Book Review—Taxes and Value

The Ongoing Research and Analysis Relating to the S Corporation Valuation Puzzle

What premium, if any, should S Corporations command? How reliable are the current models? How reliable is the evidence that supports the position of the leading U.S. Tax Court cases? What should valuation analysts and consultants consider as they advise newly formed corporations considering making the S election and S corporation shareholders that are about to discuss buy-sell agreements? In this book, Fannon and Sellers critique existing theory and practice and propose a new model to value S corporations.

This past year, Nancy Fannon and Keith Sellers released Taxes and Value: The Ongoing Research and Analysis Relating to the S Corporation Valuation Puzzle (the book is published by BVR and can be purchased through BVR or NACVA).  During the summer of 2015, the authors presented at NACVA’s Annual Conference in New Orleans where they critique, “hypothesis and largely unfounded presumptions that have framed the tax-affecting discussion.”  In this book that, “set forth the findings of decades…that historical market returns impound the effects of shareholder taxes, and these returns can be adjusted to estimate a cost of capital appropriate for pass-through entity valuation.”  Given that it is the beginning of the year, that S corporation shareholders may be discussing exit strategies and buy-sell agreements, and that many valuation analysts provide consulting services too, perhaps it is worth considering what Fannon and Sellers have to say about valuing S corporations.

Chapter 1 presents “The Importance of Matching the Cost of Capital with the Income Stream” which provides an overview of the concept of matching the cost of capital with the income stream.  Significantly, the authors critique analysts that, “derive the cost of capital by reference to long-term historical returns realized in the public market.  In the application of the income approach, a return derived from publicly traded companies is used to value the closely held pass-through entity.  However, there is a mismatch between the pass-through entity and the public-market return used to value it.”  Matters are further complicated because there is a significant distinction between the theory underlying the Tax Court’s holdings and the theory underlying the S corporation models.  The Tax Court has taken the positions that would only be appropriate if personal taxes did not affect value.  In contrast, the valuation profession has generally adopted the position whereby it acknowledges that personal taxes affect value.

While the authors support the latter argument, they opine that the literature reveals the S corporation models are also flawed in that they overstate the magnitude of the taxes actually incurred by public-market investors at the personal level, causing these models to generally reach an overstated value conclusion.  The chapter presents additional data and research and concludes asking, “to what extent have valuation analysts failed to correctly match cash flows with the appropriate cost of capital?”

Chapter 2 presents “Introduction to the Concept of Implicit Taxes.”  The authors explain that implicit taxes can be measured as the difference in per-shareholder tax return that a fully taxable investment and an identical, tax-favored investment generate.  “The classic example would be the difference in rates of returns on a fully taxable bond and an otherwise identical tax-exempt municipal bond.”  The discussion in this chapter and lessons from the bond markets provides the foundation for the discussion found in Chapters 4 and 5.

Chapter 3 provides “An Explanation of the Implications of Shareholder Taxes on the Corporate Cost of Capital.”  The authors assert, “research clearly demonstrates that shareholder-level taxes do affect value” and the chapter provides an explanation of how.  They conclude, “taxes on dividends and capital gains impact corporate cost of capital” and note that Scholes highlighted the difficulty in quantifying the actual expected impact, due to the, “confounding effects of variations in: (1) expected dividend-payout policies; (2) expected holding periods; and (3) shareholder tax clienteles.”

Chapter 4 presents “Literature Review: Research on the Effect of Taxes Embedded in the Cost of Capital.”  The discussion begins with a review of the literature relating to the capitalization of dividend taxes into share price.  The authors focus on findings of Dhaliwal who challenged previous studies—which relied on historical (ex post) returns to support theories of tax capitalization—by testing for dividend tax capitalization using expected (ex ante) required returns.  They note, “this is an important distinction for private-company valuation because the extent of the capitalization of the tax effect varies depending on the market return the analysts selects.”

Chapter 5 discusses the “Impact of Prior Research on Private-Company Valuation.”  The authors reiterate that, “prior research conclusively demonstrates that shareholder-level taxes can impact equity value.”  How should valuation professionals?  The authors warn that, “when a required rate of return metric derived from historical market return is used to value a private company, analysts need to understand the characteristics of that public return data and use care when selecting appropriate data so that the data will best match the characteristics of the subject company.  That is they need to ensure that the cost of capital matches the measure of cash flow used in the valuation.”

The chapter concludes asking, “how is this matching possible, given the amalgam of factors impounded in market returns?  In the following chapters, we discuss the existing alternatives and propose a possible alternative solution.”

Chapter 6 summarizes “Research Related to the Magnitude of Taxes Embedded in the Cost of Capital.”  With respect to the dividend and/or capital gains taxes borne by public market investors, they observe that, “shareholder taxes deducted from cash flow-based models should reflect the fact that public-market investors pay a mix of dividend and capital gain taxes, and many investors pay no taxes at all.  Therefore, the extent of shareholder taxes deducted from public-market C corporation component of calculation should be muted.”  This is consistent with Dhaliwal’s research and “should tell analysts that the shareholder tax embedded in the market is less than the statutory rate.”  Stated otherwise, “research informs us that using the statutory rate in any S corp models almost certainly overstates the magnitude of the calculated premium.”

The authors propose that an alternative to the cash flow based models “is to make an adjustment directly to the cost of capital, where the mismatch arises in the first place.”

Chapter 7 is “An Alternative Approach to the Valuation of Pass-Through Entities.”  Here, Fannon and Sellers review that manner in which the magnitude of tax capitalization has been tested in academic research studies.  In the final chapter, they turn to the application of such research in an alternative to the cash flow-based models.

Chapter 8, “An Alternative Approach to the Valuation of Pass-Through Entities”, presents an alternative valuation model.  They critique traditional approaches that make adjustments for tax effects as a cash-flow adjustment; this is described in Chapter 6.  Significantly, the authors caution that, “private-market valuation analysts use these public-market returns—which they argue are too high—to value private companies whose investors don’t experience dividend and capital gains taxes and, as such, the value of private company should not reflect the effects of the shareholder tax penalty.  Accordingly, this guide suggests that valuation analysts consider adjusting the market return to remove the effect of shareholder tax penalty from it, much in the same way that analysts adjust for size, liquidity, and other factors.

If you value S corporations or advise S corp shareholders, this book is good for reading and using as a reference since there are considerable questions regarding how one should value controlling and minority shareholder interests.

The book is also one that practitioners should use to refer to.  It contains Appendices A through G.  In particular, the appendices contain: “Evolution of Pass-Through Entity Valuation”, “Understanding the Basics of the Cost of Capital”, “Corporation versus S Corporation Transaction Pricing”, and “Digests of Cases Addressing Pass-Through Entity Issues”.  The latter appendix includes renowned cases previously discussed in QuickRead and additional cases that will underscore the very issues valuation analysts will address pre-litigation or in connection with litigation.

Roberto Castro, Esq., MST, MBA, CVA, CMEA is technical editor of QuickRead. Mr. Castro is a Washington State attorney with a focus on business, bankruptcy, exit and succession planning, wills, probate, trusts, and gun trusts. He is a member of WealthCounsel. Mr. Castro is also managing member of Central Washington Appraisal, Forensics and Economics, LLC and a business broker with Murphy Business.
Mr. Castro can be contacted at: (509) 679-3668 or by e-mail to: rcastro@rcastrolaw.com.