Doublespeak: The Government’s Position on the Valuation of S Corporations and Why it Matters for ESOP Valuations

In valuations for gift and estate tax purposes, the Internal Revenue Service (“IRS”) has taken the position that taxes paid by S corporation investors do not affect the value of the company (a position that is demonstrably false). Relying on this position, the IRS has disallowed any deduction for taxes on business earnings in the application of the income approach. Failing to deduct income taxes from the income stream (typically in the order of magnitude of 35% to 40%) means that an S corporation may be faced with estate taxes on an inflated valuation. This, of course, is what the government wants – a higher valuation for estate and gift purposes.

In contrast, in valuations of S corporations with Employee Stock Ownership Plans (“ESOP”), the Department of Labor (“DOL”) has taken the position that taxes on income must be deducted from the income stream, “as if” the company were a C corporation (with no further adjustment). However, the company may well remain an S corporation. If the company is treated as a C corporation instead of an S corporation, the DOL’s position may result in an understated valuation. This, too, is what the government wants – a lower valuation for the ESOP transaction.

When valuing an S corporation, the IRS insists taxes cannot be deducted, while the DOL takes the position that they must be deducted. Clearly, both positions cannot be right. In fact, both are wrong.

Recognizing this, valuation analysts have long fought the position of the IRS, and now have a case in tax court that may decide the issue. However, ESOP valuations of S corporations being treated “as if” they were C corporations have typically gone unchallenged by those who value these companies (including the valuation analysts, trustees, and investment bankers involved).

Value as a C Corporation or an S Corporation?

Valuation of an S corporation or an interest in one (regardless of whether the valuation is for transfer tax purposes or for an ESOP) requires the answer to a threshold question, before one can determine the proper tax treatment. That question is: what form of entity should be assumed in the valuation?

Oftentimes, if the interest is a minority interest the answer is relatively easy. If the company is an S corporation, and the minority interest owners do not have the power to change the form of entity, it is typically a reasonable assumption to assume the form of entity will continue. The same applies to a minority interest in a C corporation.

However, if the interest being valued is a controlling interest, discerning the appropriate form of entity to utilize in the valuation requires consideration of the types of entities that comprise the pool of most likely buyers for the interest. This can be determined by examining the types of entities active in the marketplace for the particular industry. Often, the answer to this includes a mix of public or private C corporations, and S corporations. For some types of businesses, it may also include private equity funds, hedge funds, mutual funds, or pension funds. Once the buyer pool is identified, the analyst should determine which entity type among the participants in the pool would be the marginal (i.e., price-setting) investor type.

If the interest being valued is likely to continue as a C corporation (either through continued minority ownership or by virtue of the marginal buyer type being a C corporation), then treating the company “as if” it were a C corporation (as is currently done for most ESOP valuations) is the proper treatment. This means deducting C corporation income taxes from the income stream in the application of the income approach.

If, however, the interest being valued is likely to continue as an S corporation (either through continued minority ownership or by virtue of the marginal buyer type being an S corporation), then treating the company “as if” it were a C corporation is not appropriate. Rather, the S corporation should be valued as what it is – an S corporation.

Tax Treatment in the Valuation of S Corporations

A wealth of academic research demonstrates undeniably that taxes borne at the individual level affect value. This has two implications for the valuation of an S corporation:

1. Individual income taxes on business income should be deducted from the income stream, at a tax rate that is appropriate for the investors; and
2. The cost of capital used to value the income stream should be adjusted, to remove the amount by which it is affected by taxes that public market investors pay. Specifically, the cost of capital that valuation analysts routinely use to value the S corporation’s earnings stream is negatively affected by the fact that investors in the public market have to pay dividend and capital gains taxes. In contrast, individual investors in S corporations avoid this “second level” of taxes. Accordingly, this negative effect should be removed from the cost of capital, so that the cost of capital appropriately matches the income stream of the S corporation.

The first of these two adjustments will typically not result in a material valuation adjustment from the manner in which ESOP analysts have typically valued S corporations – that is, it’s merely a substitution of individual level tax rates for corporate level tax rates (unless, of course, tax rates change materially).

However, the second of these adjustments may result in an increase to the valuation (compared to simply treating the company as a C corporation), depending on a myriad of facts and circumstances that affect the valuation. Simply ignoring this aspect of S corporation valuation could cause the valuation to be understated.

What Form is the Transaction Most Likely to Take?

There is a further tax adjustment that should be considered relating to so-called “tax amortization benefits.” Tax amortization benefits potentially arise when a transaction is structured as an asset sale. In such a transaction, the assets of the company are written up to their fair market value at the time of the transaction. This write-up results in enhanced tax deductions for tax depreciation or amortization, for which buyers will pay a premium. Many (but not all) valuation analysts routinely make this adjustment when it can be demonstrated that the form of transaction is most likely to be an asset sale (regardless of whether the marginal buyer for the interest is a C corporation or an S corporation).

However, there is an additional circumstance under which S corporation stock sales can realize this same premium. A buyer and seller in a transaction involving greater than 80% of the stock of an S corporation can jointly make an election under Internal Revenue Code Section 338(h)(10), under which a stock sale can be treated as an asset sale, resulting in tax benefits. The failure to recognize these tax benefits, and the premium buyers pay for them, can result in an understatement of the value of the S corporation.

Summary

Tax adjustments are a material aspect of valuation. Failure to recognize the manner in which S corporations are taxed (or, in the case of ESOP appraisals, that the company is an S corporation at all!) can result in a materially understated valuation for ESOP purposes.