S Corporation: To Tax Affect or Not?

Whether valuators of businesses should “tax-affect” or “not tax-affect” an S corporation’s earnings is a controversial issue. The Internal Revenue Service is increasingly scrutinizing taxpayers and their business valuators fail to address the tax-affecting issue in valuations of S corporations. Any valuation of an S corporation (or other pass-through entity) should consider specific adjustments that recognize the tax differences between S corporations and C corporations.

The Tax Courts nor the business valuation community have not recognized a “peer reviewed and tested S corporation valuation model” that addresses the tax attributes of S corporations. The business valuation community has attempted to recognized, but has not recognized, a single, stand-alone model as a standard.

Case Law and the Significance of the S Corporation Issue

Prior to 1999, the Internal Revenue Service (in IRS Valuation Guide for appeals officers) stated that S corporation income should include a provision for corporate income taxes, commonly referred to as “tax affecting”. Additionally, tax-affecting was specifically approved by the Tax Court in Estate of Hall v. Commissioner (1975) and Rudolph M. Maris v. Commissioner (1980).

In 1999, the decision of Gross v. Commissioner changed course in the manner in which valuation experts and the Tax Court treat S corporations. The Tax Court accepted a valuation that concluded that the subject S corporation valuation should not fully reflect a corporate income tax. The Tax Court reasoned that the primary benefit of S corporation status is the absence of corporate-level taxes. The U.S. Court of Appeals of the Sixth Circuit upheld Gross in 2001. In reaching its conclusion, the Court emphasized that there was no evidence that the subject corporation was likely to lose its S corporation status.

In 2006, in Robert Dallas v. Commissioner, the taxpayer’s valuation expert tax-affected the S corporation’s income while the valuation expert for the Internal Revenue Service did not. The taxpayer’s valuation expert attempted to distinguish the case from Gross because the S corporation in Gross distributed all its income to shareholders, while the S corporation in Dallas distributed only amounts required to satisfy the shareholder pass-through income tax liabilities. The taxpayer’s underlying logic was that the distribution of approximately 100% of income results in returns to shareholders over-and-above that of the associated tax liabilities. In contrast, distributions to shareholders that are less than the associated tax obligation results in no such return to shareholders. By rejecting this logic, the Tax Court indicated that the Gross treatment of tax-affecting “is independent of the proportion of earnings distributed.”

In 2006’s Delaware Open MRI Radiology Associates v. Kessler, the Court noted that the S Corporation status was a valuable attribute and it was unlikely that the corporation would convert to a C Corporation status. The Court also noted that fully tax-affecting the S corporation’s earnings would undervalue the company, depriving the minority shareholders of fair value. But declining to tax-affect would overvalue the company by ignoring the impact of personal taxes. The court’s solution was a hybrid approach designed to capture the economic advantages enjoyed by an S corporation shareholder, who receives dividends free of corporate taxes.

In the hybrid approach, the court applied a hypothetical “predividend” corporate tax rate of 29.4%. This rate, when combined with an assumed 15% dividend rate, taxed the company as if it were a C corporation but also reflected the enhanced after-tax benefits enjoyed by S corporation shareholders.

In the 2012 Massachusetts divorce case, Bernier v. Bernier, the case required the valuation of two supermarkets organized as S corporations. The husband’s valuation expert fully tax-affected the companies’ earnings at the corporate rate and the wife’s expert did not tax-affect at all. After an expedited appeal, the Massachusetts Supreme Court ordered the trial court to adopt the tax-affecting method used in Kessler.

On remand, the husband’s expert combined the federal and state individual income tax rates to arrive at a tax-affecting rate of about 46% and a value of $9.3 million. The wife’s expert used the Kessler method, but incorporated a 40% assumed dividend rate, which was the applicable dividend rate on the valuation date. Since the personal income tax rate on that date was also 40%, the resulting tax-affecting rate was zero, which produced a value of $14 million.

The trial court rejected both approaches, finding that the husband’s expert undervalued the companies and that the wife’s expert, by applying a 0% tax-affecting rate, ignored the Supreme Court’s “clear mandate” by not tax-affecting. Instead, the court applied the 29.4% tax-affecting rate used in Kessler.

On appeal, the appellate court accepted the wife’s approach, making a clear distinction between not tax-affecting and “utilizing a zero percent tax affecting rate arrived at through application of ‘all applicable rates.’” The Kessler method was constructed to apply taxes to an S corporation as if it were a C corporation, but still produce the after-tax returns an S shareholder would receive. In Kessler, the dividend rate was 15%, so a 29.4% pre-dividend rate was appropriate. In Bernier, however, the dividend rate was 40%, requiring a 0% pre-dividend rate to duplicate an S shareholder’s returns and so, the plot continues to thicken.

No Consensus Yet

In 2013, a team of IRS engineering managers, BV specialists, and attorneys came together and developed a consistent approach for valuing S corporations. More specifically, it was a “reasonableness” approach, depending on the particular facts of the case, after considering a multitude of issues for applying specific methods. However, this approach was not adopted across the IRS uniformly.

Some parties in the IRS adopted the view that the issue is as a legal issue rather than factual issue. Some believed the court decisions on tax affecting have resolved the issue as a matter of law and would compel the IRS to appeal any case in which the valuator has tax affected. Others believed that it still is a factual issue, and some cases will call for tax affecting, but others will not. In the end, the IRS did not officially resolve the issue.