By John Hempstead, ASA, CFA
Managing Director, Hempstead & Co. Inc.
Synopsis
S corporations have become the corporate vehicle of choice for operating privately-held businesses. Because of their special tax attributes, however, they present certain challenges to appraisers attempting to value them for estate and gift tax or other purposes.
This article discusses the challenges and traces the changes that have taken place in S corporation valuation practices over the past five to ten years. This is done by looking at the key court opinions issued over that period that have dealt with S corporation valuation issues.
The S corporation has emerged in recent years as the most popular corporate vehicle for operating a privately-held business. As a result of this, S corporations are increasingly and in larger number being subject to appraisal for estate and gift purposes. Certain of the corporate valuation methods used in the past by members of the appraisal profession did not match up with the tax singularities of S corporations. Therefore appraisers, taxpayers and the IRS have had to find new ways of valuing these entities.
How are S Corporations Taxed?
A regular or "C" corporation pays a federal income tax of approximately 35% on its earnings. Its shareholders are taxed at their personal income tax rate on any dividends distributed by the company. In effect, income earned and distributed by a C corporation is taxed twice, once at the corporate level and again at the shareholder level.
An S corporation (also called a Sub-S corporation), by contrast, pays no federal income tax on its earnings. Instead, its shareholders pay personal income taxes on their pro-rata share of the company's earnings, at rates ranging up to about 35%. This tax must be paid whether or not the S corporation distributes any of its earnings.
What's the Valuation Problem?
Business appraisers value companies in order to determine their fair market value. They seek to determine how much a hypothetical investor would pay for shares in the company being appraised. A common way appraisers do this is by looking at what investors have paid for shares of other companies that bear similarities to the company being appraised.
One of the most important sources of information on what investors have paid for investments in companies is the stock market. Stock market data is used in a valuation approach called the market comparable or guideline company method. To illustrate it with a simplified example, suppose an appraiser is trying to value a supermarket chain. To use the market comparable method, he'd examine publicly-traded supermarket chains and seek to determine what the ratio of their stock prices is to their earnings (the P/E ratio). He would then apply this ratio to the earnings of the supermarket chain he is trying to value to come up with its value. A problem arises, however, if the company he is appraising happens to be a Sub-S company. The target company is a Sub-S company, but all of the public companies used to come up with the ratio are C companies. (Virtually all publicly-held corporations are C companies.) The target company pays no corporate income taxes, but the public companies pay taxes of about 40% on their earnings (including state corporate income taxes).
The problem here is that there's a mismatch between the income stream of the public companies and that of the private company he is trying to value. Some way must be found to adjust for this lack of comparability.
One Solution to the Valuation Problem
One approach to the problem is to "tax affect" the earnings of the S corporation being appraised by applying to them a "synthetic" regular corporate tax rate. Thus, for example, an S corporation with pretax income of $10 million a year would be treated as if it were subject to a tax rate of, say, 40% and therefore had after-tax income of $6 million. The P/E ratio derived from the market prices of the public companies would then be applied to the tax affected earnings of $6 million in order to come up with a value for the subject company. One justification for making this adjustment is that if the subject company were to be acquired by a public company, it would become a C company and would thereafter be subject to corporate income taxes and would therefore contribute only $6 million in earnings. By making the tax adjustment to earnings, the appraiser is looking at the company in the same light as would a prospective buyer.
Another method used to value a company is to make a projection of its future earnings and to discount the future earnings to their present value using an appropriate discount rate. As in the previous example, the appraiser would tax affect the projected earnings before discounting them, in effect, valuing the company as if it were a C company.
Tax affecting the earnings of an S corporation and then valuing it as if it were a C corporation was until the late 1990s a widely-used method for valuing S corporations.
