Dissecting the IRS Job Aid on S Corporation Tax Affecting

Background and Objectives of the Job Aid (Part 2 of 3)

In the first of this three-part series, the leading cases involving tax-affecting where analyzed; those cases discussed included: Gross, Wall, Heck, Adams, Dallas, Gallagher, Korbel, and Guistina. This second part analyzes the first two parts of the Job Aid by section, the “Executive Summary” and first three subsections of the “Discussion and Analysis”, ending with “Additional Factors for Consideration”.

The second part of this three-part series, analyzes the first two sections of the Job Aid.

Analysis of the Job Aid—by Section

The Job Aid is partitioned into four primary sections: Executive Summary, Discussion and Analysis, Assessment and Synthesis and, finally, Appendices.  Interestingly, the document numbers only 32 pages while, literally, thousands of pages have been dedicated to this topic over the last 15-plus years.

Executive Summary

The Job Aid’s Executive Summary addresses the fundamental tax law framework contained in Subchapter S of the Internal Revenue Code,[1] which dictates the requirements to qualify for S corporation status.  The presentation is basic and without explanation, simply listing the most common statutory requirements.

Interestingly, from this brief overview of the statutory rules, the Job Aid leaps to a broad, and generally, cloudy conclusion that, “The Valuation Analyst should pay specific attention to the risks attendant in a non-controlling interest in an electing S corporation and how these risks are most properly recognized.  Adjustments to the cost of capital and the minority and marketability discounts may or may not be appropriate based on the specific facts and circumstances.”

Discussion and Analysis

This section of the Job Aid sets out a brief Introduction, followed by six separate sub-sections addressing the following items:

• Identification of Property to be Valued;
• Valuation—Background and Approach;
• Additional Factors for Consideration;
• Evidence-Based Valuation Analysis;
• Theory-Based Valuation Analysis; and
• Weighting of Factors and Approaches.

After reintroducing readers to the Gross decision, the Introduction simply provides the process by which the Job Aid was developed and sets up the balance of the document.

The first substantive topic of this section, The Identification of Property to be Valued, sets out the obvious, and accurate, statement, “In any valuation engagement, the threshold question is the identification of the property to be valued.”

The primary content of the balance of that section addresses tax items related to classification of entities as S corporations for Federal income tax purposes and the “Check the Box” rules, including a very minimal discussion of Treasury Regulations 301.7701-1 through 3, governing entity classification selection.  While the issue of entity classification can be quite complex (and presents tax practitioners with significant challenges), the Job Aid, itself, does not provide ample guidance to gain this understanding.  The document does, however, point out that, “Valuation Analysts should familiarize themselves with the pertinent State and local laws, including tax laws, applicable to the specific business entity to be valued.”  Again, this statement, while logical and conveying common sense, does not really provide any additional technical guidance to practitioners or taxpayers.

The section concludes with another broad statement: “The suggestion by some commentators that a Valuation Analyst must apply, as a matter of conventional practice, a valuation paradigm based on taxable corporations (C corporations) to entities that do not pay tax ignores a major factual component, that the entity being valued has chosen its form, including its pass-through tax status, for business reasons.”

Importantly, the Job Aid further notes, “If a valuation is to be persuasive, it must be based on the actual attributes of the interest being valued.  Accordingly, pass-through entities should be, where at all possible, compared to other pass-through entities in the valuation process.”

While the statement is accurate, there are a number of difficulties in applying the concept in the real world of business valuation.  There is rarely sufficient economic, financial, and other information within current available resources to facilitate a direct one-on-one comparison with any aspect of the valuation process.  That being said, it becomes incumbent upon the valuator under professional standards to attempt to research and identify credible sources of information that allow for meaningful application to the subject company under valuation.  Oftentimes, as is well known, this information is imperfect and requires both mechanical and judgmental modification and adjustment to reflect the subject company’s attributes.  Collecting collaborative data on S corporations, costs of capital specific to those entities and specific pricing mandates, and valuation multiples is likely to be a difficult, at best, and possibly fruitless effort, given currently available resources.  Though some studies have started to be published, little credible and widely-accepted evidence exists at this time.  This limitation drives the need to look at after-tax data more commonly available to the business valuation community.

The next sub-section, titled, Valuation—Background and Approach provides some general discussion on Revenue Ruling 59-60.[2]

The Additional Factors for Consideration sub-section discusses the availability of public market data published by Ibbotson Associates (Morningstar, Inc.) (discontinued at the date of this article)[3] and the fact that the information gathered by Ibbotson “reflects entity-level tax in the calculation of reported rates-of-return.”

The discussion goes on to point out, “some commentators have suggested that if the Ibbotson rates-of-return are to be used in a present value calculation of the earnings stream…of an electing S corporation, the S corporation earnings stream should be reduced to reflect an imputed C corporation tax liability.”

