Tax Effecting Nontaxable Entities’ Earnings Post-Gross

Tax Effecting Nontaxable Entities’ Earnings Post-Gross

In the aftermath of the IRS’ victory in Walter L. Gross v. Commissioner; T.C. Memo. 1999-254, valuators must confront once again the issue of whether or not a nontaxable entity’s earnings must be tax-effected in order to arrive at a correct valuation conclusion. In Gross, the Judge ruled that an S corporation’s earnings should not be reduced by C corporate taxes when valuing the entity using data derived from the capital asset pricing model which is based upon publicly-traded C corporations. In addition, he rejected the taxpayer’s Daubert challenge of the IRS expert’s failure to tax effect.

Nontaxable pass-through entities such as partnerships, LLCs, S corporations and sole proprietorship generally do not pay federal income taxes on their entity level earnings, rather the taxes are paid by the individual owners on their own tax returns. As such, unlike a C corporation, there is no double taxation when previously taxed entity level earnings are distributed as dividends to the individual owners. In addition, and more importantly, these pass-through entities provide an increase in basis to their owners for all earnings retained in the business, in turn reducing the tax when the business is later sold.

Compare a hypothetical C and S Corporation, each engaged in an identical business activity that requires all profits to be retained to fund growth, and therefore paying no dividends. With respect to the current after-tax cash retained by each, assuming that the S distributed the tax cost to its shareholders, there will be no difference if marginal tax rates are identical (ignore state taxes for simplicity, although they may have a significant impact on the computation and your conclusion). In fact, the S corporation may have less after-tax cash since the highest individual marginal rate of 39.6% exceeds the highest corporate rate of 34% (35% for large entities with taxable income over $10 million). (After various "phaseouts" the S rate may be even greater than the statutory 39.6%). In the absence of dividends, there is no double taxation of C Corporation earnings prior to a sale or other disposition. We assume that a valuation would be based upon the actual tax rate in effect for each of the entities, rather than assuming both are taxed at the same rate, since they are not, in fact, taxed at the same rate.

Exhibit 1

	S Corporation			C Corporation
Year	Annual Earnings	Value	Book Retained Earnings	Annual Earnings	Value	Book Retained Earnings
1	915	9,152	915	1,000	10,000	1,000
2	961	9,609	1,876	1,050	10,500	2,050
3	1,009	10,090	2,885	1,103	11,025	3,153
4	1,059	10,594	3,944	1,158	11,576	4,310
5	1,112	11,124	5,057	1,216	12,155	5,526
6	1,168	11,680	6,225	1,276	12,763	6,802

To get a sense of the long-term difference between the two, assume that the entities operate for 6 years with no dividends, with a cost of capital of 15%, annual earnings growth of 5%, and a resultant capitalization rate of 10%. Initial investment is zero, consisting entirely of sweat equity. Annual earnings pre-tax are initially $1,515, such that after-tax earnings for the C are an even $1,000, assuming a 34% tax rate. S tax rate is 39.6% and after-tax earnings are initially $915.

At the end of year 6, the retained earnings in the C corp will have grown to 6,802 while those of the S corp will be 6,225. The S corp shareholders will have the advantage at this point of having a basis in their stock equal to the retained earnings, while the C Corporation shareholders will have no addition to basis from their earnings. Herein in lies the first key element of the analysis.

Example 1

Assume the value of the two entities is equal to their book retained earnings. At this point, the C shareholders will have a taxable long-term capital gain of 6,802 on the sale of their stock (assuming no initial basis), resulting in taxes of 1,360 and after-tax proceeds of 5,442. The S shareholders have after-tax proceeds equal to gross proceeds of 6,225. This implies a premium for the S stock of 14.4% (6225/5442). This is not a liquidation analysis, but rather a tax analysis associated with the result if a hypothetical seller sold his or her stock. Although a variety of factors can influence the calculation, most S corp shareholders will have a basis equal to their prorata share of S retained earnings (accumulated adjustments accounts) if they have been shareholders since inception.

Example 2

Assume now that the value of the entities in year 6 is equal to the capitalization of their current year’s after-tax earnings at 10%. As shown in the table above, the value of the S is 11,680 while the value of the C is 12,763. If the stock is sold, the S shareholders have a gain of 5,455, and after tax proceeds of 10,589. The C shareholders have a gain of 12,763 and after-tax proceeds of 10,210. This implies a premium for the S stock of 3.71% (10,589/10,210).

