Court Allows Tax-Affecting in S Corporation Valuation
By Asif Charania, CPA/ABV/CFF, ASA | Valuation and Forensic Services Senior Manager
The goal of many businesses is to minimize its tax liability, whether it’s at the corporate level or the shareholder level. One could argue that taxes are the largest expense a business incurs and, at times, the biggest burden on cash flow. Further, valuation 101 teaches us that the value of any asset is the present value of future economic benefits (i.e. cash flow). Whether you pay taxes at the corporate level or the shareholder level, the cash will eventually end up in the hands of the IRS. Ignoring one of the biggest burdens on cash flow (i.e. taxes) may grossly overstate value, which can have significant consequences from an estate and gift tax perspective.
Ever since the tax court’s ruling in Gross v. Commissioner in 1999, the IRS has taken the position that valuation analysts should not tax-affect earnings of pass-through entities (e.g. S Corporations and LLCs) when estimating the value of a business . However, a recent decision by Chief Judge William C. Griesbach in the matter, James F. Kress and Julie Ann Kress v. United States of America, accepted the tax-affecting of earnings for the valuation of minority interests in an S Corporation, which is a monumental victory for business owners and their advisors.
The IRS Position
On October 29, 2014, the IRS released a job aid for its internal valuation analysts suggesting that it is inappropriate to tax-affect the cash flows of pass-through entities (“PTE”) for valuation purposes.
With respect to the attribute of pass-through taxation, absent a compelling showing that unrelated parties dealing at arms-length would reduce the projected cash flows by a hypothetical entity level tax, no entity level tax should be applied in determining the cash flows of an electing S Corporation. In the same vein, the personal income taxes paid by the holder of an interest in an electing S Corporation are not relevant in determining the fair market value of that interest.
The Kress Decision
In Kress v. U.S., Judge Griesbach primarily relies on the conclusions determined by the taxpayers’ primary expert in valuing minority interests in Green Bay Packaging, Inc. (“GBP”) for gift tax purposes. The plaintiff also retained a second expert while the government retained its own expert (the “government expert”). It is noteworthy that the IRS initially provided its own estimate of value, but eventually abandoned its position.
It is particularly important to note that all experts, including the government’s expert, “applied C-corporation level taxes to GBP’s earnings to effectively compare GBP to the other C-corporations.” Further, the government’s expert “then applied an adjustment to reflect the value of GBP as an S-corporation.” After recognizing that all of the experts tax-affected earnings, the Court further stated:
|The court finds GBP’s subchapter S status is a neutral consideration with respect to the valuation of its stock. Notwithstanding the tax advantages associated with subchapter S status, there are also noted disadvantages, including the limited ability to reinvest in the company and the limited access to credit markets. It is therefore unclear if a minority shareholder enjoys those benefits.|
Importance of the Decision
The Court’s decision to allow tax-affecting of earnings in valuations of S-Corporations (and presumably other PTEs) is a key breakthrough for business valuation professionals and taxpayers. The ability to consider the impact of taxes in valuation for estate and gift purposes provides that businesses are not overvalued, which allows businesses and their financial advisors greater flexibility when preparing estate plans.
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