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Tax-Affecting S-Corporations: The Fight is Not Lost!

Friday, July 01, 2016

The valuation community has gone head to head time and time again with the Internal Revenue Service when it comes to tax-affecting S-Corporations, and history reflects that the Tax Courts have sided with the IRS’s position time and time again.

Over the past decade or so, the Courts have repeatedly ruled against tax-affecting S-Corporations, leaving many valuation professionals frustrated on the grounds that assuming a 0% corporate tax rate leaves companies’ earnings overvalued. Yet every argument brought fourth to the Courts by proponents of tax-affecting have been struck down. This includes arguments from sufficiency of cash flow to funding shareholders’ tax liabilities to the viability of qualifying for S-Corporation election. One Tax Court judge, however, claims the Court’s stance on the issue is not so apoplectic as it may seem.

It’s important to understand why the Court’s have ruled against each argument for tax-affecting thus far. The best way to do this is by studying the unique conditions of each court case:

  • Gross vs. Commissioner: This iconic court case took place in the late 20th century and set the stage for future rulings to come. The argument for tax-affecting was that if an S-Corporation doesn’t distribute all of its income, these distributions may be less than the tax-obligations the shareholders face, and thus tax-affecting is necessary to compensate for this shortcoming. However, after researching the corporation’s history of distributions, the Court found it unlikely that the corporation would discontinue distributing nearly 100% of its earnings.
  • Wall vs. Commissioner: In this case, the argument for tax-affecting the S-Corporation was that potential acquirers would be unable to fulfill the requirements of the S-election, and thus tax-affecting the corporation’s earnings would compensate for that. Ultimately the Court cited its decision in Gross, ruling that tax-affecting would bring no value to the S-election.
  • Adams vs. Commissioner: This case took a slightly different approach. Instead of directly tax-affecting the S-Corporation’s earnings, the valuation expert used an after-tax discount rate, and to compensate, added a pre-tax capitalization rate. The Court ruled that this methodology inherently tax-affected earnings at the corporate level, and by using a pre-tax capitalization rate, the process was thus unbalanced. The Court then implemented a 0% tax-rate.

There are plenty of other court cases to read up on this topic, but Gross, Wall, and Adams all accurately reflect the Tax Court’s current position on tax-affecting. The U.S. Tax Court judge David Laro, however, believes the fight for tax-affecting is not over. There has been so much opposition to the Tax Courts’ rulings thus far on this subject that he believes “it bears further review”. If tax-affecting is ever to be held acceptable in the valuation world, its going to take a much stronger argument and delivery of evidence to sway the Courts.

Avenue M® Advisors, Inc., is a national, boutique company performing business valuations, advisory consulting services and exit planning services for companies of all sizes. Tax-affecting is a controversial topic that Avenue M addresses in the valuation reports.

If you have any questions on Tax-Affecting S-Corporations in a business valuation, or would like to speak with us about another area of interest, please contact Avenue M at 818.758.8457.