S Corporation Valuations

Avoiding the Chaos and Selecting the Proper Methodology

Over the past 20 years, business valuation analysts (and the courts) have debated whether there is an S corporation premium vis-à-vis the C corporation. This debate has led to the profusion of models and confusion. Four predominant models currently in use include: the Fannon, Delaware MRI, Van Vleet’s SEAM, and Treharne Model. Each of these models makes a different assumption. As for the similarities and differences of the four models, James Hitcher in this September 30, 2021, VPS StraightTalk Series primarily focused on Van Vleet, Delaware MRI, and Treharne model. The webinar was co-led by James Hitchner and Samuel Y. Weissinger. This article summarizes some of the issues discussed; readers of QuickRead may consider subscribing to the series or, alternatively, contacting VPS to listen to this presentation and downloading two articles that accompanied the PowerPoint presentation.

Over the past 20 years, business valuation analysts (and the courts) have debated whether there is an S corporation premium vis-à-vis the C corporation. This debate has led to the profusion of models and confusion. The models used have changed over time. For the purpose of this webinar, four models were mentioned, including: the Fannon, Delaware MRI, Van Vleet’s SEAM, and Treharne Model. Each of these models makes a different assumption. As for the similarities and differences of the four models, James Hitcher in this September 30, 2021, VPS StraightTalk Series primarily focused on Van Vleet, Delaware MRI, and Treharne model. The webinar was co-led by James Hitchner and Samuel Y. Weissinger. This article summarizes some of the issues discussed in this webinar; readers of QuickRead may consider subscribing to the series or, alternatively, contacting VPS to listen to this presentation and downloading two articles that accompanied the PowerPoint presentation.

Review of S Corps: Genesis

The S corp, also known as the subchapter or small business corporation, is a tax code that was enacted into law by Congress in 1958. The S corp was created to encourage and support the creation of small and family businesses, while eliminating the double taxation that conventional corporations were subjected to. S corps are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corps report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corps to avoid double taxation on the corporate income. S corps are responsible for tax on certain built-in gains and passive income at the entity level.

To qualify for S corp status, the corporation must meet the following requirements:

• Be a domestic corporation
• Have only allowable shareholders
  • May be individuals, certain trusts and estates, and
  • May not be partnerships, corporations, or non-resident alien shareholders
• Have no more than 100 shareholders
• Have only one class of stock
• Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations)

Despite the popularity of S corp and debate on whether there was and remains an S corp premium, the consensus is “no”; there is none now. The view is that TCJA has impacted both C and S corps. In S corp engagements, valuation analysts must pay special attention to: 1) the standard of value that will apply; (2) the premise of value (and consider whether the S corp election will continue and whether the entity is a going concern); 3) the percentage ownership that is the subject of the calculation or conclusion of value (Is a controlling interest the subject of the valuation? A minority interest?); and 4) cash distributions being made by the entity (Is the S corp distributing 100%? Less than 100% of the cash flow?).

So, what is going on with S corp valuations? The consensus is that S corps should be tax adjusted and valuation analysts must consider the newer C corp and individual rates, as well as the distributions to pay the tax.

IRS S Corp Job Aid

The IRS S Corp Job Aid, published in 2014, remains a source that valuation practitioners need to consider in their engagements. It may be due for revision, post TCJA. Quotes such as:

“With respect to the attribute of pass-through taxation, absent a compelling showing that unrelated parties dealing at arms-length would reduce the projected cash flows by a hypothetical entity level tax, no entity-level tax should be applied in determining the cash flows of an electing.”

“In the same vein, the personal income taxes paid by the holder of an interest in an electing S corporation are not relevant in determining the fair market value of that interest.”

are contrary to the prevailing view and contrary to the position the Job Aid takes in other parts where it states and recognizes that:

 “If a valuation is to be persuasive, it must be based on the actual attributes of the interest being valued”.

“If an S corporation distributes just enough of its earnings to cover the interest holders’ tax liabilities, there may be little potential valuation difference at the investor level between the S corporation and a taxable entity, assuming similar tax rates at the entity and investor levels.”

“If the S corporation distributes less than the tax liability amount, an interest in the taxable entity could potentially be more valuable.”

The later points reveal an inconsistency in the Job Aid, but also acknowledges what most practitioners believe. So, should S corporations be tax affected? Hitchner answers, “yes”.

The TJCA: Is there Now a C Corp Premium?

In this section, Hitchner expresses the view that perhaps no S corp premium ever existed; however, as for service business, the answer is “yes”, but it is gone with passage of the TCJA. For non-service businesses, the answer depends on the model being used, but the view is that too is gone (if it ever existed). As for the use of an S corp premium, applied to a minority interest, that is a mistake and does not make sense since applying a premium to the minority interest, the end result is that the cumulative effect of doing so is that the sum of the minority interests would exceed the controlling interest value.

