Gross World ' Updated,” Business Valuation Review (September 2004).

Christopher Mercer's model concludes that at the enterprise level, an S corporation has the same value as an otherwise identical C corporation. At the shareholder level, an S corporation interest may be worth somewhat more or somewhat less than an otherwise identical interest in an otherwise identical C corporation. (Z. Christopher Mercer, “Are S Corporations Worth More Than C Corporations?” Business Valuation Review (September 2004).)

But Chris Treharne's model recommends identifying the incremental cash flow differences between S-corporation and C-corporation minority interests. He would then determine their present values. He would do this by establishing the present value of retained cash flow by tax-affecting the S corporation's cash flow at C corporation income tax rates. Value attributed to the investor's cash flow is adjusted for tax benefits associated with the S corporation shareholder's not having to pay a second level of tax. The present value of the cash flow to the investor is adjusted for the income tax differences between the individuals and C corporations. (Monograph: “Valuation of Pass-Through Entities: Minority and Controlling Interests,” Chris D. Treharne, ASA, MCBA, BVAL, Gibraltar Business Appraisals, and Nancy J. Fannon, CPA, ABV, MCBA, submitted by the S corporation to the Treasury Department.)

Daniel Van Vleet's model has two basic premises. The first is that there are significant differences in the income tax treatment of S corporations, C corporations and their respective shareholders. The other premise is that capital markets are efficient, at least over the long term, therefore, equity security prices, price/earnings multiples and equity investment rates of returns of publicly traded C corporations reflect the income tax treatment of C corporations and their shareholders. Van Vleet developed the S corporation economic adjustment model (SEAM) to address the differences in net economic benefits between C corporation and S corporation shareholders. (Daniel R. Van Vleet, ASA, CBA, “The S Corporation Economic Adjustment Model,” Chapter 4, The Handbook of Business Valuation and Intellectual Property Analysis (New York: McGraw-Hill, 2004).)

Conclusion

In summary, all four models are based on reliable economic theory and market evidence. In valuing S corporations and other pass-through entities, the first step is to determine whether the interest being valued is a controlling or a minority interest. If the interest is a minority interest, one of the four models should be used, depending on the individual facts and circumstances of the valuation. If the interest is a controlling interest, many experts conclude that there may be little difference in value because of corporate structure.

However, a buy-sell agreement mandating “controlling interest attributes” may be distinguished if the relevant buyers are only other qualified holders of the pass-through entity's stock. In addition, the experts agree that the change in tax basis attributable to retained earnings of an S corporation can affect the value of an S corporation, but they disagree where in the valuation process this characteristic should be considered. Therefore, the business valuation appraiser should be evaluating the facts and circumstances of the specific situation and be knowledgeable of the various models summarized in the preceding paragraphs.

Expect your expert to wrestle with this issue in your next valuation assignment regarding S-corporation or LLC equity. Applying C-corporation tax rates to the earnings flow without application of some premium as calculated by one of the models discussed lessens the amount of the forecasted earnings and should find less marital equity value. Beware of the analyst who uses only a singular income-based method, ignoring market and cost approach perspectives, because these alternative methods offer a “sanity check” of the results from an income method. The advantage to appraising value using multiple methods and “reconciling” the indications is that the opinion is more robust and grounded.

Tax affecting is a perilous game, and many venues will question an automatic application of a tax rate when evidence shows that the subject company pays no corporate tax. Jack Bogdanski opined recently that “when valuing S-corporation stock, tweak the discount rate but don't call it tax affecting.” (Jack Bogdanski, “Tax Affecting Has Stalled in the Courts '” BV Wire, Dec. 21, 2011, issue #3, page 1.) Beware of the options your expert must consider!

Rob Schlegel, a member of this newsletter's Board of Editors, is an Accredited Senior Appraiser in Business Valuation by the American Society of Appraisers, and also holds the Master Certified Business Appraiser designation from the Institute of Business Appraisers. He is a Principal in the Indianapolis, IN, office of Houlihan Valuation Advisors. Penny Lutocka is a Certified Public Accountant and a Certified Fraud Examiner also practicing in Indianapolis.