Seismic Shift in Pass-through Entity Valuation for IRS Reporting

Did you just hear that massive roar of applause? No, I don’t mean the celebration that ensued at Augusta National Golf Club on April 14, 2019 after Tiger Woods put an exclamation point on one of the most impressive comeback stories of all time. What I’m referring to is the wave of jubilation emanating from lawyers, CPAs and valuation experts upon reading the decision in the Kress matter (James F. Kress and Julie Ann Kress v. U.S., Case No. 16-C-795, U.S. District Court, E.D. Wisconsin, March 25, 2019).

The United States District Court-Eastern District of Wisconsin recently issued a much-anticipated decision in Kress regarding the valuation of an S corporation for IRS gift tax purposes. Specifically, the decision in Kress called for the earnings of an S corporation to be tax-affected in determining its value. In other words, the IRS allowed income taxes to be considered in the valuation of a pass-through entity (which produces a lower, and more accurate, value than if income taxes were ignored in the valuation process).

What makes this decision groundbreaking is that the IRS has been challenging the use of tax-affecting pass-through entity income streams in determining the value of such companies since the Gross case in 1999. The fact that tax-affecting has been expressly permitted in Kress, coupled with the fact that the IRS’s own expert even tax-affected the subject company’s earnings in determining its value, is a big win not only for taxpayers, but also for valuation experts. The valuation community had reached a consensus that pass-through entities’ earnings must be tax-affected in order to determine a reasonable and accurate value, but the IRS had held fast to its contrary position in the Gross case (and other similar cases).

Kress is a big first step toward bringing the IRS’s position on tax-affecting into conformity with the position espoused by the vast majority of the valuation community—that income taxes must be considered in the valuation of pass-through entities in order to accurately determine their value.

SIDEBAR SECTION: It is important to note that income taxes are levied on the earnings of both pass-through entities and C corporations, just at different levels (the shareholder/investor level and entity level, respectively). Prior to Kress, the IRS had erred by calling for pass-through entities to be valued using benefit streams that did not take income taxes into account.  This approach treats pass-through entities and their investors as if they are not liable for any income tax at all, which significantly overstates the value of these entities. Kress, however, correctly addresses the fact that the income taxes are still levied on pass-through entity earnings, just at the shareholder/investor level rather than the entity level.

While this news may not be as spellbinding as Tiger returning to glory, it is a huge victory for taxpayers and valuation experts that will certainly be celebrated with fervor within the professional community.

Do you have questions about the pass-through entity, or other valuation and litigation issues? Please contact Sean R. Saari, Partner, Advisory Services.