S Corporations: A Taxing Question (Part I)

A hot topic confronting the valuation community these days is whether to discount the earnings or cash flows of a Subchapter “S” corporation by subtracting the shareholder-level income taxes before capitalizing those earnings or cash flows in a business valuation. Intuitively, it stands to reason that an S corporation is not intrinsically more valuable than a C corporation that would generate the same net income or cash flow if it did not have to pay corporate-level income taxes. Perhaps this is why the valuation community has endorsed the practice of “tax-affecting” the earnings of S corporations – until recent court decisions have called into question that practice.

In several recent decisions, “tax-affecting” S corp earnings has been disapproved by the Tax Court. Most recently, in Dallas v. Commissioner, the Tax Court rejected several arguments frequently cited by valuation experts as reasons for “tax-affecting” S corps:

(1) The Tax Court rejected the argument that the company (a family-owned chemical-processing business) might lose its Subchapter “S” status. There was no evidence of record to suggest that the stock transfers which prompted the experts to value the business for estate and gift tax purposes would result in a loss of Subchapter “S” status.

(2) The Tax Court rejected the argument that “tax-affecting” S corp earnings is the standard method among NACVA-certified experts and is taught in NACVA courses for valuation professionals. The expert who had advocated “tax-affecting” in this case testified about an informal poll he took at a cocktail party during a NACVA convention. Not surprisingly, the judge did not regard his poll as scientifically valid. Similarly, the Court dismissed testimony that most bankers and business brokers usually tax-affect S corporation earnings.

(3) The Tax Court rejected the rationale set forth by the Delaware Court of Chancery in its opinion published in Delaware Open MRI Radiology Assoc. v. Kessler. The Tax Court held that the “fair value” standard employed in shareholder dissent cases like Kessler is not necessarily the same as “fair market value” in estate and gift tax cases.

Some of the leading commentators in the business valuation field have been following these cases closely. Those commentators seem to agree that whether “tax-affecting” is appropriate is fact-dependent. In Part Two of this post, I will describe some of the theories that these commentators have developed and how they might apply in a divorce context.