Bar News - April 6, 2007
Business Law: S Corporations and Value: Big Dollars at Risk
By: Nancy J. Fannon
Nearly 62 percent of all corporations that filed income taxes in 2003 were S corporations. Many of those corporations have transitioned ownership in the last several years, oftentimes handing the stock down from parent to child in the natural order of the family businesses. Undoubtedly, few of them knew that they made such a gift at their peril, in the midst of what has become the most hotly debated issue in the history of valuation—how to value stock in a Subchapter S corporation.
And, this is not just a tax issue anymore. The proper way to value an S corporation has been raised in divorce courts across the country where treatment among analysts varies to the extreme, and was discussed at length in a recent case in the Delaware Chancery Court decision, DE Open MRI Radiology Associates v. Howard B. Kessler, et al. [CA-275-N].
To understand the basic issue is simple: when determining the value of a corporation, it was established practice to deduct income taxes from the corporate earnings stream. Value would then be calculated either as a multiple of that earnings stream or by capitalizing it. However, we now have five decisions in which the tax court has declined to deduct income taxes from corporate earnings when calculating the value of the S corporation for gift and estate tax purposes. The implications are obvious: if you don’t deduct corporate income taxes of, say, 40 percent from the income stream to which you apply a multiple (or capitalize), you get a much higher value than if you do deduct corporate income taxes.
Think that’s not such a big deal? Think again. Let’s take a look at the implications for an S corporation that has an estate/divorce/corporate need for valuation, assuming a few facts. Let’s say the S corporation has cash flow of $1,000,000. One analyst says the right way to value the S corporation is to deduct taxes, the other says you don’t, because S corporations don’t pay income tax. At a 20 percent cost of capital, here’s the numbers:
Deduct Tax Don’t Deduct Tax
Company cash flow
Net after tax cash flow
20 percent 20 percent
Value determined by analyst
This is a 66 percent value differential. And by the way…while most analysts either do or don’t deduct taxes when valuing an S corporation, neither extreme is right, if that’s all the analyst does in their analysis of the tax issue.
Unfortunately, this basic view of the issue is deceptively simple, and misses the true economic benefit of investing in an S corporation. It is this deceptively simple concept which first reared its head in the case of Gross v. Commissioner, and has hampered small businesses attempting to transfer ownership ever since.
S corporations, first recognized as a corporate form in 1958, were intended to bring tax relief to small business. It is doubtful if valuation was thought of at the time the original bill was written, as it wasn’t the motivation behind crafting the legislation that led to their creation. Among financial analysts, the notion that the valuation of these entities would be any different than any other corporate form was barely an afterthought, receiving only scant attention in professional journals. Any attention it did receive was largely ignored by analysts. That changed after Gross. Since then, the valuation of S corporations has been the subject of significant debate, the result of which was the creation of substantive financial and economic models for the valuation of these entities. The foundation for these models are not new: the notion that income taxes affect rates of return and value dates back to work done by the most noted and distinguished financial experts of their time in the 1960s, and it was upon their early work that the models that we use today were built.
It is not surprising that the courts have been slow to adopt appropriate techniques for valuing this complex form of entity, as they have heard precious little evidence to convince them. Many analysts themselves have been slow to accept the valuation models for S corporations, being frustrated with complicated modeling and a deluge of conflicting financial guidance since the Gross case was decided. However, today, nearly all financial analysts who have seriously studied the issue now agree that the value of an S corporation or interest in it is often greater than a comparable publicly traded C corporation. This differential is typically between 5 to 20 percent, and not anywhere near the 65 percent premium that has been placed on them by the IRS and in tax court decisions. This is a very material difference between the real value to the investor and the “phantom” value found in IRS and court decisions, and can result in millions of dollars of overvaluation. To argue this position effectively, however, the analyst must thoroughly understand why this is so.
The balance of this article, while not a technical writing on this complex topic, is an overview of the issues involved in the debate, provided as part of an effort to bring clarity to the valuation of S corporations, in the hope that judges, practitioners, attorneys, and the courts can begin to understand the fundamental issues that drive the value of this form of entity.
Value and Taxes
Anyone who has done any amount of investing understands this fairly simple concept: if you have to pay taxes on the income you receive from an investment, you end up with less in your pocket than if you didn’t have to pay taxes. Therefore, all things being equal, if one investment had taxes levied on it, and the other didn’t, an investor would choose the one that didn’t. This issue has formed the heart of the S corporation debate: an investment in an S corporation must be worth more than an investment in a publicly traded C corporation, simply because there is a level of taxes being avoided.