The Job Aid offers no commentary or resolution to this observation.  It simply notes that, “It is far from clear that the buyers and sellers of interests in electing S corporations actually analyze their investments in this manner.  A significant feature of the S corporation election is to eliminate the payment of tax at the entity level.  This is an important economic attribute that must be recognized in the valuation of an interest in an electing S corporation.”

An economic reality of any electing S corporation is the expectation that the Company will, ultimately, distribute sufficient cash flow necessary to provide investing shareholders with the means to pay the required Federal and State income taxes on the corporation’s income.  If such were not the case, the investors would require a significantly higher rate of return to allow for the satisfaction of those corporate liabilities passed-through to the shareholder group.  Moreover, the provision of these monies to shareholders to fund the shareholder-level tax liabilities arising from the reporting of corporation income at the shareholder level, acknowledges the lack of availability for the funds for other uses within the corporate operating entity.  Thus, the economic effect is to force the S corporation to distribute cash to pay taxes on its income.

A second common theory set out in this section notes that some have suggested “in the context of a pass-through entity, the definition of entity-level tax should include all of the tax associated with the entity’s operations.”  The Job Aid concludes that this suggestion redefines the valuation standard and moves it from fair market value to investment value while comingling entity-level and investor-level taxes.  The discussion sets out a number of difficulties that might arise in valuator selection of an appropriate individual income tax rate.

Thirdly, this sub-section of the Job Aid notes that while some have suggested the identity of the person who pays the tax is not relevant to the valuation problem, this proposition overlooks the fact that tax structures and rates differ between corporate and individual taxpayers in ways too great to render them irrelevant.

There is nothing new in the above three points; issues with which valuators have struggled mightily since the opinion in Gross was first rendered.  It is noteworthy, however, that while the Job Aid does a competent job of identifying many of the difficult problems, it offers its employees no guidance on how best to deal with those issues in the context of an examination of value.  This failure to include any meaningful new guidance or theoretical approaches to dealing with these complexities renders the Job Aid somewhat less than useful in aiding either the Agency’s employees or the business valuation community.

The Job Aid does minimally speak of “control interests” in this section, setting out the opinion by some that where these interests are involved, there is no difference between electing S corporations and publicly-traded c Corporations.  The Job Aid notes that this position overlooks “important valuation factors that are influenced by the public marketplace” and lists some of these factors.  The commentary in the Job Aid seems to have missed the point as few valuators complying with professional standards would use publicly-traded guideline information (under an income or market approach) without making appropriate adjustments in consideration of factors such as those listed in the Job Aid.  The argument against the assertion that controlling interest valuations of S corporations versus C corporations are similar is in the definition of fair market value and the fact that many potential buyers in the hypothetical universe of buyers would not qualify as S corporation shareholders under the Internal Revenue Code.

Another matter addressed in this section of the Job Aid points out an additional issue regarding the Ibbotson data.  Since that data is after entity-level tax, but before shareholder (investor)-level tax, consideration of shareholder-level taxes in the valuation of S corporation ownership interests represents a “mismatch” and a fundamental error in the valuation of these interests.

In fact, though not yet argued before the Tax Court, studies have shown that the effect of shareholder taxes on C corporation dividends and gains does have a market impact on rates of return set out in the Ibbotson data.  Examples of such studies include work by David A. Guenther and Richard Sansing,[4] as well as Dan Dhaliwal, Linda Krull, Oliver Zhen Li, and William Moser.[5]  An excellent discussion of these studies and the application of the research to cost of capital in determining the value of equity ownership interest in S corporations can be found in the book, Taxes and Value, authored by Nancy J. Fannon and Keith F. Sellers.[6]  This treatise was published after the release of the Job Aid, and the studies noted above are not referenced in the Internal Revenue Service document.

The Additional Factors for Consideration sub-section goes on to address the importance of shareholder agreements in valuing noncontrolling equity ownership interests in electing S corporations, noting that, “perhaps the two most significant investor concerns are the distribution policy…and the differential tax rates that might exist between the corporate level and the shareholder level.”  While this information is well-known to informed practitioners within the business valuation community, it is good to know the Internal Revenue Service is in agreement with current thinking within that community with regard to distribution policies.  In addition to other provisions within any shareholder agreement, obviously, distributions, or lack of distributions, can have an impact on the valuation of these equity interests.

With respect to appropriate tax rates, this section addresses varying circumstances that might call for an applied rate different from the maximum statutory, and marginal rate.  Again, the issue has been framed for some time in the business valuation community but specific guidance for a means to calculate the “correct” tax rate does not exist and the Job Aid provides no further clarification on this issue.

Perhaps the most interesting element in the Additional Factors for Consideration sub-section is the commentary on “The Universe of Hypothetical Buyers” and “The Hypothetical Seller.”  Both concepts are, of course, integral to understanding the fair market value standard of value and require care and study by valuation analysts.

With respect to the former, the Job Aid notes that it is essential to carefully study the buyer universe as “the identity of the available hypothetical buyer for a given interest…will determine many things about the nature of the transfer, including the Federal tax status of the transferred interest.”  Interestingly, the commentary notes: “Valuation theory tells us that, if a mixed universe of potential buyers exists, it is the buyer that does not suffer entity level taxation that will drive the ultimate transaction price, all other things being equal.”