The table which follows shows the premium for S status in a hypothetical stock sale for each year using the same analysis for a sale at book value and at fair market value assuming a 10% cap rate applied to after-tax earnings. Note as well that we have assumed the highest personal tax rate is applicable to S earnings, such that after-tax earnings are always less than C after-tax earnings.

Exhibit 2

Year	Premium-Book	Premium-FMV
1	114.39%	93.80%
2	114.39%	95.98%
3	114.39%	98.06%
4	114.39%	100.03%
5	114.39%	101.92%
6	114.39%	103.71%
7	114.39%	105.42%
8	114.39%	107.04%
9	114.39%	108.59%
10	114.39%	110.06%
11	114.39%	111.47%

In fact, the value premium of the S election in terms of after-tax proceeds versus a C status is a constant 14.39% for all stock sales at book value, regardless of cap rate, but continues to increase over time for a given cap rate for all sales based upon a capitalization of after-tax earnings.

As you might infer, the lower the cap rate, the higher the value of the earnings and therefore the greater the spread between adjusted basis of stock and value. This makes the value of the S election less significant in a sale of stock since the gain will be high relative to the basis. The reverse is also true, however, in that higher cap rates result in lower valuations, and result in a lower spread between value and basis. The S election is, not surprisingly, of greater import for small business in reducing the tax upon a disposition of stock if that business has a comparatively low fair market to book value ratio.

Now, assume that the stock cannot be sold but an asset sale must take place. This is the norm in most small business transactions and where the S election has it greatest impact on after-tax value – which is what the hypothetical seller should (and does) base sale decisions on.

For the S corporation there is no difference in the tax result, all things being equal, between a stock sale and an asset sale (depreciation recapture ignored for this purpose). For the C corporation, however, there is a significant diminution in value as a result of the double taxation, if the assets are sold for an amount in excess of book value. (For a book value sale, there would be no gain at the C corporate level, and the proceeds would be taxed at capital gains to the shareholders when distributed in redemption of the stock).

This highlights another key factor: If the business is in an industry and of a size where an asset sale is expected, an S corporation has a significant premium vs. a C. The following chart assumes that the assets are sold by the C corporation, the tax paid at the highest rate, and the after-tax proceeds are distributed to shareholders in redemption of their stock. The S corp. premium assumes that there would be no corporate level tax in an asset sale and that the proceeds would be taxed once to the S shareholders at the capital gain rate of 20%, after recovery of their basis as shown in Exhibit 1.

Exhibit 3

Asset Value	Corporate tax	Redemption	Shareholder tax	Net After-tax	S Corp Premium
10,000	3,400	6,600	1,320	5,280	142.13%
10,500	3,570	6,930	1,386	5,544	145.43%
11,025	3,749	7,277	1,455	5,821	148.57%
11,576	3,936	7,640	1,528	6,112	151.57%
12,155	4,133	8,022	1,604	6,418	154.42%
12,763	4,339	8,423	1,685	6,739	157.13%

Clearly, the premium for S status will be much less if the small C corporation can take advantage of the graduated corporate rates, although these do little to shield gains in excess of $100,000.

The "Retention/Redemption" Strategy

Given the importance of tax factors in valuation, the valuator must be familiar with the types of tax planning that minimizes the impact of the difference between C and S corporations. For example, a strategy that makes sense for the small C corporation is to retain annual income of $50,000 at the lowest marginal bracket of 15%, and use the after-tax amount to later redeem the stock of the shareholders at a 20% capital gain rate. (An extension of this strategy would be to have the corporation partially redeem the seller’s stock, have the new buyer purchase a small amount of it outright, and have the remaining shares purchased by the corporation on the installment method: a leveraged buyout. A variation would be to have the corporation borrow money from a financial institution to redeem the shares for which retained cash earnings are not available.) In this scenario, the effective tax rate incurred per dollar of pre-tax proceeds used for redemption is 32% (80% of 15% plus 20%) in the C corporation, compared to the 20% for a straight S corporation. The Exhibits below compare the result using this strategy in the same format as was used in Exhibits 1 and 2, with Exhibit 5 being for a stock sale.

