Hot Topics in Business Valuations

With any profession there are topics that are controversial, new and/or debated.  The business valuation profession is no different and below are two of the topics that may be of interest to you.

 

There is much debate on how to account for the differences in taxation between s corporations and c corporations.  C corporations are taxed entities and the after-tax cash flow that is distributed to shareholders is taxed again ("double-taxed") at current dividend tax rates of 15% federal and the respective state tax rate.  S corporations are not taxed entities - the earnings are taxed only at the shareholder's personal income tax level.  Privately held corporations typically prefer to be taxed as s corporations to avoid the double taxation of c corporations.

 

When performing valuations business appraisers often employ a build-up approach in determining the capitalization or discount rate that is applied to a cash flow stream.  If a 20% capitalization rate is determined under the build-up approach this is the equivalent of using a 5X (5-times) after-tax cash flow multiple. 

 

The build-up approach uses data from publicly traded investments in determining the capitalization rate.  The rates of return data from these publicly traded investments is generated by comparing the returns to the after-tax cash flows of each investment.  The entities are c corporations and have already paid income taxes on the earnings.  Therefore, the capitalization or discount rates are effectively after-tax cash flow rates of return.

 

The issue is how to account for the income tax savings s corporation shareholders enjoy that c corporation shareholders do not.  The rates of return used in determining a capitalization or discount rate (the multiple) is an after-tax rate of return applicable to c corporations.  The earnings of an s corporation are pretax.  S corporation shareholders do not pay the dividend tax (Federal 15% and applicable state tax rate) that c corporation shareholders pay.  In addition, s corporation shareholders receive a stock basis increase on income amounts earned but undistributed (left within the corporation) whereas c corporation shareholders do not.  Should an adjustment be made to account for the income tax advantages of an s corporation and if so, how should this adjustment be made?

 

 

Many recent tax and matrimonial court cases have debated and attempted to solve this issue.  While no one-size fits all answer has been found, all cases indicate that one must account for the income tax differential when performing s corporation business valuations.  Ignoring the income tax differences is not acceptable.  Tax affecting the earnings by using a blanket 40% c corporation tax rate alone ignores some of the tax advantages of s corporations and undervalues the s corporation. 

 

How to quantify this tax advantage is an art rather than science.  A relatively simple way to account for s corporation income tax benefits is by:

 

1.      Tax effecting the earnings of the s corporation using c corporation income tax rates;

2.      Taking the c-corporation equivalent after-tax cash flow of the s corporation (step #1 amount) and dividing by 1 minus the personal dividend tax rate to account for the s corporation shareholders are not subject to the dividends tax.  This result is then capitalized in determining the cash flow stream earnings value of the s corporation.

3.      Where applicable, account for the stock basis build-up for s corporation shareholders on the earnings retained by the corporation.  This is done by taking the projected earnings retained each year and multiplying by the capital gains tax rate (tax savings).  Perform this for a projected stock holding period and present each year's tax savings to today using an appropriate discount rate.  This value is added to the earnings stream value in determining the value of the s corporation.

 

The stock basis adjustment value can be the source of great debate.  For instance, if purchasing the s corporation - would an investor pay more because of the s corporation stock basis build-up value when he/she has no idea on his/her investment time-frame? 

 

 

A topic of debate for estate/gift tax valuations is the discount for a built-in-gains tax liability.  This occurs when a corporation has appreciated property or unrealized capital gains that will be subject to income tax at some point in the future.  For example, if a corporation holds marketable securities worth $1M and having a cost basis of $400K, there is a built-in-gain of $600K.  There is approximately $240K of unrealized tax liabilities ($600K X 40%) relating to the marketable securities market value over its cost basis.

 

 

If the value of the corporation is based upon an asset valuation approach - would a willing buyer and a willing seller adjust the purchase/sale price to account for future tax liabilities, and if so, how would this adjustment be determined? 

 

In Estate of Jelke III v. Commissioner, 507 F.3d 1317 (11^th Cir. 2007), the tax court allowed a built-in-gain discount equivalent to the projected annual portfolio turnover % multiplied by the total unrecognized built-in-gain multiplied by the corporate tax rate.  It did so until the total portfolio had turned over (16.8 years) and the total built-in-gain tax realized.  The annual built-in-gains tax amount realized over the 16.8 years were present valued back to today using a 13.2% discount rate to determine the amount of the discount. 

 

The taxpayer appealed the Jelke decision and scored a major taxpayer victory.  The 11^th Circuit, in the decision dated November 15, 2007, overturned the tax court decision and allowed a dollar for dollar built-in-gain tax discount. 

 

The IRS has appealed the decision.  The tax court's opinion prior to taxpayer's appeal appears to make logical sense.  The fact is that the built-in-gains tax liability will likely be recognized over the expected portfolio turnover rate at the tax rates applicable each year.  The tax due each year is not equal to the today's dollar value and should be present valued back to today at an appropriate discount rate.