Since the 1999 Tax Court case Gross v. Commissioner (Gross) 1 the Tax Court has consistently rejected the concept of tax affecting the earnings of S corporations. Prior to the Gross decision in 1999, it was common practice among valuation practitioners to tax-affect the benefit stream of S corporations to put the S corporation on a comparable basis with C corporations. Gross v. Commissioner 1999 Gross v. Commissioner is a 1999 Tax Court Memorandum decision (upheld by the Sixth Circuit Court of Appeal in 2002) 2 involving gift tax for a small minority interest of a family owned Pepsi-Cola bottler. The company had a stock transfer agreement in effect which limited the qualified pool of buyers to those who could qualify as an S corporation shareholder. Historically, the company had distributed 100% of earnings as cash distributions to the shareholders. There was no intention of any of the shareholders to sell their shares at the date of the valuation. The valuation expert for the taxpayer tax-effect the S corporation benefit stream using a 40% assumed tax rate while the valuation expert for the IRS did not tax effect the benefit stream. The taxpayer s expert argued that tax-affecting the benefit stream was a common practice and that there was IRS support for this position based citing the IRS Valuation Guide for Income, Estate, and Gift Taxes and the Examination Techniques Handbook. The Tax Court rejected the taxpayer expert s arguments for tax-affecting earnings. The valuation expert for the IRS did not tax-affect the S corporation benefit stream but employed the income approach using a pre-tax benefit stream incorrectly matched to an after-tax 1 Gross v. Commissioner, TCM, 1999-254 (July 29, 1999). 2 Gross v. Commissioner, 2001, U.S. App. Lexis 24803 (6 th Cir., November 19, 2001).
capitalization rate. The court agreed with the IRS and did not tax-affect earnings stating that the taxpayer s expert introduced a fictitious tax burden. The court stated: Mr. Wilhoite has failed to convince us, however, that Dr. Bajaj should have applied a hypothetical corporate tax rate in excess of the zero- percent actual corporate tax rate he did apply. If, in determining the present value of any future payment, the discount rate is assumed to be an after-shareholder-tax rate of return, then the cash-flow should be reduced (tax affected) to an after-shareholder-tax amount. If, on the other hand, a preshareholder-tax discount rate is applied, no adjustment for taxes should be made to the cash-flow. 12 Since, in applying his discounted cash-flow approach, Dr. Bajaj assumed a preshareholder-tax discount rate, he made no error in failing to tax affect the expected cash-flow. If Mr. Wilhoite's criticism is based on his assumption that Dr. Bajaj wrongly disregarded shareholder level taxes, then he is in error. Wall v. Commissioner 2001 Wall v. Commissioner 3 was a gift tax case involving non-voting shares gifted to 20 trusts for their 10 children. The IRS valued the gift at $260.13 per share while the taxpayer valued the gifts at $221.75 per share. Both the valuation expert for the taxpayer and the valuation expert for the IRS tax-affected the earnings of the S corporation. The court noted the following: We also note that both experts' income-based analyses probably understated Demco's value, because they determined Demco's future cash-flows on a hypothetical after tax basis, and then used market rates of return on taxable investments to determine the present value of those cash-flows. The court threw out both experts calculations under the income approach because it believed the valuations were understated from the tax-affecting the cash flows of the company and then applying after-tax market rates of return to determine the present value of the cash flows. The court apparently believed that tax-affecting the earnings and then using discount rates based on C corporation rates of return on investments would place the S corporation on an 3 Wall v. Commissioner, TCM, 2001-75 (March 27, 2001).