Exhibit 4

	S Corporation			C Corporation
Year	Annual Earnings	Value	Book Retained Earnings	Annual Earnings	Value	Book Retained Earnings
1	915	9,152	915	1,288	12,879	1,288
2	961	9,609	1,876	1,352	13,523	2,640
3	1,009	10,090	2,885	1,420	14,199	4,060
4	1,059	10,594	3,944	1,491	14,909	5,551
5	1,112	11,124	5,057	1,565	15,654	7,116
6	1,168	11,680	6,225	1,644	16,437	8,760

Exhibit 5

Year	Premium-Book	Premium-FMV
1	88.82%	72.84%
2	88.82%	74.53%
3	88.82%	76.14%
4	88.82%	77.67%
5	88.82%	79.13%
6	88.82%	80.53%
7	88.82%	81.85%
8	88.82%	83.11%
9	88.82%	84.32%
10	88.82%	85.46%
11	88.82%	86.55%

The S is now valued at a discount from the C corporation since the S is presumed to pay taxes at the highest personal tax rate of 39.6% and the C corporation at the lowest marginal corporate rate of 15%. (Note that personal service corporations pay tax at a flat 35% and that this example does not apply to these entities.) This is, of course, one of the principal reasons that high-income taxpayers investing in small business may choose C status over S.

This highlights one of the difficulties in justifying the election of S status for an existing C corporation. Any taxable income recognized during the 10 years following the election will be taxed to the new S at the highest C Corporation rate of 35%, not at the graduated rates. If the ownership does not contemplate retiring for 10 or more years, or if there is no intangible value, than it may well make sense to pursue this S election strategy and minimize taxable income. If retirement is contemplated before 10 years, the "retention/redemption" strategy is more tax effective, assuming no IRS challenge to an accumulated earnings tax. Exhibit 6 compares the result of the retention/redemption strategy in an asset sale to that of an S corporation.

Exhibit 6

Asset Value	Corporate tax	Redemption	Shareholder tax	Net After-tax	S Corp Premium
12,879	4,379	8,500	1,700	6,800	110.36%
13,523	4,598	8,925	1,785	7,140	112.92%
14,199	4,828	9,371	1,874	7,497	115.36%
14,909	5,069	9,840	1,968	7,872	117.69%
15,654	5,322	10,332	2,066	8,265	119.90%
16,437	5,589	10,848	2,170	8,679	122.01%

The S election will always have a premium in the event an asset sale is the form of transfer for the business, although this premium is much less when the C corporation is eligible to use the graduated corporate rates. In addition, existing C corporations may be better off if a sale is contemplated before the 10 year built-in gain periods elapses for a newly filed S election.

What if the valuation subject is a C Corporation that has just elected S? The discount can be computed by applying the 35% tax rate to the forecasted corporate income until the valuation date built-in gain is fully realized. Discounting this tax back to the present using the rate in the forecast gives the amount of the discount. Exhibits 7 and 8 use data derived from Exhibit 1 to illustrate the computation for a sale in the first year, and in the fifth year.

Exhibit 7

YEAR 1		35.00%		39.60%
Total Built-in Gain	Realized	Built-in Gain Tax	Shareholder Gain	Tax	After-tax
8,236	1,515	530	985	390	595
6,721	1,591	557	1,034	410	625
5,130	1,670	585	1,086	430	656
3,460	1,754	614	1,140	451	689
1,706	1,706	597	1,109	439	670
Present value		1,914
Discount as % of FMV of 9,152		20.92%

Exhibit 8

YEAR 5		35.00%		39.60%
Total Built-in Gain	Realized	Built-in Gain Tax	Shareholder Gain	Tax	After-tax
6,067	1,112	389	723	286	437
4,955	1,168	409	759	301	459
3,787	1,226	429	797	316	481
2,560	1,288	451	837	331	506
1,272	1,272	445	827	328	500
Present value		1,409
Discount as % of FMV of 9,152		12.67%

Implications for valuation

One approach the valuator could use would be to value an S corporation using the accepted method of tax effecting the earnings, then perform an analysis of the hypothetical after-tax proceeds in the event of an asset sale and/or a stock sale for an identical C corporation. The S proceeds will generally be the same regardless of whether an asset or stock sale tales place. For the C Corporation, the impact of an assumption of an asset sale may be more dramatic, particularly when the principal assets are zero basis intangible assets developed internally. The difference in the after-tax proceeds would represent the basis for a valuation premium for the S Corporation.

