Current Developments in Valuation of S Corporation Ownership

Transcription

1 Current Developments in Valuation of S Corporation Ownership Robert J. Grossman Melissa Bizyak

2 Two Key Developments Taxes and Value, Nancy J. Fannon and Keith F. Sellers, BVR IRS Job Aid, Valuation of Non-Controlling Interests in Business Entities Electing to be Treated as S Corporations for Federal Tax Purposes October 29, 2014

3 Three Possible Means to Measure the S Corporation Value Component 1. Modification of Cash Flow Stream (Numerator) 2. Modification of Cost Capital (Denominator) 3. Use of an S Corporation Premium

4 Most Common Methodologies 1. Modification of Cash Flow Stream (Numerator) 3. Use of an S Corporation Premium

5 Popular Models- Historical Roger J. Grabowski Model Chris D. Treharne Model Daniel R. Van Vleet Model Z. Christopher Mercer Model

6 Popular Models Quantifying benefit(s) of S Corporation status Nancy J. Fannon introduces an additional model The Simplified Model for S Corporation Valuation Note: Ms. Fannon has withdrawn this model and moved to consideration of the S Corporation benefit in the determination of the cost of capital.

7 Quantifying benefit(s) of S corporation status Three main benefits to owning an S Corporation: One level of tax at shareholder level Increase in basis to the extent taxable income exceeds distributions Realize more proceeds upon a sale if buyer receives increased tax savings by an asset sale and a step-up in basis

8 S Corps vs. C Corps: Understanding Valuation Differences Simplified Model for S Corporation Valuations Created by Nancy J. Fannon Draws on the four existing models

9 S Corps vs. C Corps: Understanding Valuation Differences Simplified Model for S Corporation Valuations Components Traditional discounted cash flow method Recognition of benefit of avoidance of dividends tax Recognition of capital gains tax benefit due to ability to build basis

10 S Corps vs. C Corps: Understanding Valuation Differences Simplified Model for S Corporation Valuations Components Traditional discounted cash flow method Recognition of benefit of avoidance of dividends tax Recognition of capital gains tax benefit due to ability to build basis

11 S Corps vs. C Corps: Understanding Valuation Differences Simplified Model for S Corporation Valuations Assumptions: Distributions as a percent of income 75% Holding period 5 yrs Likelihood of buyer qualifying as a pass-through buyer 100% Addition to ROR for ability to build-up basis 0%

12 S Corps vs. C Corps: Understanding Valuation Differences Simplified Model for S Corporation Valuations

13 S Corps vs. C Corps: Understanding Valuation Differences Simplified Model for S Corporation Valuations

14 S Corps vs. C Corps: Understanding Valuation Differences Simplified Model for S Corporation Valuations

15 S Corps vs. C Corps: Understanding Valuation Differences Simplified Model for S Corporation Valuations

16 S Corps vs. C Corps: Understanding Valuation Differences EMERGING THOUGHTS Nancy Fannon has recently withdrawn her simplified model December 2011 she co-authored an article with Keith Sellers Valuation of Pass-Through Entities: Looking at the Bigger Picture Looks at the ways in which valuators try to quantify the value difference between an otherwise identical C and S Corporation

17 Taxes and Value Further research and analysis set out in Taxes and Value Nancy J. Fannon and Keith F. Sellers Published Spring 2015 BVR Referenced hereafter as TAV

18 Taxes and Value TAV- Primary Overriding Theory The impact of taxes on asset values and return on assets is implicit in cost of capital (required investment returns)

19 Taxes and Value NACVA TAV- p. 15 To fully understand, valuators must differentiate: Explicit taxes- taxes paid to a taxing authority Implicit taxes- difference in pre-shareholder tax return that a fully taxable investment and an identical, tax favored investment generate

20 Taxes and Value Example: Taxable Corporate Bond vs. Tax Exempt Bond Identical risk should convey identical rates of return However, this Analysis Measures only Pre-Tax Return After-Tax Returns must be considered

21 Shareholder Taxes and Cost of Capital TAV- p. 24 When shareholder-level taxes are imposed, shareholder pre-tax returns must increase in order for shareholder total after-tax returns to remain constant!

22 Confirming Studies Sample: Merton F. Miller, Debt and Taxes, Fraud of Finance, May, 1977, Volume 32, Vol. 2, pages Conclusion: Investors base their returns on the after-personal-tax returns of various investments.

23 Confirming Studies Sample Edward L. Mayden, Empirical Tax Research in Accounting: A Discussion, Journal of Accounting and Economics, September 2001, Vol. 31, Nos. 1-3.

24 Mayden Study Conclusion The effect of taxes on prices [of public shares] when current prices are lower than they otherwise would be because of future explicit taxes on those assets- is generally defined as tax capitalization.

25 Confirming Studies Sample James Poterba and Lawrence Summers, The Economic Effects of Dividend Taxation, NBER Working Paper No. 1353, June, 1985 George Zudrow, On the Traditional and New Views of Dividend Taxation, National Tax Journal, 1991, p. 64

26 Confirming Studies Conclusion Present value of shareholder- dividend tax is capitalized in price Note: Tax clients affect that conclusion

27 Confirming Studies Sample Jia-Wen Liang, Steven P. Matsuanga, and Daniel C. Morse, University of Oregon, The Effect of the Expected Holding Period on the Market Reaction to a Decline in the Capital Gains Tax Rate, Journal of American Taxation Association, Winter 2002

28 Confirming Studies Conclusion Stock prices reflect investor- level capital gains taxes

29 TAV p. 41 Private Company Impact Two Choices Remove effect of shareholder-level tax on observed market returns Use unadjusted market returns and adjust income stream Both are difficult!

30 Private Company Impact TAV p. 43 Company- specific and shareholder- specific attributes play a significant part in determining the magnitude of the impact of shareholder- level taxes on the cost of equity of public companies

31 Private Company Impact TAV p Actual and anticipated shareholder- level taxes are capitalized in market price and, by extension, in observed market returns; 2. Market participants (individuals, institutions, etc.) and their tax situations affect the magnitude of firms tax capitalization; 3. The composition of market participants and tax clienteles has changed over time;

32 Private Company Impact TAV p Firms respond to changing tax policies by attempting to minimize shareholder taxes; 5. Investors also respond to tax policies by maximizing after-shareholder-level returns; and 6. Changes in any of these factors can change the marginal investor for a given security.

33 Fannon/Sellers Proposed Approach Cash Flow is After corporate-level taxes NAV p. 59 Analyst must then remove effect of shareholderlevel tax embedded in observed market returns

34 Fannon/Sellers Proposed Approach Magnitude of adjustment Time horizon critical NAV p. 60

35 Fannon/Sellers Proposed Approach NAV p. 61 The tax penalty (required adjustment to observed market returns) can be estimated by calculating the shareholder taxes borne by publicmarket investors over the return horizon.

36 Fannon/Sellers Proposed Approach Arithmetic Average Required 1. Effective federal, state, and capital gains tax 2. Average holding period 3. Percentage of market held by tax advantaged institutional investors *from 1926, or 1963 to date NAV p. 61

37 Fannon/Sellers Proposed Approach Steps required 1. Calculation on dividend tax on income returns 2. Calculation of capital gains tax (with deferred period) 3. Calculating impact of tax-favored institutional investment (by reducing the calculated taxes by the magnitude of these investments)

38 Taxes and Value A must read for all Business Valuators! This book is comprehensive, well thought-out and exceedingly well researched.