Tax Court finds ‘tax affecting’ appropriate for S corporation valuation

In brief

In Cecil v. Commissioner (TC Memo 2023-24), the US Tax Court upheld the use of ‘tax affecting’ to determine the value of S corporation shares for Federal gift tax purposes. ‘Tax affecting’ is a valuation approach that applies a hypothetical entity-level tax to a pass-through entity’s taxable income, which reduces the value of the business. 

Since the 1999 Tax Court decision in Gross v. Commissioner (TC Memo 1999-254), the IRS generally has taken the position that an entity-level tax should not be applied in determining the projected earnings and value of an S corporation. Taxpayers have disagreed with the IRS on the basis that, while the entity itself is not subject to tax, the income that flows through to the owners of the business will be subject to tax. Therefore, taxpayers have argued, the valuation of the future income streams should be adjusted to reflect the tax liability borne by the shareholder(s). 

The Tax Court, since the Gross decision, typically has addressed the issue of tax affecting on a case-by-case basis. In Cecil, although the taxpayer and the IRS disagreed on how to value the S corporation shares, experts from both sides testified that the entity’s projected cash flows should be tax affected. For this reason, the Tax Court determined that tax affecting was appropriate. [Estate of William A.V. Cecil, Sr., Donor, Deceased v. Commissioner, United States Tax Court, T.C. Memo 2023-24 (Feb. 28, 2023)] 

Observation: Although the outcome in Cecil (if followed in other cases) should be welcome news to taxpayers, questions still remain. In reaching its decision, the Tax Court emphasized that tax affecting was only appropriate in this case “given the unique setting at hand.” The court did not set forth specific factors that could indicate when tax affecting might be deemed appropriate in other cases. The court stated that “we are not necessarily holding that tax affecting is always, or even more often than not, a proper consideration for valuing an S corporation.” The absence of a unified approach creates uncertainty and challenges for taxpayers seeking clarity on this matter.

Application of tax affecting to the valuation of an S corporation

Background

When the value of a C corporation is calculated under the discounted cash flow method, the impact of tax that must be paid by the corporation at the entity level is taken into account. This tax-based reduction is known as tax affecting, which decreases the net present value of the entity’s future income and, consequently, its valuation. 

Traditionally, appraisers who value S corporations using the discounted cash flow method will do so as if the entity was structured as a C corporation (using after-tax discount rates). However, notable differences exist between the taxation of C corporations and S corporations. For example, unlike C corporations, S corporations generally are not subject to Federal income tax at the entity level; instead, the S corporation shareholders are taxed directly on their pro-rata share of the entity’s taxable income. Further, distributions from S corporations may not be subject to tax at the shareholder level, whereas distributions from C corporations generally are taxed to shareholders as dividend income. 

Based on these differences, valuing an S corporation’s pre-tax cash flows using after-tax discount rates (when the entity itself is not subject to tax) could lead to mismatched results. Nevertheless, as S corporation shareholders still are subject to tax on the entity’s earnings, the value of the S corporation could be overstated without factoring in a reduction for the shareholder-level tax. 

The question as to whether (and to what extent) this reduction should be available to S corporations and other pass-through entities has been the subject of debate over the past several decades. As pass-through entities do not pay income tax at the entity level, the IRS’s position generally is that a reduction for the tax effect should not be included in the entity’s valuation. 

Earlier court decisions 

In 1999 the IRS successfully challenged the application of tax affecting in Gross v. Commissioner. The following summarizes Gross and then highlights several recent cases in which tax affecting was accepted.

Gross v. Commissioner: In 1999, the Tax Court agreed with the IRS and determined that tax affecting should not be utilized to value gifted S corporation shares. The IRS’s expert had supported its conclusion that tax affecting should not be applied because the entity was an S corporation at the time of the valuation and was likely to remain one and the entity distributed almost all its income to its shareholders on an annual basis. The taxpayer’s valuation expert asserted that tax affecting should be allowed because it was an accepted practice among valuation professionals and was necessary to offset certain disadvantages of being an S corporation. 

Siding with the IRS, the Tax Court found 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.” [T.C. Memo 1999-254, July 29, 1999]

Kress v. Commissioner: Twenty years after Gross, a US District Court opened the door to tax affecting when valuing an S corporation. Kress also involved the gifting of minority interests of an S corporation, and similar to Cecil, the valuation experts hired by the taxpayer and the IRS both tax-affected the earnings attributable to the subject interests and contemplated an adjustment for the potential tax benefit of the S corporation relative to if it were a C corporation. While other valuation issues also were considered, the court accepted the taxpayer’s expert’s valuation, including the tax-affected reduction. [Kress v. United States, Case No. 16-C-795, US District Court, March 25, 2019]

Aaron U. Jones v. Commissioner: The Tax Court supported tax affecting in Jones. Similar to Kress, in Jones both experts’ valuation reports for the IRS and taxpayer incorporated tax affecting. Highlighting that perhaps the use of tax affecting is a point of contention between lawyers and not valuation experts, the Tax Court noted “[w]hile respondent objects vociferously in his brief to petitioner’s tax-affecting, his experts are notably silent.” The Tax Court further stated that “[the estate’s expert’s] adjustments include a reduction in the total tax burden by imputing the burden of the current tax that an owner might owe on the entity’s earnings and the benefit of a future dividend tax avoided that an owner might enjoy.” Consequently, the “tax-affecting may not be exact, but it is more complete and more convincing than respondent’s zero tax rate.” [T.C. Memo 2019-101, August 19, 2019]