The Gross Case Changes the Game
A Tax Court case, Gross et al. v. Commissioner, T.C. Memo. 1999-254 (July 29, 1999), changed the rules on how S corporations were to be valued for estate and gift tax purposes. This case revolved around the fair market value of shares of G & J Pepsi-Cola Bottlers, Inc., a large Ohio-based bottling company. G & J was an S corporation. The taxpayers claimed a gift value of $5,680 per share while the IRS argued a value of $10,910. The lion's share of the difference arose because the taxpayers' valuation expert tax affected the company's earnings by 40% before doing his valuation while the IRS's expert did not.
The taxpayers' expert believed that tax affecting earnings was justified because of certain risks inherent in S corporations, namely, (i) if an S corporation distributes less than all of its income, the actual distributions might be insufficient to cover its shareholders' tax obligations, (ii) an S corporation might lose its favorable tax status, and (iii) an S corporation has a great disadvantage in raising capital due to the restrictions of ownership necessary to qualify for the S corporation election.
The Judge found these reasons to be unconvincing. With respect to the first point, he noted that G & J had followed a practice for many years of paying out virtually all of its earnings to shareholders. With respect to the possible loss of tax status, the Court felt it was unreasonable to tax affect the earnings without establishing the likelihood that the election would be lost. Finally, with respect to the disadvantage in raising capital, the Judge felt that this should be taken into account in determining an appropriate cost of capital to be used in the valuation, rather than by tax affecting the earnings.
Finally, the Court pointed out that although the IRS's expert made no adjustment for shareholder level taxes, such an adjustment was not necessary because he had used a pre-shareholder-tax discount rate in coming up with his value.
The Judge found the value to be $10,910 per share, the very value the IRS had argued for in court. This decision was upheld on appeal Gross et al. v. Commissioner, U.S. Court of Appeals for the Sixth Circuit, Nos. 97-04460; 97-04469, (November 19, 2001).
Tax Affecting Starts to Become Passé
Not long after the Gross appellate opinion was issued in November 2001 came another S corporation case, Estate of Heck v. Commissioner, T.C. Memo. 2002-34 (February 5, 2002). This case involved the valuation of shares of champagne producer F. Korbel & Bros., Inc., a California S corporation. What is interesting here is that neither the taxpayers' expert nor the IRS's expert tax affected the company's earnings. Both appraisers did, however, apply a discount to their final value of on the order of 10% to reflect "risks associated with Korbel's status as an S corporation."
Monkeying with the Discount Rate
In another S corporation valuation case, Estate of Adams v. Commissioner, T.C. Memo. 2002-80, (March 28, 2002), both experts abstained from tax affecting earnings. The taxpayer's expert, however, made an adjustment to the capitalization rate he used to calculate the value of the future cash flow of the company. He converted the capitalization rate from an after-corporate-tax rate to a before-corporate-tax, increasing it from 20.53% to 31.88%. This, of course, had the effect of decreasing the value of the company. The taxpayer's expert justified this adjustment on the grounds that the cash flows he was capitalizing were pre-corporate-tax cash flows (remember, he hadn't tax affected them).
The Judge disagreed. He said that the cash flows were after-corporate-tax cash flows. It just happens that in this case the corporate tax rate is zero. Since the cash flows are after-corporate-tax cash flows, the Judge said that the appraiser must use the lower, after-corporate-tax capitalization rate.
A Recent Case which Splits the Apple
Vice Chancellor Strine, of the Delaware Chancery Court, was faced with the S corporation issue recently in an appraisal/entire fairness action called Delaware Open MRI Radiology Associates, P.A. (Consolidated C.A. No. 275-N, April 26, 2006). Although not a tax case, and embodying a different standard of value, his opinion is worth examining in some detail as it contains a very sophisticated elaboration of the S corporation valuation issues involved.
The case involved a group of eight radiologists that owned a company called Delaware Open MRI Radiology Associates, P.A. (Delaware Radiology). The company performs MRI scans. A radiology practice owned by the eight radiologists, called Fox Chase Medical Center Radiology Associates, P.C. (Fox Chase) performed the diagnostic "reads" of the scans made by Delaware Radiology.