equivalent basis with a C corporation but give no value to S corporation status. This court recognized that there is value to the S corporation status in that there is only a single level of tax levied at the owner level. Adams v. Commissioner 2002 The Adams case 4 involved a 61.59% controlling interest held by an estate as compared to the very small minority interest valued in Gross. In addition, the Adams shareholders did not have an agreement which restricted the sale of shares to only qualified S corporation shareholders as in Gross. The valuation analyst for the taxpayer matched a pre-tax discount rate with pre-tax earnings. It is a basic premise of valuation to match the discount rate with the earnings stream. The court disagreed and stated that an after-tax discount rate should have been used under the assumption that the S corporation s entity level tax rate was 0%. The court made no distinction between the minority interest in the Gross case and the fact that the Adams case involved a controlling interest. The court cited Gross and stated: We disagree that Shriner's estimates of WSA's prospective net cashflows are before corporate tax because it is appropriate to use a zero corporate tax rate to estimate net cashflow when the stock being valued is stock of an S corporation. Gross v. Commissioner, supra. WSA is an S corporation, and its cashflows are subject to a zero corporate tax rate. Thus, Shriner's estimates of WSA's prospective net cashflows are after corporate tax (zero corporate tax rate) and not before corporate tax as the estate contends. We disagree that Shriner properly converted the capitalization rate because there was no need to do so. The parties agree that Shriner's estimated capitalization rate (before he converted it to before corporate tax) is an after corporate tax rate. Thus, as in Gross, the tax character of Shriner's estimate of WSA's prospective net cashflows matches that of the unconverted capitalization rate because both are after corporate tax. It follows that Shriner should not have converted the capitalization rate from after corporate tax to before corporate tax because the tax character of both his estimated net cashflows for WSA and unconverted capitalization [*17] rates is after corporate tax. 44 Adams v. Commissioner, TCM, 2002-80 (March 28, 2002).
We conclude that Shriner improperly increased the capitalization rate from 20.53 percent to 31.88 percent. Heck v. Commissioner 2002 Heck 5 is an estate tax case involving a 39.62% minority interest where the taxpayer valued the shares at $16,380,000 and the IRS valued the shares at $30,177,000. The court ultimately valued the shares at $20,269,736 using the discounted cash flows approach and rejecting the market approach as unreliable in the current case. The valuation analyst used by the taxpayer was the same expert used by the IRS in the Gross case. The valuation analyst used by the IRS was the same expert used by the IRS in the Adams case. Neither of valuation analysts tax-affected S corporation earnings. The expert for the IRS used CAPM in developing a discount rate of 14.7% while the expert for the taxpayer used the Ibbotson build-up method to develop a 16.71% discount rate. The court used a 14.22% WACC, used a 10% discount for the additional risks taken on by a minority interest shareholder due to S corporation status, and also took a 15% marketability discount. Delaware Open MRI Radiology 2006 Delaware Open MRI v. Howard B. Kessler, CA. No. 275-N (April 2006). Delaware Open MRI Radiology Associates v. Howard B. Kessler, Court of Chancery of Delaware, New Castle, 898 A.2d 290; 2006 Del.Ch. Lexis 84 In Delaware Open MRI Radiology 6, the court determined that the interest of a dissenting shareholder should be tax-affected. The expert for the controlling interest group tax-affected S corporation earnings as if the entity was a C corporation. The expert for the minority interest group did not tax-affect. The court stated: 5 Heck v. Commissioner, TCM, 2002-34 (February 5, 2002). 6 Delaware Open MRI Radiology Associates v. Howard B. Kessler, Court of Chancery of Delaware, New Castle, 898 A.2d 290; (April 26, 2006).
To ignore personal taxes would overestimate the value of an S corporation and would lead to a value that no rational investor would be willing to pay to acquire control. 99 This is a simple premise -- no one should be willing to pay for more than the value of what will actually end up in her pocket -- that can best be firmly grasped through a concrete example. The court opined that there was no evidence that the company would ever convert to a C corporation, that not tax-affecting overstates value, and that refusing to tax-affect would produce a windfall to the minority shareholders. The court developed a model that values what the minority shareholders would receive as if the entity was a C corporation and compared it to the value received as an S corporation. The court in recognizing that tax is paid at the owner level effectively tax-affected earnings. The court s model then calculates an S corporation cash flow multiple which increases the value of the S corporation because of the dividend tax avoided. This is similar to the Van Vleet model which is discussed in a separate section of this paper. Dallas v. Commissioner Dallas v. Commissioner 7 is a gift tax case involving the sale of 55% of the nonvoting stock of an S corporation to trusts for the benefit of children in exchange for cash and promissory notes and dealt with the value of the stock and the value of each note. The taxpayer used two valuation analysts who both tax-affect earnings. One expert reduced S corporation earnings by 40% on the assumption that after a sale, the corporation will likely lose S corporation status. The second expert reduced S corporation earnings by 35% citing that the shareholder is liable for income tax at the owner level on S corporation earnings whether they are distributed or not. The IRS expert did not tax effect earnings. The court rejected tax-affecting based on the fact that the S corporation had stable and profitable operations, had consistently paid out cash flow to cover shareholder level taxes, that this was a valuation of a minority interest, and that there was no 7 Dallas v. Commissioner, TCM, 2006-212 (September 28, 2006).
