S-Corporations and Taxes: A Summary of Relevant Case Law

Taxes on S-Corporations are Hotly Discussed by Legislators and May Change. Here’s the History, Standing Precedents, and Current Law.

S Corporations have been much in the news lately, as we’ve noted on the QuickRead blog. In this piece, Peter Agrapides provides a comprehensive chronological account of valuation cases where the issue of tax affecting S-Corporations has taken center stage.

The following provides a comprehensive chronological account of valuation cases where the issue of tax-affecting S-Corporations has taken center stage.  While the IRS currently holds firm in their argument that the earnings of S-Corporations should not be tax-affected, two internal IRS documents actually mention making adjustments for taxes to S-Corporations.  The documents are titled IRS Valuation Guide for Income, Estate and Gift Taxes: Valuation Training for Appeals Officers and IRS Examination Technique Handbook.  Further, while the Tax Court repeatedly affirms the argument of the IRS, it specifically confirmed tax-affecting S-Corporations in two separate cases: Maris v. Commissioner (41 TCM CCH 127, 138 1980) and Hall v. Commissioner (34 TCM CCH 648, 667 1975).  

Walter L. Gross v. Commissioner
TC Memo 1999-254
July 29, 1999

The Tax Court ruled that the earnings of an S-Corporation should not be tax-affected despite the argument of one of the taxpayer’s experts.  The expert testified that he was required under the Uniform Standards of Professional Appraisal Practice (USPAP) to be aware of, understand, and follow recognized appraisal methods and techniques.  He further noted that in order to comply with the USPAP rule, it was necessary to tax affect the earnings of an S-Corporation.  He imputed a 40 percent corporate tax rate in his calculations. 

Walter L. Gross v. United States
2001 Fed.App. 0405p (6th Cir.) No. 97-04460
November 19, 2001

The United States Court of Appeals for the Sixth Circuit affirmed the Tax Court’s ruling that it was not proper to tax affect S-Corporation earnings for valuation purposes.  The Court noted, “We disagree with the tax court’s characterization of the respective experts’ approaches to tax affecting as a mere difference in variables.  There was no spectrum of tax percentages from which the court could have selected.  Rather, the choice was either a corporate tax rate of 40 percent or a rate of 0 percent, the latter meaning no tax affect at all.  But while the tax court’s analysis was rather cursory, we do not believe that further evaluation was necessary under the circumstances.” 

Wall v. Commissioner
TC Memo 2001-75
March 27, 2001

The Tax Court completely ignored the income approach calculations prepared by both experts, citing the inability of the subject company to make projections.  However, the Court made several comments about imputing income taxes to the earnings of an S-Corporation, saying that the tax-affected cash flow used by both appraisers was incorrect.  The Court said, “Because this methodology attributes no value to Demco’s S-Corporation status, we believe it is likely to result in an undervaluation of Demco’s stock.”  The Court cited Gross v. Commissioner TC Memo 1999-254.

Estate of Heck v. Commissioner
TC Memo 2002-34
February 5, 2002

Both the taxpayer and IRS expert calculated incomevalues of the subject company without deducting federal income taxes from the company’s normalized earnings.  The IRS expert did, however, subtract a 10 percent discount for “additional risks with S-Corporations,” including “the potential loss of S-Corporation status and shareholder liability for income taxes on S-Corporation income, regardless of the level of distributions” to arrive at his fair market value.  The Tax Court did not allow the discount and settled on a combined discount of 35 percent.

Estate of William G. Adams Jr. v. Commissioner
TC Memo 2002-80
March 28, 2002

The Tax Court did not allow an adjustment of the capitalization rate to account for imputed income taxes on an S-Corporation’s income.  The taxpayer’s expert grossed up the 20.53 percent after-tax discount rate to 31.88 percent to match the pre-tax S-Corporation cash flow stream to which it was applied.  The Tax Court said, “We disagree that the taxpayer’s expert’s estimates of WSA’s prospective net cash flows are before corporate tax because it is appropriate to use a zero corporate tax rate to estimate net cash flow when the stock being valued is stock of an S-Corporation.  WSA is an S-Corporation and its cash flows are subject to a zero corporate tax rate.  Thus the taxpayer’s expert’s estimates of WSA’s prospective net cash flows are after corporate tax (zero corporate tax rate) and not before corporate tax as the estate contends.”

Dallas v. Commissioner
TC Memo 2006-212
September 28, 2006

The Tax Court again rejected the argument that the subject company’s normalized earnings should be tax-affected.  Both of the taxpayer’s experts tax affected the normalized earnings of the subject company; one expert used a 35 percent rate and the other used a 40 percent rate.  Both experts testified that they were under the assumption that the subject company would lose its S-Corporation status after or as a result of the hypothetical sale of its stock.  The court noted that there was no evidence that the company expected to lose its S-Corporation status.  The court further noted that the company had a history of distributing sufficient cash for the shareholders to pay their taxes on their pro-rata proportion of S-Corporation earnings and there was no evidence that this practice would change.  One taxpayer expert made several claims as to why the practice of tax-affecting is commonplace.  In one argument, he stated that the American Society of Appraisers rejects any application for certification if the candidate submits reports for review that do not tax-affect S-Corporation earnings.  The IRS appraiser noted that his reports submitted to the ASA for review had been accepted without tax affecting.

Peter H. Agrapides, MBA, AVA, is a Principal at Western Valuation Advisors, which has offices in Salt Lake City, Utah and Las Vegas, Nevada. Mr. Agrapides’ practice focuses primarily on valuations for gift and estate tax reporting. He has experience valuing companies in a diverse array of industries. These engagements have ranged from small family owned businesses to companies over $1billion.