All eight doctors were originally together in one practice. In 1999, however, three of the eight partners left Fox Chase to start a new practice. This created a number of problems, which ultimately led the five remaining Fox Chase doctors, who collectively owned 62.5% of the Delaware Radiology shares, to decide to effect a squeeze-out merger of the three minority shareholders of the company.
The terms of the merger, which took effect on January 20, 2004, provided for a payment to the minority shareholders of $16,229 per share. The minority shareholders, unhappy with this valuation, submitted a demand for an appraisal. Their appraisal expert valued the company at $66,074 per share.
The opposing valuation experts took utterly differing positions on the issue of the proper treatment of Sub-S taxation (or lack of taxation). The appraiser for the majority shareholders treated the company as if it were a normal or C corporation for valuation purposes. He applied a 40% corporate tax rate to the earnings of the company.
The appraiser for the minority shareholders, on the other hand, did not tax affect its earnings at all in performing his valuation.
The Court had problems with both approaches. The Judge described his problem with the majority approach this way; "Delaware Radiology is a very small entity. The record reveals no set of circumstances in which it is likely that Delaware Radiology will convert to C corporation status....The S corporation tax status is a highly valuable attribute to the shareholders of Delaware Radiology...an appraisal petitioner is entitled to be paid for that which has been taken from him... As a matter of fairness, the merger price had to take into account these (S-Corp.) benefits and provide fair compensation for the (minority group's) loss. (The majority group's) approach denied the (minority group) members the value they would have received as continuing S corporation stockholders in Delaware Radiology and, therefore, ensured that the merger price was lower than fair value."
The Court found the minority approach to be "equally flawed," in that it "overstates the value fairly belonging to the (minority group)." He pointed out that if the universe of buyers is principally composed of C corporations, it would be highly misleading to do a market-based comparable acquisition valuation of an S corporation using sales of C corporations to C corporations and then to assume that an S corporation would be sold at a higher price because of its tax status.
He summarized the dilemma as follows; "I am not trying to quantify the value at which Delaware Radiology would sell to a C corporation; I am trying to quantify the value of Delaware Radiology as a going concern with an S corporation structure and award the (minority group) their pro rata share of that value."
After due consideration, the Judge developed an approach that he felt properly captured the value of the company's S status without overstating it, as he felt would be the case if the minority group approach were adopted. For purposes of analysis, he assumed a hypothetical corporation that had $100 of pretax earnings, and paid out all of its after-tax earnings to its shareholders. He then calculated how much of this $100 would remain with the shareholder after all taxes had been paid. He made the calculation twice, once assuming that the company was a C corporation, and once assuming that it was an S corporation. He then compared the amount retained by the shareholder after all taxes. Using a corporate and personal income tax rate of 40%, and a dividend tax rate of 15%, he found that the C corporation shareholder would retain $51 out of the $100, and the S corporation shareholder would retain $60 out of the $100.
He then calculated a hypothetical corporate tax rate which, if applied, would leave a C corporation shareholder with the same after-tax earnings that he would have if the company were an S corporation. That rate is 29.4%, as is shown in the last column of the table below:
C Corp S Corp S Corp Valuation
Income Before Tax $100 $100 $100
Corporate Tax Rate 40% -- 29.4%
Available Earnings $60 $100 $70.60
Dividend or Personal Income Tax Rate 15% 40% 15%
Available After Dividends $51 $60 $60
The Court then applied this tax rate of 29.4% to the pretax earnings of the company for purposes of calculating its value in order "to measure with the greatest practicable precision the fair value of the (minority group's) interest in the going concern value of Delaware Radiology."
Conclusion
We can see that an evolution has taken place in the accepted approaches to valuing S corporations. No doubt the practice will continue to change. Estate and gift tax advisors must be sure that their valuation experts are familiar with the terrain when venturing into this murky area.
