Analyst Consideration of Negative Influences on S Corporation Business Values

(Part I of II)

Analysts are quick to identify and quantify the implicit and explicit S status economic benefits in the S corporation business valuation. The objective of this discussion is to summarize the offsetting economic risks associated with an S corporation ownership interest. Analysts should be equally aware—and intentionally consider the risks as well as the benefits—of S corporation status in the subject private company or professional practice valuation. This discussion summarizes many of these risk factors that analysts, private company/practice stockholders, and the company/practice professional advisers should consider in the valuation of an S corporation ownership interest. Part one of this two-part discussion considers the general ownership limitations and the general transferability restrictions related to S corporation stock.

Introduction

The valuation of an S corporation ownership interest is a typical business valuation assignment. Such valuations are regularly developed for transaction pricing, taxation planning and compliance, financial accounting, personal financial planning, financing collateral, family law and other types of litigation, and many other purposes. For purposes of this discussion, the S corporation can be a privately owned company or a professional practice.

In such equity interest valuation analyses, valuation analysts (“analysts”) typically recognize the economic benefits of the S corporation tax pass-through entity (TPE) status—compared to that of a C corporation tax status. Analysts have developed a variety of procedures to quantify the value impact (typically the value increment) associated with the S corporation’s TPE status. Many of these procedures involve the following three-step process: (1) value the subject entity as if it were a C corporation, (2) separately measure some (or all) of the federal income tax benefits related to the subject entity’s S corporation tax status, and (3) sum the two value components to conclude the total value of the subject S corporation ownership interest.

However, analysts sometimes neglect to account for the fact that there are negative influences as well as positive influences associated with an entity’s S corporation income tax status. Such negative influences include restrictions on the number of and type of company or practice shareholders, limitations on the current shareholders’ ownership exit opportunities, inadvertent disqualification events regarding the S corporation status, special tax situations upon the death of the S corporation shareholders, state income tax requirements for S corporations, and other issues that may negatively impact the value of an S corporation ownership interest.

In business and security valuations developed for transaction, taxation, litigation, and any other purpose, the analyst should be aware of—and intentionally consider—the “cons” as well as the “pros” of the subject entity’s S corporation income tax status.

There are special tax considerations related to the transfer of S corporation stock at the time of the owner’s death. Therefore, owners of S corporation stock have to be intentional with regard to the risks (and the tax costs) associated with an inadvertent termination of the subject entity’s S corporation status. Also, S corporation owners—and analysts—should be aware that many states tax S corporations for state corporation income tax purposes. Many states tax S corporations as if they were C corporations. In addition, many other states apply a special corporate income tax rate to S corporations.

The point of this discussion is that there are both positive and negative influences on the value of an S corporation business entity. This discussion will not recommend specific analyst procedures related to the measurement of the S corporation status value premium. Likewise, this discussion will not recommend specific analyst procedures related to the measurement of the discount for lack of marketability (DLOM) or any other value decrement related to an entity’s S corporation tax status. Such recommendations are beyond the scope of this discussion; these procedural topics have been thoroughly addressed in the valuation professional literature.

Analysts are quick to identify and quantify the implicit and explicit S status economic benefits in the S corporation business valuation. The objective of this discussion is to summarize the offsetting economic risks associated with an S corporation ownership interest. Analysts should be equally aware—and intentionally consider the risks as well as the benefits—of S corporation status in the subject private company or professional practice valuation. This discussion summarizes many of these risk factors that analysts, private company/practice stockholders, and the company/practice professional advisers should consider in the valuation of an S corporation ownership interest.

Part one of this two-part discussion considers the general ownership limitations and the general transferability restrictions related to S corporation stock. Part two of this discussion will consider the inadvertent disqualification risks, the tax consequences at the time of the S shareholder’s death, and the state income tax considerations related to S corporation stock ownership.

Summary of S-Corporation Economic Benefits

The economic benefits of electing S corporation federal income tax status are generally well known. An S corporation is sometimes referred to as a hybrid-type of business organization, between a C corporation and a partnership. The S corporation tax status avoids the double taxation disadvantage associated with the typical privately owned C corporation. In an S corporation, all entity-level income, losses, deductions, and certain credits pass through to the company/practice shareholders. That is why an S corporation is frequently referred to as a TPE. For federal income tax purposes, all of the entity’s income is taxed once, at the shareholder level. (Again, some states may tax S corporation income at the entity level.)

