If you had the choice of investing in two companies, both of which will earn $100 per year, but one company must pay $40 in taxes while the other pays nothing, which would you choose? The answer is easy – the company that does not have to pay taxes. But what if I told you that you would have to pay $40 in taxes personally on the earnings of the company that did not have to pay any taxes?
The answer is not as clear cut once we introduce this nuance to the story because it would appear as if both companies are equally valuable. This simple illustration highlights one of the most controversial issues in both the business valuation community and the Tax Courts in recent years – whether it is appropriate to “tax-affect” the earnings of pass-through entities such as S-corporations, limited liability corporations, and partnerships, when determining their value.
One school of thought on the subject is that because pass-through entities do not pay tax at the entity level, tax-affecting the earnings of such businesses (deducting an estimated amount of income tax from the entity’s earnings based on pre-tax income) is inappropriate. As a result, the value of a pass-through entity will be much higher than if income taxes had been deducted in determining its value. This approach gained popularity as five memorandum decisions issued by the Federal Tax Court from 1999-2006 denied a deduction for income taxes in determining the value of various S-corporations for gift and estate tax purposes.
On the other hand, a more recent decision from the Delaware Chancery Court allowed a deduction for income taxes in the valuation of a pass-through entity. The Court’s reasoning was based on the theory that although income taxes are avoided at the business level for pass-through entities, the owners are ultimately responsible to pay income taxes on their share of the entity’s earnings that “pass-through” to them. Valuation analysts who subscribe to this theory argue that although income taxes are not paid at the entity level, there are still income taxes that must be paid on the earnings of pass-through entities – they are just paid at the shareholder/member level. When this theory is applied in the valuation of a pass-through entity, the resultant value is often times significantly lower than if the business’s earnings had not been tax-affected.
What does this mean for the owners and members of S-corporations, limited liability corporations, and partnerships? It means that when you are having your business valued, especially for estate or gift tax purposes, it is imperative that you gain an understanding of how the business valuation analyst intends to handle the controversial issue of tax-affecting pass-through entity earnings. Not only can the treatment of income taxes for pass-through entities have a significant impact on the concluded value of your business, it can also play a role in the likelihood of that value being challenged by the IRS. Therefore, it is crucial that your valuation analyst have a thorough understanding of the many complexities of this controversial issue, as well as a strategy for addressing them, or you could end up with a value that may not only be incorrect and unsupportable, but also result in the under-calculation (or over-calculation!) of your liability for estate tax, gift tax, or divorce purposes.
Looking for tax-related valuation services in Cleveland or Akron? Contact our business valuation services group at 440-449-6800 for more information.