Managing Director, Hempstead & Co. Inc.
Synopsis
S corporations have become the corporate vehicle of choice for operating privately-held businesses. Because of their special tax attributes, however, they present certain challenges to appraisers attempting to value them for estate and gift tax or other purposes.
This article discusses the challenges and traces the changes that have taken place in S corporation valuation practices over the past five to ten years. This is done by looking at the key court opinions issued over that period that have dealt with S corporation valuation issues.
The S corporation has emerged in recent years as the most popular corporate vehicle for operating a privately-held business. As a result of this, S corporations are increasingly and in larger number being subject to appraisal for estate and gift purposes. Certain of the corporate valuation methods used in the past by members of the appraisal profession did not match up with the tax singularities of S corporations. Therefore appraisers, taxpayers and the IRS have had to find new ways of valuing these entities.
How are S Corporations Taxed?
A regular or "C" corporation pays a federal income tax of approximately 35% on its earnings. Its shareholders are taxed at their personal income tax rate on any dividends distributed by the company. In effect, income earned and distributed by a C corporation is taxed twice, once at the corporate level and again at the shareholder level.
An S corporation (also called a Sub-S corporation), by contrast, pays no federal income tax on its earnings. Instead, its shareholders pay personal income taxes on their pro-rata share of the company's earnings, at rates ranging up to about 35%. This tax must be paid whether or not the S corporation distributes any of its earnings.
What's the Valuation Problem?
Business appraisers value companies in order to determine their fair market value. They seek to determine how much a hypothetical investor would pay for shares in the company being appraised. A common way appraisers do this is by looking at what investors have paid for shares of other companies that bear similarities to the company being appraised.
One of the most important sources of information on what investors have paid for investments in companies is the stock market. Stock market data is used in a valuation approach called the market comparable or guideline company method. To illustrate it with a simplified example, suppose an appraiser is trying to value a supermarket chain. To use the market comparable method, he'd examine publicly-traded supermarket chains and seek to determine what the ratio of their stock prices is to their earnings (the P/E ratio). He would then apply this ratio to the earnings of the supermarket chain he is trying to value to come up with its value. A problem arises, however, if the company he is appraising happens to be a Sub-S company. The target company is a Sub-S company, but all of the public companies used to come up with the ratio are C companies. (Virtually all publicly-held corporations are C companies.) The target company pays no corporate income taxes, but the public companies pay taxes of about 40% on their earnings (including state corporate income taxes).
The problem here is that there's a mismatch between the income stream of the public companies and that of the private company he is trying to value. Some way must be found to adjust for this lack of comparability.
One Solution to the Valuation Problem
One approach to the problem is to "tax affect" the earnings of the S corporation being appraised by applying to them a "synthetic" regular corporate tax rate. Thus, for example, an S corporation with pretax income of $10 million a year would be treated as if it were subject to a tax rate of, say, 40% and therefore had after-tax income of $6 million. The P/E ratio derived from the market prices of the public companies would then be applied to the tax affected earnings of $6 million in order to come up with a value for the subject company. One justification for making this adjustment is that if the subject company were to be acquired by a public company, it would become a C company and would thereafter be subject to corporate income taxes and would therefore contribute only $6 million in earnings. By making the tax adjustment to earnings, the appraiser is looking at the company in the same light as would a prospective buyer.
Another method used to value a company is to make a projection of its future earnings and to discount the future earnings to their present value using an appropriate discount rate. As in the previous example, the appraiser would tax affect the projected earnings before discounting them, in effect, valuing the company as if it were a C company.
Tax affecting the earnings of an S corporation and then valuing it as if it were a C corporation was until the late 1990s a widely-used method for valuing S corporations.
