How the IRS Values Non-Controlling Interests in S Corps

With Commentary by Original IRS Champion

Leading valuation practitioners have proposed various models to guide practitioners valuing controlling and non-controlling interests. The published Tax Court cases—precedents—have favored the position of the IRS. The author suggests that is not surprising. In a soon-to-be released book, Michael Gregory highlights the importance of a new Job Aid focused on valuation of S corporations.

This is a pre-announcement on two new IRS Job Aids.  QuickRead subscribers likely know about the original Job Aid, the IRS Job Aid on the Discount for Lack of Marketability, which became public in 2011.  In 2013 I released a book regarding that Job Aid.[i]   Last year I became aware of two other Job Aids that arrived in late March 2015 after a Freedom of Information Act (FOIA) request for them was filed with the IRS last fall.  I will be releasing both Job Aids with commentary from experts.    The following summarizes one of the Job Aids regarding minority interests in S Corps.  Look for  a future QuickRead article about the other Job Aid on Reasonable Compensation.

The IRS internal white paper is titled “The IRS Valuation of Non-Controlling Interests in Business Entities Electing to be Treated as S Corporations for Federal Tax Purposes”.  It is dated October 29, 2014. In my forthcoming book I will share my insights to help readers, particularly business appraisers, to enable them to respond to this commentary.   This Job Aid presents background on this topic area from the perspective of the IRS.   The authors of this Job Aid are IRS professionals that examine S Corp valuations.

There has been considerable litigation involving S Corp valuations.  S Corp valuations are often an area of contention between business appraisers and the IRS.  Prior to the Gross case (U.S. Tax Court Memorandum 1999-254) appraisers automatically tax affected an S Corp the same way they valued C Corps.  Six court cases later, the decisions still state:

“We do not, however, think it is reasonable to tax affect an S corporation’s projected earnings with an undiscounted corporate tax rate without facts or circumstances sufficient to establish the likelihood that the election would be lost.”

Given the above, it is significant to note that none of the cases (Gross, Gross on Appeal, Wall, Heck, Adams, Dallas, Gallagher) has overcome this hurdle.  The reason is not surprising; the IRS decides which cases go to court and thus decides which cases present the best facts to sustain the IRS position.  Today, there are practitioners and business appraisers that believe this is a factual issue and others that believe this is a legal issue.  For the business appraiser that elects to tax affect this is the high hurdle that needs to be overcome.

In the forthcoming publication I critique this process and offer business appraisers alternatives to consider when faced with how to value a Subchapter S Corporation and include this as a chapter in the book, Business Appraisers and the IRS[ii] and in the book Valuing Interests in S Corps[iii].   For those pushing the idea that S Corps should always be tax affected similar to C Corps the following is presented as a reminder relative to S Corps:

• Shareholders pay taxes once based on individual rates
• S Corporation shareholders avoid double taxation on the corporate income
• S Corporations are responsible for tax on certain built-in gains and passive income
• Today, there are more S Corps than C Corps (66%) according to IRS data

 And that the provisions for S Corps were formed:

• With Internal Revenue Code Sections 1361 to 1379
• In 1956, and were modified in 1982
• To allow small enterprises advantages
• To allow corporate form without C Corp tax disadvantage

There is no double taxation on an S Corp, but pro rata net income of the S Corp is taxed to shareholders whether shareholders actually receive a distribution or not.   Distributions are taxed at the individual rate.  In addition, there are additional risks for an S Corp such as:

• Changes in federal tax laws
• Changes in federal tax laws affecting S Corps
• Minority versus controlling interests
• Market place for interest

Given the above, it is not surprising that there are at least five models being promoted within the business valuation community.   The authors of the leading models are Fannon, Grabowski, Mercer, Treharne and Van Vleet.  The IRS also appears to be looking at the decision of MRI Radiology Associates from the Delaware Chancery[iv] and would like to potentially litigate on this matter.

There is also an excellent paper written by Nancy Fannon and Keith Sellers entitled “Valuation of Pass-Through Entities: Looking at the Bigger Picture” that was given at the American Taxation Association Midyear Meeting: JLTR Conference, December 2011,[v] that presents excellent information regarding market information associated with a higher Equity Risk Premium (ERP) for S Corps based on research by Dan Dhaliwal et al.    Now, Fannon and Sellers have a book coming out next month titled, Taxes and Value: The Ongoing Research and Analysis Relating to the S Corporation Valuation Puzzle that is sure to be a must read for business valuers.

Business valuation professionals are bound to be engaged to value controlling and non-controlling interests in an S Corporation.  Knowledge of the five leading models is critical.  The new Job Aid with commentary will serve them and their clients well.

Michael A. Gregory, MBA, ASA, CVA, is Managing Member of Michael Gregory Consulting, LLC. The firm provides management, appraisal, and engineering experience to help clients navigate IRS related issues, review appraisals for quality control or litigation, lead strategic planning sessions, train managers, and perform mediation services. Michael worked for the Internal Revenue Service for 25 years and he is an Accredited Senior Appraiser with the American Society of Appraisers (ASA), and a Certified Valuation Analyst with the National Association of Certified Valuation Analysts (NACVA). Michael can be reached at mg@mikegregory.com or at (651) 633-5311.

[i] Michael A. Gregory, Discount for Lack of Marketability and the IRS, (Roseville, Minnesota: Birch Grove Publishing, 2013), 151. www.mikegreg.com

[ii] http://www.mikegreg.com/business-appraisals-and-irs

[iii] http://www.mikegreg.com/valuing-interests-s-corporations

[iv] Delaware Open MRI Radiology Associates v. Kessler, C.A. No. 275-N, April 26, 2006

[v] http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2003901##