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TAX AFFECTING S CORPS

In the most recent gift tax case, the experts on both sides applied a C corporation tax rate to the companies S corporation earnings. Initially, the IRS (Kress v. U.S.) claimed that the taxpayers paid insufficient gift taxes. The plaintiffs, after paying the amount in question, sued in federal district court.

Testimony was provided from qualified valuation experts, who each tax affected. The government's expert also applied an S corporation premium to account for the perceived tax advantages of S corporation status. The court declared neutrality on the benefits, stating that it was not clear that the gifted minority shareholders would enjoy them.

The" tax affecting" issue has literally raged for 40 years among persons in the valuation community, with strong positions taken on either side in past valuations. Only recently have the IRS and tax court agreed that tax affecting S corporations is the correct approach. This agreement should finally end this hotly debated topic. There are textbooks and numerous articles devoted to fully explaining the rationale for tax affecting.

Even prior to the Gross case in 1999, a Tax Court opinion, most valuators accepted that the earnings of a pass-through entity (PTE) should be tax affected for valuations. While not taxed at the entity level, the tax is paid at the ownership level. Thus, the S corporation tax burden is not eliminated; rather, the tax on distributions (dividends) is eliminated. Most appraisers valued the PTE similar to a Corporation, net of the income tax on entity earnings. Valuators have used the C corporation federal tax rate to tax affect S corporations. Prior to 2017, this rate was higher than the expected shareholder rate for a PTE. The tax Act of 2017 reduced the C corporation tax rate to 21%, greatly narrowing the prior rate disparity. And the old argument that S entities were up to 40% more valuable, since there were no corporate earnings, is a moot point. The cash flow valuation should also include the state rate. Thus, CA is 21 + 8.9% or about 30%.

In addition to the discounted cash flow analysis, the other primary approach to value is the market comparison technique. This approach uses EBITDA or revenue as a benchmark times a market multiple to ascertain a purchase price, as if the company were sold. Since the marketplace of buyers and sellers does not provide any evidence of multiples differing between a C or S corporation, the tax affecting is consistent with this second approach to value. If there were the aforementioned 40$ value gap, then every C corporation seller would convert to an S prior to the sale.

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