The Gross Case Changes the Game
A Tax Court case, Gross et al. v. Commissioner, T.C. Memo. 1999-254 (July 29, 1999), changed the rules on how S corporations were to be valued for estate and gift tax purposes. This case revolved around the fair market value of shares of G & J Pepsi-Cola Bottlers, Inc., a large Ohio-based bottling company. G & J was an S corporation. The taxpayers claimed a gift value of $5,680 per share while the IRS argued a value of $10,910. The lion's share of the difference arose because the taxpayers' valuation expert tax affected the company's earnings by 40% before doing his valuation while the IRS's expert did not.
The taxpayers' expert believed that tax affecting earnings was justified because of certain risks inherent in S corporations, namely, (i) if an S corporation distributes less than all of its income, the actual distributions might be insufficient to cover its shareholders' tax obligations, (ii) an S corporation might lose its favorable tax status, and (iii) an S corporation has a great disadvantage in raising capital due to the restrictions of ownership necessary to qualify for the S corporation election.
The Judge found these reasons to be unconvincing. With respect to the first point, he noted that G & J had followed a practice for many years of paying out virtually all of its earnings to shareholders. With respect to the possible loss of tax status, the Court felt it was unreasonable to tax affect the earnings without establishing the likelihood that the election would be lost. Finally, with respect to the disadvantage in raising capital, the Judge felt that this should be taken into account in determining an appropriate cost of capital to be used in the valuation, rather than by tax affecting the earnings.
Finally, the Court pointed out that although the IRS's expert made no adjustment for shareholder level taxes, such an adjustment was not necessary because he had used a pre-shareholder-tax discount rate in coming up with his value.
The Judge found the value to be $10,910 per share, the very value the IRS had argued for in court. This decision was upheld on appeal Gross et al. v. Commissioner, U.S. Court of Appeals for the Sixth Circuit, Nos. 97-04460; 97-04469, (November 19, 2001).
Tax Affecting Starts to Become Passé
Not long after the Gross appellate opinion was issued in November 2001 came another S corporation case, Estate of Heck v. Commissioner, T.C. Memo. 2002-34 (February 5, 2002). This case involved the valuation of shares of champagne producer F. Korbel & Bros., Inc., a California S corporation. What is interesting here is that neither the taxpayers' expert nor the IRS's expert tax affected the company's earnings. Both appraisers did, however, apply a discount to their final value of on the order of 10% to reflect "risks associated with Korbel's status as an S corporation."
Monkeying with the Discount Rate
In another S corporation valuation case, Estate of Adams v. Commissioner, T.C. Memo. 2002-80, (March 28, 2002), both experts abstained from tax affecting earnings. The taxpayer's expert, however, made an adjustment to the capitalization rate he used to calculate the value of the future cash flow of the company. He converted the capitalization rate from an after-corporate-tax rate to a before-corporate-tax, increasing it from 20.53% to 31.88%. This, of course, had the effect of decreasing the value of the company. The taxpayer's expert justified this adjustment on the grounds that the cash flows he was capitalizing were pre-corporate-tax cash flows (remember, he hadn't tax affected them).
The Judge disagreed. He said that the cash flows were after-corporate-tax cash flows. It just happens that in this case the corporate tax rate is zero. Since the cash flows are after-corporate-tax cash flows, the Judge said that the appraiser must use the lower, after-corporate-tax capitalization rate.
A Recent Case which Splits the Apple
Vice Chancellor Strine, of the Delaware Chancery Court, was faced with the S corporation issue recently in an appraisal/entire fairness action called Delaware Open MRI Radiology Associates, P.A. (Consolidated C.A. No. 275-N, April 26, 2006). Although not a tax case, and embodying a different standard of value, his opinion is worth examining in some detail as it contains a very sophisticated elaboration of the S corporation valuation issues involved.
The case involved a group of eight radiologists that owned a company called Delaware Open MRI Radiology Associates, P.A. (Delaware Radiology). The company performs MRI scans. A radiology practice owned by the eight radiologists, called Fox Chase Medical Center Radiology Associates, P.C. (Fox Chase) performed the diagnostic "reads" of the scans made by Delaware Radiology.
