Most U.S. businesses operate as so-called “pass-through” entities, including partnerships, limited liability companies (LLCs) and S corporations. For decades, the IRS and valuation professionals have been at odds over how to value pass-through businesses because of their unique tax characteristics.

Taxation of pass-through entities

For pass-through entities, all items of income, loss, deduction and credit pass through to the owners’ personal tax returns, and taxes are paid at the level of the individual owners. Distributions to owners generally aren’t taxable to the extent that owners have positive tax basis in the entity.

For the most part, operating as a pass-through entity is a smart tax-saving strategy for entities that qualify. However, for minority owners that have no control over distributions, this favorable tax treatment may be less advantageous — especially if the business doesn’t distribute enough cash to cover the owners’ tax obligations related to the business.

In a business valuation context, the term “tax affecting” refers to reducing the earnings of a pass-through business for an assumed corporate tax rate. In the 1990s, valuation professionals often used measurements of income for pass-through entities that included a provision for deducting hypothetical entity-level corporate income taxes.

Inconsistent legal precedent

In a landmark 1999 case — Gross v. Commissioner (T.C. Memo. 1999-254, July 29, 1999, affd. 272 F. 3d 333, 6th Cir. 2001) — the U.S. Tax Court dismissed the application of hypothetical corporate taxes to the income of an S corporation. This landmark decision effectively created a valuation premium for operating as a pass-through entity. It was followed by several more Tax Court cases that disallowed tax affecting.

This legal precedent was challenged in 2019 by another landmark decision, Kress v. Commissioner (2019 WL 1352944, U.S. District Court, E.D. Wisconsin, Case No. 16-C-795, March 26, 2019). Here, the U.S. District Court for the Eastern District of Wisconsin accepted the application of a hypothetical corporate tax rate to an S corporation’s earnings. The court highlighted the disadvantages of subchapter S status, including limits on access to credit and on the ability to reinvest in the company. This case re-opened the door to tax-affecting in other cases involving pass-through entities.

IRS job aid

An IRS job aid entitled, “Valuation of non-controlling interests in business entities electing to be treated as S corporations for federal tax purposes,” provides useful guidance on tax affecting. However, it may be applied more generally to all types of pass-through entities that are appraised for any purposes, not just for tax reasons.

According to the job aid, if a valuator tax affects a company’s earnings, he or she must provide valid reasons that a hypothetical investor would discount the earnings for entity-level taxes. The job aid points out that, while avoiding entity-level taxes is an important benefit to consider when valuing an S corporation, valuators also must consider the downsides to owning a minority interest in an S corporation.

5 factors

Five factors that are considered when deciding how to handle entity-level taxes in a business valuation include:

1. Size and composition of the pool of hypothetical buyers,
2. Economic interests of the hypothetical seller,
3. Actual revenues available to and the actual expenses to be paid by the entity that has elected to be taxed as an S corporation,
4. Availability at the entity level of equity and debt capital, and
5. Probable holding period of the transferred interest.

Ideally, a pass-through entity should be compared to other pass-through entities in the valuation process. But doing so is often difficult because much of the data used to value private businesses comes from the public markets, which are made up primarily of C corporations.

Afterthought

When it comes to tax affecting pass-through entities, there’s no clear-cut guidance that prescribes a specific tax rate or denies tax affecting altogether. Rather, tax affecting may be permitted on a case-by-case basis, depending on the facts and circumstances.

(This is Blog Post #1137)