The Four Models

The four models discussed in the webinar are applied to controlling interests.

Fannon Model

While the Fannon model was discussed, Hitchner and Wessinger focused on Van Vleet, Delaware MRI, and Treharne.

Van Vleet SEAM Model

Van Vleet’s SEAM model assumes that investors are indifferent to unrealized capital appreciation vs. cash distributions. In Hitchner’ s opinion, that is assumption rarely stands. Recently, Van Vleet has recently updated the 2002 SEAM model. The newer SEAM version adapts to the TJCA, particularly with the use of temporary and permanent periods for various factors. The SEAM model also prepares the model to adjust for service and non-service businesses.

The presentation includes an illustration of model that summarizes the steps recommended by Van Vleet.

Delaware MRI

Delaware MRI is a 2006 case. According to Vice Chancellor Stine, to “be consistent with Delaware law, I must tax affect Delaware Radiology’s future cash flows at a lower level that recognizes the full effect of the Kessler Group’s ability to receive cash dividends that are not subject to dividend tax rates. In order to accurately capture the value to the Kessler Group of Delaware Radiology’s S corp status, I have estimated what an equivalent, hypothetical ‘pre-dividend’ S corp tax rate would be.”

The advantage of this model is that it is easy to apply and to explain. The disadvantage of this model is that it assumes 100 percent income is distributed in perpetuity, it assumes statutory tax rates, does not reflect holding period or distribution expectations of the investor, and the application of debt-free earnings may result in error in calculation of the equity value.

The illustration used by Hitchner and Wessinger explains how this model would be applied to non-service and service businesses.

Treharne Model

The traditional Treharne model adjusts a discounted cash flow method or capitalized cash flow method to reflect the minority shareholder’s allocable share of cash flows based on the sum of:

• Present value of retained cash flow,
• Present value of net cash flow to investor,
• Present value of the double taxation adjustment, and
• Present value of the tax-rate differential adjustment.

Each component is calculated separately by the model. The Treharne model is the only model that differentiates value based on the amount of cash flow distributed to the S corp shareholder.

The Treharne model makes further assumptions that the analyst can handle (and adjust) to the base model and those include:

• Assumes cash flows retained by the entity build-up in cash,
• Does not reflect potential misuse of retained cash flows by the control investor(s),
• Does not assume reinvestment of cash flows in entity to grow business or make acquisitions that could result in accretive value to investor,
• Does not capture any interest or other return on cash, and
• Without adjustment, could have distributions of net income greater than actual cash flows, implying a requirement for debt financing.

The webinar material includes an illustration of the four steps and guidance on what practitioners should consider if they use this model.

Case Law

Hitchner and Wessinger spend time discussing case law. James F. Kress and Julie Ann Kress v. United States of America, Case No. 16-C-795, United States District Court Eastern District of Wisconsin, March 25, 2019, is considered a “big deal”; one that suggests that there may be an agreement now between the Service, practitioners, and courts regarding the merits of tax affecting; all three experts in this case tax affected the earnings of the S corp.

The presentation includes the views expressed by Z. Christopher Mercer and Van Vleet on the significance of the case; Mercer sees it as rightly decided, while Van Vleet expresses reservations and urges readers of the decision to be cautious when interpreting this and other court decisions.

The webinar also included a discussion of Estate of Aaron U. Jones v. Commissioner, T.C. Memo. 2019-101. Here, Hitchner shares that it is his impression that, “the door is now open for valuation professionals to provide more support for their PTE valuation conclusions that recognize tax differences relative to C corp data used to value PTEs.” In addition, Hitchner is of the view that, “in the post TCJA era, PTEs are more likely to have larger income tax liabilities than C corps because personal income tax rates assessed against PTE income are often higher.”

Conclusion

This webinar was marketed to advanced practitioners; however, it includes sufficient information to allow newer practitioners to learn quickly. During the webinar, there were 6 polls, and these reveal a fair amount of differences amongst attendees on how they handle S corp valuations. This webinar addressed several of the popular models used by business valuation professionals and highlighted the differences between them and the respective advantages/disadvantages of each. That was useful. Further, the webinar included a summary of the Kress and Jones cases and views held by leading practitioners in the field with regard to how to value S corps.

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Roberto H. Castro, JD, MBA, MST, CVA, is Managing Member of the Law Office of Roberto H Castro, PLLC and Legal Compliance counsel for Equilus Capital Partners, LLC, a closely held Real Estate Limited Partnership Fund. He is also Technical Editor of QuickRead and a member of NACVA’s CUV team.

Mr. Castro can be contacted (509) 679-3668 or by e-mail to rcastro@rcastrolaw.com.