All eight doctors were originally together in one practice. In 1999, however, three of the eight partners left Fox Chase to start a new practice. This created a number of problems, which ultimately led the five remaining Fox Chase doctors, who collectively owned 62.5% of the Delaware Radiology shares, to decide to effect a squeeze-out merger of the three minority shareholders of the company.
The terms of the merger, which took effect on January 20, 2004, provided for a payment to the minority shareholders of $16,229 per share. The minority shareholders, unhappy with this valuation, submitted a demand for an appraisal. Their appraisal expert valued the company at $66,074 per share.
The opposing valuation experts took utterly differing positions on the issue of the proper treatment of Sub-S taxation (or lack of taxation). The appraiser for the majority shareholders treated the company as if it were a normal or C corporation for valuation purposes. He applied a 40% corporate tax rate to the earnings of the company.
The appraiser for the minority shareholders, on the other hand, did not tax affect its earnings at all in performing his valuation.
The Court had problems with both approaches. The Judge described his problem with the majority approach this way; "Delaware Radiology is a very small entity. The record reveals no set of circumstances in which it is likely that Delaware Radiology will convert to C corporation status....The S corporation tax status is a highly valuable attribute to the shareholders of Delaware Radiology...an appraisal petitioner is entitled to be paid for that which has been taken from him... As a matter of fairness, the merger price had to take into account these (S-Corp.) benefits and provide fair compensation for the (minority group's) loss. (The majority group's) approach denied the (minority group) members the value they would have received as continuing S corporation stockholders in Delaware Radiology and, therefore, ensured that the merger price was lower than fair value."
The Court found the minority approach to be "equally flawed," in that it "overstates the value fairly belonging to the (minority group)." He pointed out that if the universe of buyers is principally composed of C corporations, it would be highly misleading to do a market-based comparable acquisition valuation of an S corporation using sales of C corporations to C corporations and then to assume that an S corporation would be sold at a higher price because of its tax status.
He summarized the dilemma as follows; "I am not trying to quantify the value at which Delaware Radiology would sell to a C corporation; I am trying to quantify the value of Delaware Radiology as a going concern with an S corporation structure and award the (minority group) their pro rata share of that value."
After due consideration, the Judge developed an approach that he felt properly captured the value of the company's S status without overstating it, as he felt would be the case if the minority group approach were adopted. For purposes of analysis, he assumed a hypothetical corporation that had $100 of pretax earnings, and paid out all of its after-tax earnings to its shareholders. He then calculated how much of this $100 would remain with the shareholder after all taxes had been paid. He made the calculation twice, once assuming that the company was a C corporation, and once assuming that it was an S corporation. He then compared the amount retained by the shareholder after all taxes. Using a corporate and personal income tax rate of 40%, and a dividend tax rate of 15%, he found that the C corporation shareholder would retain $51 out of the $100, and the S corporation shareholder would retain $60 out of the $100.
He then calculated a hypothetical corporate tax rate which, if applied, would leave a C corporation shareholder with the same after-tax earnings that he would have if the company were an S corporation. That rate is 29.4%, as is shown in the last column of the table below:
C Corp S Corp S Corp Valuation
Income Before Tax $100 $100 $100
Corporate Tax Rate 40% -- 29.4%
Available Earnings $60 $100 $70.60
Dividend or Personal Income Tax Rate 15% 40% 15%
Available After Dividends $51 $60 $60
The Court then applied this tax rate of 29.4% to the pretax earnings of the company for purposes of calculating its value in order "to measure with the greatest practicable precision the fair value of the (minority group's) interest in the going concern value of Delaware Radiology."
Conclusion
We can see that an evolution has taken place in the accepted approaches to valuing S corporations. No doubt the practice will continue to change. Estate and gift tax advisors must be sure that their valuation experts are familiar with the terrain when venturing into this murky area.
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