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Keeping Your Balance: Tax-affecting an S corporation 2011-12 updates

By James P. Schnell
Posted: 6:15 pm Thu, October 18, 2012

James P. Schnell

During 2008 I wrote an article for this publication on this topic. At that time, the IRS had come out strongly against the concept of tax-affecting S corps. There were an initial series of court cases, which upheld that position to the detriment of some taxpayers and estates.

However, the valuation and general taxpaying communities were left with the rather large conundrum: cash flows from a C corporation are post-tax, whereas cash flows from an S corporation are pre-tax to the extent of the personal tax rate of its shareholders.

Since then the profession, the IRS and the courts have continued to work together to attempt to agree on or define some workable solutions. While we are not there yet by any means, the following are some updates of events within the last three to four years.

In spring 2012, a survey was conducted among business valuation professionals to gauge their current position and/or understanding of the issue of whether or not and how to tax affect an “S” corporation in a business valuation engagement. The results were both unique and not wholly unexpected when considering this issued is mired within the courts and valuation community.

More than half (54 percent) of respondents said they do not apply a “premium” to account for the difference between the data on publicly traded C corps, from which they derive the cost of capital to the subject company to which they apply it. One contributor noted, “I consider actual taxes/tax rate paid by the entity, no phantom imputation.” Conversely, another contributor said, “What do buyers do? Our position is that in the real world, buyers tax affect an investment … in terms of using after-tax cash flows as the metric for value.” However, interestingly embedded in the survey results was a strong showing (29 percent) of those surveyed who do not apply a PTE premium, but rather choose to adjust the discount rate instead. One contributor alluded that they felt this is the way the IRS is going.

Forty-six percent of survey participants apply an S corp premium. By far the most commonly used models were the ones by Van Vleet (Daniel R. Van Vleet, ASA, CBA developed the SEAM model in 2002) and the Delaware Chancery (Delaware Open MRI Radiology v. Kessler in 2006). For the record, our firm approach is based upon tax affecting an S corporation utilizing the Delaware Chancery Model. Since every business valuation is embedded with several assumptions; we apply a hypothetical income tax rate to a stream of S corp. earnings as one of our rational assumption.

“The most notable thing about the valuation of pass-through entities (including S corporations) may be … that there’s nothing new to note, says Nancy Fannon (Meyers, Harrison & Pia). Has the IRS backed off its historic resistance to tax affecting the income stream of S corporations and similar PTEs to account for the difference between the public market data, from which they derive the cost of capital, and the subject PTE, to which they will apply it?

“I’ve been told yes, but the cases I’ve been called on indicate otherwise,” Fannon says. “Next to discounts for lack of marketability, there may be no issue more material to the valuation of a closely held company than tax affecting, yet I find there is an utter lack of consensus among professional business appraisers on what to do, leaving potentially widely disparate results from one practitioner to the next.”

One great example of how mired this issue is right now among professionals, the IRS and the courts is the Massachusetts Supreme Court case of Bernier v. Bernier. This is a protracted divorce case that was remanded to the trial court in June 2012 for a third try at correctly applying and achieving results regarding tax affecting. This case was based upon the Delaware model.

Stay tuned as we eagerly anticipate developments in this area over the next two to five years to supply all of us with more definitive guidance.

James P. Schnell, CPA/ABV, CVA, is a tax and business valuation partner with Mengel, Metzger, Barr & Co. LLP. He may be reached at jschnell@mmb-co.com or (585) 423-1860.

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