Why tax-affecting matters

Posted On: SEPTEMBER 2020

Valuation of pass-through entities

Why tax-affecting matters

If you own a closely held business, it likely represents a significant portion of your wealth; wealth that your loved ones will rely on as a source of income after your death. So, the valuation of the business for gift and estate tax purposes is critical to determining how much of your estate goes to your family and how much goes to the government.

If the business is structured as a pass-through entity — such as an S corporation, partnership or limited liability company (LLC) — the use of tax-affecting can substantially reduce its value, allowing your estate to slash its tax bill.

Tax-affecting defined

Tax-affecting — which involves discounting a pass-through entity’s projected earnings by an assumed corporate income tax rate — is widely accepted in the valuation community, but the IRS routinely challenges the practice. Historically, the U.S. Tax Court has sided with the IRS. In a recent estate tax case, however, the Tax Court accepted the use of tax-affecting by a valuation expert. Although the practice remains controversial — at least from the IRS’s perspective — the court’s decision may signal a greater willingness to accept it in future cases.

Why tax-affect?

When valuing businesses or business interests, valuation professionals often rely on income- based methods — which project the business’s future earnings or cash flow and discount them to present value — or on market-based methods — which apply earnings multiples derived from public or private company market data. In either case, the subject company’s earnings are critical.

Pass-through businesses pay no entity-level taxes. Rather, as the name suggests, their profits and losses are passed through to the owners, who report their shares on their personal income tax returns. Nevertheless, valuation professionals often discount a pass-through entity’s earnings to reflect an assumed corporate income tax rate. Why? Because, despite the lack of entity-level taxes, owners still pay taxes on their shares of the entity’s profits at their individual rates, and pass-through entities commonly distribute sufficient earnings to cover those taxes.

Another rationale for tax-affecting is that it accounts for the risk that a pass-through entity will convert to a C corporation in the future (because, for example, it loses its S corporation status or merges into a C corporation).

Although it’s important to recognize the real impact of taxes on a pass-through entity, applying an assumed corporate rate, without more, may undervalue the entity because it ignores the tax advantage such a structure provides. Because there’s no entity-level tax, pass-through entities avoid the double taxation experienced by traditional “C” corporations.

A C corporation’s earnings are taxed twice, once at the corporate level and again when they’re distributed to shareholders in the form of dividends. Thus, valuators often add a premium when valuing pass-through entities to reflect this tax advantage. But note that, since the Tax Cuts and Jobs Act cut corporate income tax rates, this advantage isn’t as significant as it once was.

Tax Court’s position

Starting with its 1999 ruling in Gross v. Commissioner, the Tax Court has consistently rejected tax-affecting in cases involving the valuation of pass-through businesses. This has been based on the reasoning that these businesses paid no entity-level taxes and were unlikely to convert to a C corporation in the near future. However, in a more recent case — Estate of Jones — the court approved tax-affecting in the valuation of two family-owned timber businesses, one structured as an S corporation and the other as an LLC, for gift and estate tax purposes.

The court found that the estate expert’s approach best accounted for the tax impact of pass- through status. He tax-affected the entities’ earnings, using a 38% rate for combined federal and state taxes, to arrive at an initial value, and then added back a premium to reflect the benefit of avoiding a tax on dividends. Tax-affecting was only one of several issues, but because the estate expert’s position prevailed, the family saved tens of millions of dollars in gift taxes.

The future of tax-affecting

Although the Tax Court distinguished its previous rulings on tax-affecting based on the facts of those particular cases, its decision in Estate of Jones seems to signal that it’s more receptive to the practice today. One thing is certain: To ensure that a valuation that incorporates tax-affecting holds up in court, it’s critical to engage a qualified valuation professional who can explain and support your position.

© 2020