For many years there has been general consensus among valuation analysts that taxes should be considered when valuing a pass-through entity (“PTE”) (i.e., S Corporation, LLC, LP, etc.). Most valuation analysts have claimed that a potential buyer would consider income taxes when negotiating a price in a potential business acquisition.
In the 1999 landmark case of Gross v. Commissioner (as well as other cases since), the Tax Courts opposed this view, holding that because the earnings of a PTE are not subject to taxes, a PTE’s forecasted earnings should not be tax-affected in a business valuation. The Tax Court’s decision in the Estate of Aaron U. Jones v. Commissioner of Internal Revenue (“Jones Case”), however, was an unexpected change in that pattern.
In the Jones Case, Aaron Jones gifted ownership in two PTEs which operated a sawmill and timberlands in May 2009. The IRS argued that the PTEs were significantly undervalued, resulting in a deficiency in gift tax of nearly $45 million. Among other issues, the IRS stated that the estate’s expert, Richard Reilly, improperly tax-affected the PTEs’ forecasted earnings when determining the value of the entities under the income approach to business valuation. Specifically, Mr. Reilly used a 38% combined federal and state tax rate to adjust the PTEs’ cash flow and cost of debt used in the discount rate determination. He then applied a premium to reflect the benefit to the PTE owners of avoiding dividend taxes that would have been owed if the entity were a C Corporation based on an empirical study analyzing S Corporation acquisitions and the entities’ histories. The tax court concluded that Mr. Reilly’s tax-affecting, although “not exact,” was “more complete and more convincing than respondent’s zero tax rate.”
The court cited other cases, including Gross v. Commissioner, where tax-affecting PTEs was rejected, and explained why the Jones case was different:
“While respondent correctly points out that we rejected the proffered tax-affecting in Gross and later cases, he misconstrues our rationale. In Gross v. Commissioner, [...] we concluded that “the principal benefit that shareholders expect from an S corporation election is a reduction in the total tax burden imposed on the enterprise. The owners expect to save money, and we see no reason why that savings ought to be ignored as a matter of course in valuing the S corporation. We then concluded that, on the record in that case, a zero-percent corporate tax rate properly reflected those tax savings, rejecting the expert’s offered justifications. More recently, in Estate of Gallagher v. Commissioner, [...] we again rejected tax-affecting because the taxpayer’s expert did not justify it but again acknowledged that the benefit of a reduction in the total tax burden borne by S corporation owners should be considered when valuing an S corporation. And in Estate of Giustina v. Commissioner, [...] we rejected tax-affecting in the valuation of a partnership because we found the taxpayer’s expert’s method to be faulty: He used a pretax discount rate to present value post-tax cash flow. The question in those cases, as here, was not whether to take into account the tax benefits inuring to a flowthrough entity but how.”
Although this is certainly not a definitive conclusion regarding whether tax-affecting of PTEs (when valuing those entities) will always be accepted by the tax court in the future, it is a positive sign for valuation experts who largely favor this practice. As the excerpt above indicates, the tax court took issue with how a PTE’s tax benefits were considered in the various cases, not that they were considered at all. The court found Mr. Reilly’s approach to be more complete and convincing than the IRS’s, which stresses the need for valuation analysts to always thoroughly document and explain each assumption when preparing a business valuation.
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