Therein lies the rub—“all other things being equal.”  Most transaction practitioners would note that while the buyer would obviously prefer tax-free status at the entity level, there are many influences on acquisition entity structure in any business purchase.  To suggest the buyer that does not suffer entity level taxation will drive the ultimate transaction price, is to significantly simplify the consideration of the hypothetical buyer.

The discussion in this section goes on to address the need to include within the hypothetical pool, buyers able to qualify as pass-through entities.  Again, this conceptual statement seems exceedingly clear, but there is a lack of guidance on how best to ensure that the pool includes all hypothetical buyers.  The Job Aid adds no clarity to that determination process.

The importance of specific provisions within a Shareholder’s Agreement that restrict transferability of shares are discussed in this sub-section, as well.  These restrictions limit buyers to those that allow for protection of the S corporation’s tax status by prohibiting transfers to nonqualified holders and providing rights of first refusal.  Most often, these provisions affect noncontrolling equity interests.

Both the distribution discussion and the commentary regarding transfer restrictions follow the case law first set out in Gross and followed in other cases.  Though it is now formalized in the Job Aid, the information presented is well-known and simply reflects current common practice in the business valuation arena.

This section also includes a brief discussion of “The Hypothetical Seller.”  The salient point made here is that the hypothetical seller is an integral element of the definition of fair market value—a point no one disputes.  The document states, “Given a potential hypothetical buyer who is able to benefit from S corporation status and, therefore, pay a higher price, the hypothetical seller would not choose a buyer subject to entity-level tax and an inability to pay the higher price.”

Once again, the Job Aid, oversimplifies the issue.  It is impossible to argue against such thinking in a vacuum, but it is more likely that any number of differences in buyers and transactions could influence value and not just tax status, though that item could, and does, impact value, as well.

Finally, a short discussion in this section centers on “The Hypothetical Sale,” reiterating the concepts noted above, and ending with a quote from the Tax Court opinion in Mueller v Commissioner,[7] “Although we have, in prior opinions, identified types of hypothetical buyers, we did so only to determine which valuation approach, among several reasonable approaches, would result in the highest bid, and therefore the one most acceptable to a willing seller…  The question is not so much ‘who’, but ‘how’.”  The point of inserting this quotation seems to be the instruction to Internal Revenue Service personnel that focus should turn to hypothetical parties and transactions that will result in the highest bid, thus first satisfying the primary motivations of the hypothetical seller.

Again, the problem is noted without any solutions being offered.  In addition, there is some question in the minds of many in the business valuation community as to whether the hypothetical sale should be accomplished via the outcome with highest probability, all things considered, or, alternatively, at the highest bid.

The sub-section titled “Identifying the Most Important Factors,” is fairly self-explanatory.  Essentially just a catch-all with little explanation, it identifies factors that specifically affect the valuation of noncontrolling interests in an electing S corporation and “may” deserve special attention.  The list includes cost of capital, marketability discounts, the entity’s ability to raise both debt and capital, a potentially smaller pool of hypothetical investors (due to S corporation shareholder qualification rules), and the impact of investor-level taxes.  There is no question that each of these items can, and does, impact value conclusions.

[1] Internal Revenue Code of 1986, as amended, Title 26, U.S. Code

[2] Revenue Ruling 59-60, 1959-1C.B., page 237

[3] The Morningstar data originally reported by Ibbotson & Associates is available through Duff & Phelps

[4] Guenther, David A. and Sansing, Richard, “The Effect of Tax-Exempt Investors on Stock Ownership and the Dividend Tax Penalty,” October 2007, Kellogg School of Management at Northwestern University

[5] Daliwa, Dan; Krull, Linda; Zhen Li, Oliver; and Moser, William, “Dividend Taxes and the Implicit Cost of Equity Capital,” Journal of Accounting Research, December 2005, Vol. 43, No.5

[6] Fannon, Nancy J. and Sellers, Keith F., Taxes and Value: The Ongoing Research and Analysis Relating to the S Corporation Valuation Puzzle, Business Valuation Resources, 2015, page 53

[7] Estate of Mueller v. Commissioner, T.C. Memo 1992-284, T.C.M. (CCH) 3027-16; 71 T.C.M.

Robert J. Grossman (Bob or Mr. Grossman) heads Grossman Yanak & Ford., LLP’s Tax and Business Valuation Groups. The firm is based in Pittsburgh, PA. Mr. Grossman has over 35 years of experience in tax and valuation matters that affect businesses, both public and private, as well as the stakeholders and owners of these businesses. The breadth of his involvement encompasses the development and implementation of innovative business and financial strategies designed to minimize taxation and maximize owner wealth.

Mr. Grossman can be contacted directly at (412) 338-9304 or by e-mail at grossman@gyf.com.