A Taxing Question (Part II): More Summertime Precedents to Make a Divorce Lawyer Blue

The courts continue to march away from the practice, widely-accepted in the valuation community, of tax-affecting pass through earnings in business valuation. Following in the footsteps of the Tax Courts in Dallas, Gross, Heck, and Adams, the Supreme Court of Rhode Island recently rejected the valuation of an expert who capitalized the earnings of a Subchapter S corporation after deducting the shareholder-level income taxes (i.e., “tax-affecting”) in a business valuation for divorce purposes.

In Vicario (2006), the husband was a 50% owner of an accounting practice grossing about $700,000 per year, a related actuarial consulting business grossing $1 million annually, and a limited liability company that owned the real estate where both companies were headquartered. The husband testified that he received no salary or distributions from the actuarial business other than annual distributions to pay his income taxes on the company’s passthrough income.

The wife’s business valuation expert used a capitalization of net cash flow approach to render his opinion of value, dividing the “weighted adjusted net cash flows” of $167,000 per year by a capitalization rate of 21 percent. Next, applying a 25% discount for lack of marketability (DLOM) and a 10% minority discount, the wife’s expert arrived at a value of $268,000 for Husband’s interest in the actuarial business. The wife’s expert explained to the trial court that he did not tax-affect passthrough income because Subchapter S corporations does not pay taxes at the corporate level.

The husband’s expert also applied a capitalization approach, but in his report, he “tax-affected” the earnings of the corporation. The husband’s expert also deducted non-recurring earnings, the value of a covenant not to compete, and the personal goodwill of the husband’s business partner. The husband’s expert testified that the wife’s expert did not calculate earnings correctly because records of accounts receivable may not have been made available to the wife’s expert. The husband’s expert also admitted that the income to be capitalized would have been greater if he had normalized repair and maintenance expenses reported in the company’s income statement.

The trial court, to its credit, did not split the difference, but rejected the opinion of the husband’s expert in favor of the wife’s expert.

In its opinion, the Rhode Island Supreme Court cited the Sixth Circuit’s decision in Gross, 272 F.3d 333 (2001), which affirmed the Tax Court’s holding that it is improper to tax-affect passthrough income when determining the value of a Subchapter S corporation for estate and gift tax purposes.

The Rhode Island Supreme Court’s analysis was cursory, holding merely that the trial court did not abuse its discretion. No consideration was given to the myriad of factors that were presented to the Delaware court in Delaware Open MRI Radiology Assoc. v. Kessler, a case hailed by business valuation experts to bolster the industry-standard practice of tax-affecting.

Delaware Open MRI is such a long decision (86 pages) that it could benefit from a table of contents. The portion dealing with tax-affecting starts at page 53. Tax-affecting is based on the principle of substitution: that a buyer would not pay more for an asset than it would cost to acquire some other asset that would provide equal or greater economic utility to the buyer. Applying the substitution principle, a buyer would not pay more for an S corporation than he would for a C corporation that provides the same economic benefit.

The advocates of tax-affecting in Delaware Open MRI also argued that it is possible for an S corporation to lose its tax-favored status under certain circumstances. In order to maintain Subchapter S status, the corporation must have no greater than 100 shareholders, all of whom generally must be individuals, not corporations or other legal entities. The corporation generally must have no more than one class of stock. Subchapter S businesses that are acquired by venture capital firms or publicly-traded companies, therefore, could be expected to lose their status. Moreover, C corporations cannot be expected to pay a premium for S corporations if they cannot benefit from the Subchapter S status. Yet, in the context of business valuations prepared for divorces and estate and gift tax returns, no actual sale is contemplated, so the loss of Subchapter S status is not likely.

On the other hand, those who rejected tax-affecting correctly point out that Subchapter S shareholders actually pay no income taxes at the corporate level. They are not “double taxed” on distributions, so perhaps there is greater value in Subchapter S status. The physicians who owned interests in this MRI operation certainly appreciated the benefit of a tax savings. The Delaware court also noted the substantial difference between the applicable personal income tax rates and the corporate tax rates that would apply if the company were a C corporation.

In order to reach a compromise between these extremes, the Vice Chancellor in Delaware Open MRI developed an effective tax rate than was less than the 40% corporate tax rate used by the dissenting shareholders’ expert and more than the 0% tax rate used by the controlling shareholders’ expert.

The recent decision in Vicario does not resolve, or even advance, the question of tax-affecting in divorce valuations. One can only hope that when this issue is addressed by the Pennsylvania courts, all the right arguments will be made.