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August 30, 2012 The Tax Lawyer

Sub S Valuation: To Tax Effect, or Not to Tax Effect, Is Not Really the Question

Vol. 65, No. 3 - Spring 2012

Daniel Tinkelman, P.V. Viswanath, & Glen M. Vogel


    The valuation of Subchapter S corporations is an important tax related issue for small corporations. For the 2008 tax year, Service data indicates that approximately 4 million Subchapter S corporations, with almost 7 million shareholders and total receipts of over $6.1 trillion, filed tax returns. This represents approximately 69% of the nearly 5.85 million tax returns filed by all corporations. Every year, some Subchapter S shareholders die, some get divorced, and some have disputes with other shareholders. After any of these events, valuation of S corporation shares is necessary to determine estate and gift taxes, divorce settlements, and equitable division of corporate ownership interests, as well as for a variety of other purposes.

    The valuation of S corporations by courts is generally accomplished through the use of expert testimony. Because of the restrictions upon S corporations, they are never publicly traded, and therefore, there are no readily available market prices for their shares. As a result, experts in business valuation use a variety of approaches to value private corporations using the facts applicable to the case at hand, certain standard valuation approaches, and their own professional judgment.

    What modifications, if any, need to be made to the methods of valuing public companies, where dividends are subject to tax at individual rates, when valuing S corporations, which are not publicly traded and where the dividends would be exempt from tax? For many years, most valuation experts believed that the S corporation status did not deserve a premium in valuation. To avoid overvaluing S corporation earnings, experts routinely “tax effected” those earnings, meaning they assumed the company was subject to the same taxes as regular corporations.

    That practice of tax effecting was challenged in 1999, in Gross v. Commissioner. In Gross, the Tax Court agreed with the testimony of an expert testifying for the Service regarding the valuation of an estate as of 1992. Here, the expert testified that tax effecting at normal corporate rates was inappropriate. However, the result of not tax effecting the S corporation’s earnings at the prevailing tax rates meant they would be valued at 67% higher than they would be valued with tax-affecting. Since this decision, the proper way to value S corporation earnings has been unsettled. As discussed below, in some cases courts have endorsed no premium—or extra value beyond that of a similar C corporation—for S corporations, in some cases a premium around 18%, and in others, such as the Gross decision, a premium as high as 67%. The appraisal profession considers this a controversial area, with some experts believing no S corporation premium is appropriate, and others endorsing the use of one of a number of different models to measure an S corporation premium. The disagreement over tax effecting continues, as evidenced by two 2011 decisions—one from the U.S. Tax Court wherein tax effecting was rejected, and one from the Supreme Judicial Court of Massachusetts wherein a different approach to the impact of S corporation status was taken.

    In Part II we discuss the valuation process in general, and argue that the proper way to address the differential tax status of Subchapter S corporations must include the consideration of currently enacted tax laws. The appropriate valuation method can be complex and has changed over time with changes in federal tax laws. In Part III, we review the courts’ treatment of the issue. Since 1958, there have been three different periods that we believe have called for different valuation treatments. While tax effecting Subchapter S earnings at the corporate rate was a reasonable valuation approach until the early 1980s, it was no longer appropriate at the time of Gross because of changes in the tax laws that are discussed in Part III.B. Similarly, while the decision of the Tax Court in Gross to simply not apply any corporate taxes in valuing the Gross estate produced a reasonable result at the time, subsequent changes in tax laws related to the rate of taxation of dividends from C corporations means that simply not tax effecting is now inappropriate. Finally, Part IV presents our recommendations and our basic conclusion that valuation experts, attorneys, and courts should not rely blindly upon precedents set in different jurisdictions, or during times when tax laws were different.

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