Paul Simon's lyrics seem to sum up the approach the Tax Court took in the case of Estate of Louise Paxton Gallagher v. Commissioner (T.C. Memo. 2011-148), which as I mentioned last month gave the Tax Court a chance to weigh in on a number of key valuation issues. In this month's e-mail, I have focused on the court's approach to valuing an S Corp...and it isn't a pretty sight!
In valuing a 15% interest in Paxton Media Group (PMG), the taxpayer's valuation expert used a discounted cash flow analysis in which he applied standard C Corp tax rates to the company's cash flows. He then discounted these cash flows to reach a present value of the cash flows which reflected the value of PMG as a C Corp. He later increased the company's value by making adjustments to reflect the additional value attaching to an S Corp's stock as a result of its specific flow-through characteristics.
The IRS' expert applied no tax burden to the company's cash flows in coming up with his discounted cash flow-based valuation, contending that PMG was not subject to corporate taxes since it was an S Corp.
The Tax Court stated: "the principal benefit enjoyed by S Corp shareholders is the reduction in their total tax burden, a benefit that should be considered when valuing an S corporation. [The Estate's expert] has advanced no reason for ignoring such a benefit, and we will not impose an unjustified fictitious corporate tax rate burden on PMG's future earnings." The court cited the decision in Gross v. Commissioner, T.C. Memo. 1999-254 as precedent for this approach.
Further, the court made no adjustment to the applicable discount rate to reflect their position that the cash flows should not be tax affected.
The Court's approach here does not appear to be very nuanced and probably does not reflect reality. The Court seems to have converted the idea that S Corp shareholders benefit from a "reduction in their total tax burden" into the concept that they avoid tax altogether on the S Corp's earnings.
If we assume an ongoing pre corporation tax cash flow for a company of $1 million and a cash flow multiple of 5, the resulting value is $5 million. If we apply a corporate tax rate of 40% to the same cash flow, we then have post tax cash flows of $600,000 and using the same multiple of 5 we obtain a value of $3 million. Would a willing buyer really pay $2 million more for a business incorporated as an S Corp compared to the same business incorporated as a C Corp?
The taxpayer's expert tried to reflect this reality in his argument by applying adjustments that capture the advantage of S Corp status rather than just assuming a zero percent corporate tax rate. The court was not convinced by the accuracy of these adjustments, but it had already rejected the tax affecting approach so it may not have been inclined to focus fully on these adjustments. See what I mean about "disregarding the rest"?
There are a number of complex models that have been advanced by valuation experts to capture the S Corp benefit and I remain hopeful that the Tax Court will be persuaded in a future published case that these are a more appropriate approach in valuing S Corps in the future.