evidence that S corporation status would change. The court did not consider that the company only distributed cash sufficient to pay owner level taxes as compared to 100% distributions in the Gross case. Neither did the court consider that there were no restrictive agreements limiting potential buyers to qualified S corporation shareholders as in the Gross case. The court stated: In reviewing the expert valuation reports, the court found that there was insufficient evidence to establish that a hypothetical buyer and seller would "tax-affect" the corporation's earnings and concluded that tax-affecting its earnings was not appropriate. Bernier v. Bernier 2007 Bernier v. Bernier 8 is a divorce case in which the husband s expert tax-affected the S corporation earnings as if the entity was a C corporation. The wife s expert did not tax-affect. The trial court adopted the tax-affecting approach by the husband s expert. The Massachusetts Supreme Court held the trial judge erred in adopting the valuation of the husband s expert witness at the average corporate rate of a C corporation. The Massachusetts Supreme Court believed that the trial court misapplied the Gross case and remanded the Bernier case back to determine a value for the S corporation using the methodology applied in the Delaware Open MRI Radiology case. The court stated: Further, careful financial analysis tells us that applying the C corporation rate of taxation to an S corporation severely undervalues the fair market value of the S corporation by ignoring the tax benefits of the S corporation structure and failing to compensate the seller for the loss of those benefits. On the other hand, in the circumstances of this divorce action, we agree with a recent decision of the Delaware Court of Chancery that failure to tax affect an S corporation artificially will inflate the value of the S corporation by overstating the rate of return that the retaining shareholder could hope to achieve. See Delaware Open MRI Radiology Assocs. v. Kessler, 898 A.2d 290, 327 (Del. Ct. Ch. 2006) (Kessler). Our review of the scant case law and the pertinent literature on the issue leads us to adopt generally the metric employed by the Kessler court, see id. at 328-330, described more fully infra, which most closely achieves the parties' stated intention in 8 Bernier v. Bernier, 449 Mass. 774; 873 N.D.2d 216 (September 14, 2007).
this case to divide the value of their S corporations equally, the outcome the judge also sought to achieve. We conclude that the metric employed by the Kessler court provides a fairer mechanism for accounting for the tax consequences of the transfer of ownership of the supermarkets from one spouse to the other in the circumstances of record. On remand on the issue of valuation, the judge is to employ the tax affecting approach adopted in Kessler. Giustina v. Commissioner 2011 In Giustina v. Commissioner 9 the tax court favored the valuation of the IRS expert in determining the value of a 41.128% limited partnership interest. The company owned multiple tracts of timberland and operated several lumber mills for over 60 years. The IRS valued the ownership interest at $35,115,000 while the taxpayer valued the interest at $12,995,000. The taxpayer s expert tax-affected cash flows by 25% based on assumed income taxes at the owner level. The court believed that the 25% reduction was not appropriate. Citing Gross, the court stated: One problem with Reilly's computations is that he reduced each year's predicted cashflows by 25 percent to account for the income taxes that would be owed by the owner of the partnership interest on that owner's share of the partnership's income. The 25-percent reduction is inappropriate because the rate at which Reilly discounted the cashflows to present value was a pretax rate of return, not a posttax rate of return. An appraiser should not reduce cashflows by income tax while simultaneously using a pretax rate of return to discount the cashflows to present value. Gross v. Commissioner, T.C. Memo. 1999-254, 78 T.C.M. (CCH) 201, 209, affd. 272 F.3d 333 (6th Cir. 2001). Thus, Reilly's cashflow estimates must be recomputed to eliminate the 25-percent discount for income tax liability. The court arrived at a valuation of $27,454,115 and in doing so used a tax rate of 0% in arriving at entity cash flows under the income approach, and weighted the income approach at 75% and the asset approach at 25% in making its determination of value. 9 Giustina v. Commissioner, TCM, 2011-141 (June 22, 2011).