In the Davis case and its progeny, the basis of the Court’s decision allowing a marketability discount for built-in gains was at least in part based upon the expectation that the hypothetical willing buyer would demand some discount for the possibility of double taxation upon the sale of nonoperating assets by the C corporation. The reverse side of the coin is that the hypothetical buyer would not expect a similar discount if the same assets were held by a S corporation. If we had two identical entities, with the only difference being S status, it would appear that both would be valued on the basis of after-tax earnings under Davis, and then the C corporation would receive a discount for built-in gains, at least as far as nonoperating assets are concerned. Should zero basis intangibles be treated any differently? To the extent they are less likely to be sold under a going concern premise of value, perhaps so, but some form of discount would appear to be warranted.

Does an analysis of Davis imply that all C Corporations had previously been over-valued on the basis of their pre-tax earnings, while S corporations had been undervalued? Does Gross miss the boat where Davis is concerned by overvaluing the S rather than undervaluing a C? The Court in Gross should have performed a sale analysis much like the Court in Jameson did in order to determine what discount or premium applied to the S corporation, similar to that in the various Exhibits in this article. Large S corporations do pay tax and typically at a rate higher than a comparable C corporation, and their earnings should be tax-effected accordingly for the valuation. Since the valuation is an "as of a specific date" determination, the Court should have compared the tax incurred by the seller owning S stock with that incurred if the seller’s had owned C stock. For example, the Court could have tax-effected the earnings, and then applied a premium based upon the ability to recover the additional basis of stock via the S election, using the 20% capital gains rate multiplied by the difference between the S basis and the basis if the corporation had always been a C.

Note: In Jameson (Estate of Jameson v. Comm (TCM 1999-43), a case decided after Davis, the Tax Court again allowed a discount for built-in capital gains tax. In this instance, the Court rejected not only the IRS’ position that no such discount should be allowed, but also the taxpayer’s computation of the discount. The corporation whose stock was the subject of the discount owned highly appreciated timber and had made an election under section 631(a) which required it to recognize (capital) gain upon the cutting of the timber, irrespective of when it was actually sold. The Court estimated the amount of timber that would be cut each year, based upon the testimony of the experts, and discounted the resultant capital gains tax back to the valuation date in order to arrive at the correct built-in capital gains discount.

The principal difference from the seller’s standpoint would have been the owner’s basis in the stock and the premium for the S status would have been the capital gains rate times the basis. The hypothetical buyer is not going to pay nearly twice as much for an S stock as a C stock, nor will the hypothetical seller expect it, as the Court seems to suggest. Rather, the buyer and seller will assess the difference in after-tax proceeds upon a sale, all other things being equal, since the seller will currently realize that benefit and the buyer will then have the same benefit available when he or she sells in the future. Horse trading tax consequences is a routine part of the arms length negotiation of a real transaction that valuation is supposed to simulate, as any experienced M&A advisor knows. Representations as to corporate tax status are a routine part of a purchase and sales agreement, particularly where an asset transaction is contemplated. In fact, asset acquisitions (as we have noted) are preferred for smaller privately held businesses since the buyer has none of the exposure associated with acquiring stock.

A prospective S Corporation buyer may also be desirous of an asset sale in order to obtain a basis step-up for depreciation and amortization purposes. Exhibit 3 illustrated the potential magnitude of the S premium where an asset sale was contemplated, including the basis recovery of the stock. Again, the horse trading of tax consequences needs to be an element of the measure of what premium an S Corporation might command because of the availability of a basis step-up to a buyer, given the seller’s (partial) indifference to an asset purchase or stock purchase..

Conclusion

S corporations will always provide a premium in terms of the after-tax value of the sale proceeds assuming that earnings are subject to the highest personal rate of 39.6% and capital gains to a rate of 20%. The principal reason for this is that S shareholders receive a basis adjustment in their stock for any earnings retained. S corporations are also preferred over C corporation if the anticipated disposition of the business is to be in the form of an asset sale rather than a sale of stock. In the latter case, buyers can obtain a basis step-up for depreciation and amortization purposes.

The true measure of the S advantage also depends on the rate of earnings growth and cost of capital, since this influences the valuation of the business and the degree to which basis increases in the S stock will be available to reduce the gain on sale of the stock. The greater the spread between the basis and the stock’s value in a stock transaction, the less important the S election is vis a vis C corporation status.

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