What tax isn’t being paid?
In order to understand what tax is being avoided, a brief review of the legislative history of Subchapter S is in order.
From 1945 to 1950, the highest marginal tax rate for corporations ranged from 42 percent to 53 percent, while the highest rate at which individuals were taxed ranged from 82 percent to 91 percent. The double taxation system put a particular strain on small businesses. A corporation making $1,000,000 profit could end up paying $420,000 corporate income taxes, and another nearly $400,000 to $500,000 in individual taxes if all were distributed, leaving precious little for the investor’s efforts. That said, then, as now, the distinction between the small corporation and the investor was something of a misnomer, as the investor controlled income, dividend, and compensation policy. The investor had the choice to simply not distribute profits, or to pay compensation (within limits) to dampen the affect of the dividend tax. However, entities that desired the corporate protection of limited liability were still at a disadvantage compared to the partnership form of entity, which had no such second level of tax.
Recognizing this, in 1954, President Eisenhower proposed that new, closely-held corporations with a small number of active shareholders have the option of being taxed in the same manner as partnerships, in order to avoid the second level of tax on dividends. While the Senate adopted this proposal, it did not pass the Conference Committee.
In 1958, President Eisenhower made his proposal to Congress again. These recommendations, along with Treasury-drafted provisions, developed into Subchapter S which Congress ultimately adopted in the Technical Amendments Act of 1958 under the Small Business Tax Revision Act. All corporate earnings would be treated as if they were distributed, and taxed once. In explaining the rationale, the committee wrote that they “…believe…that the enactment of a provision of this type is desirable because it permits businesses to select the form of business organization desired, without the necessity of taking into account major differences in tax consequence… Where the earnings are distributed (and are in excess of what may properly be classified as salary payments), the benefit will extend to individuals with somewhat higher rates since in this case a ‘double’ tax is removed.”
Neither Eisenhower in his proposal, nor Congress in their adoption, had any intention of removing taxes on corporate income. Rather, their intent was to tax small corporations in the same manner as partnerships, and do away with the dividend tax that hampered the corporate form.
The current direction of the IRS and the tax court on this issue is inconsistent with the very intention of subchapter S. The tax court has, in five decisions, eliminated any deduction for corporate income taxes. This implies that Congress intended to avoid taxes on corporate income, and avoid the dividend tax. Clearly, if this were the reality for owners of S corporations, it would both delight those owners, and break our federal (and state) budgets. While this many be wishful thinking, it is flawed, as any investor in an S corporation knows.
Why doesn’t the model work?
Several tax court cases have taken the position that it is both the income tax and the dividend tax that the S corporation shareholder is avoiding.
From the perspective of the investor, the income tax is real and must be paid before value can be achieved, and it is only from the investor’s standpoint that the investment must be viewed. To ignore the reality of corporate income taxes is to create phantom income for the S corporation shareholder, and to place a false burden on them.
It is also important to keep in mind that value in an S corporation is relative to a publicly traded C corporation. Holders of publicly traded stock must pay personal dividend and capital gains taxes on their investments, while these taxes are avoided by investors in S corporations. This is important because we use the rates of return of these publicly traded C corporation investors when we value an S corporation; in using this information, we must distinguish that which is different from that which we borrowed (i.e., the rate of return.). The avoidance of the dividend tax is different. An S corporation owner will end up with more cash in their pocket as a result of the avoided dividend tax. This is the basis of the benefit that the economic models for the valuation of the S corporations measure.
The valuation of S corporations has a solid foundation in financial and economic theory. We have at least one opinion that demonstrated these economics, the Delaware Court of Chancery in the case of Delaware Open MRI Radiology Associates. However, due to complex financial modeling and years of debate, these fundamentals have yet to be widely embraced by financial analysts, and have been largely ignored by the courts as a result. It is my hope that with a simplified view of the issue, more analysts, attorneys, and judges can begin to understand this issue which affects over 3.5 million US companies and their investors.
Nancy J. Fannon, ASA, MCBA, CPA×ABV, owner of Fannon Valuation Group in Portland, Maine can be reached at firstname.lastname@example.org. This article was published in the Maine Lawyers Review, February 2007; Portions of this article have been published, or are being published, in CPA Expert, Valuation Examiner, and Business Valuation Review. ©Fannon Valuation Group All Rights Reserved