Valuing pass-through entities vs. C corporations
Valuing interests in pass-through entities, such as S corporations and limited liability companies (LLCs), can be deceptively complex. This complexity stems from a mismatch between the data commonly used to value privately held companies and the tax benefits associated with pass-through entities.
The problem
When valuing privately held companies using an income approach, the appraiser often uses discount or capitalization rates derived from comparable, publicly traded companies. Similarly, the guideline public company method values privately held companies using price-to-earnings ratios or other market multiples exhibited by comparable public companies.
Using this data to value pass-through entities is like comparing apples to oranges. Public companies are C corporations, which are subject to double taxation — once at the corporate level and again at the shareholder level when earnings are distributed as dividends.
Pass-through entities don’t pay corporate income taxes; the owners report their proportionate shares of the company’s activity on their individual income tax returns.
Tax-affecting: The old solution
Until about a decade ago, the typical solution to the mismatch between public company data and pass-through tax status was to “tax-affect” a pass-through entity’s earnings. In other words, a valuator would subtract taxes (calculated at an assumed corporate tax rate) from earnings as if the entity were a C corporation.
The rationale for tax-affecting was that it reflected taxes that equity owners had to pay on their individual returns as well as the risk, in the case of an S corporation, that S status would be lost (for example, if it were acquired by a C corporation). The problem with this approach is that it fails to account for the fact that, in most cases, pass-through entities provide their owners with greater after-tax benefits than an equivalent C corporation.
For this reason, a series of court cases in the late 1990s and early 2000s rejected tax-affecting in situations where loss of S corporation status wasn’t foreseeable.
Modeling: The current approach
Today, the valuation community — as well as the IRS and a number of courts — recognizes that adjusting for the differences between C corporations and pass-through entities isn’t an “all or nothing” proposition. Full tax-affecting may undervalue a pass-through entity, while an entity valued without adjusting for taxes may be overvalued.
In recent years, several analytical models have been developed — such as the S corporation Economic Adjustment Model (SEAM) or Fannon’s Simplified Model — which provide a more accurate picture of a pass-through entity’s economic benefits. Using these models, a valuator begins by tax-affecting the pass-through entity’s earnings as if it were a C corporation to provide an apples-to-apples comparison with public company data.
Once the appraiser determines the entity’s tax-affected value, he or she adjusts that value to reflect any additional economic benefits the owners enjoy by virtue of the entity’s pass-through status — including avoidance of double taxation and an increased tax basis for dividends received. In some situations, adjustments may not be warranted. This may be the case, for example, if the company has a history of not paying dividends or when there’s reason to believe a company will lose its S status.
No cookie-cutter formula
Because of their tax advantages, pass-through entities are often worth more than their C corporation counterparts. Valuations of pass-through entities, however, must be looked at on a case-by-case basis to determine whether additional value to the buyer exists. Because there’s no cookie-cutter formula for measuring the difference, appraisers employ modeling techniques to quantify the economic benefits associated with a company’s pass-through status.