Not having to pay federal income taxes at the entity level is the principal economic benefit of the S corporation election. This particular economic benefit may be most valuable in the early years of an entity’s business life. This is because the start-up or early-stage entity may have limited liquidity. The cash that would otherwise go to make C corporation income tax payments could be used to fund growth-related operating expenses, working capital investments, or capital expenditures.

It is noteworthy that S corporations are exempt from federal income taxes on most—but not all—income. For example, certain capital gains and passive income are subject to federal taxation at the S corporation level.

In addition, the S corporation tax status may reduce the total income tax liability of the privately owned company/practice stockholders. By characterizing the cash distributions from the company/practice as either salary payments or dividends/distributions, the shareholder/employees may be able to reduce their self-employment taxes. The S corporation is allowed to deduct business expenses and reasonable salaries paid to employees (including shareholder/employees).

S corporation shareholders can be company/practice employees. Such employee/shareholders can earn salaries that are deductible by the company/practice. In addition, such employee/shareholders can also receive distributions of the company/practice profits on a tax-free basis—as long as the distributions do not exceed the shareholder’s stock basis. If the distributions do exceed the shareholder’s stock basis, then the excess may be taxed as capital gains (i.e., at a lower tax rate than would apply to ordinary income.).

Outside of the taxation area, incorporation may provide credibility to a start-up, early-stage, or other privately owned company or professional practice—compared to either sole proprietorship or partnership status. That is, potential customers, suppliers, landlords, employees, bankers, and others may find a corporation entity to be more credible—compared to a similar sized partnership or proprietorship. And, like any other corporation, an S corporation provides certain legal liability protections to the company or practice owners—compared to the proprietorship or partnership form of business organization. For example, S corporation status (and limited liability company [LLC] status) provide the assets of the business owners with certain protection from business creditors. In addition, the S corporation (and the LLC) business owners generally cannot be held personally responsible in lawsuits filed against the company/practice.

Risks Associated with the S Corporation Income Tax Status

S corporations are permitted under Subchapter S of the internal Revenue Code. An S corporation is defined in Internal Revenue Code Section 1361. To achieve S corporation income tax status, the entity has to file Form 2553, Election by a Small Business Corporation. The Form 2553 should be signed by all of the company/practice shareholders. The Form 2553 should be filed with the Internal Revenue Service (1) within 75 days of the company’s initial incorporation or (2) within 75 days after the beginning of each tax year. The Service may accept the filing of an S election after the 75-day period has passed, but the Service is not requested to do so.

Valuation analysts, private company/professional practice owners, and the company/practice professional advisers are generally familiar with the economic benefits associated with S corporation tax status. The most significant of these economic benefits were summarized above. In particular, the taxation-related benefits of S corporation status are well known. Analysts have developed numerous methods and procedures to incorporate the value increment—or value premium—associated with this tax status election into the valuation of S corporation ownership interests. These methods and procedures are generally described in the professional valuation literature and will not be repeated here.

As with most federal taxation elections, there are risks as well as benefits associated with the S corporation income tax status. Private company and professional practice owners should consider these risks when making investment, transaction, financing, taxation, and even litigation decisions. The shareholders’ financial and estate planners should consider these risks when making and implementing personal financial planning or estate planning recommendations to owners of private companies and professional practices. Legal counsel should consider these risks with regard to family law, bankruptcy, shareholder disputes, and other controversy decisions related to the client’s private company or practice. And valuation analysts should consider these risks in the valuation of the S corporation business entity and the S corporation securities.

Analysts may consider that such risks may have a decremental impact or negative influence on the subject entity’s value. Analysts may consider if that impact or influence may partially offset or mitigate the incremental value—or the value premium—associated with the entity’s S corporation status. These analyst considerations are the primary focus of this discussion. Some of the risks associated with an S corporation ownership interest are summarized below. The analyst should be aware of these risks—and their associated value influences—when developing and reporting the S corporation valuation analysis.

A description of how (procedurally) the analyst incorporates these risk considerations is beyond the scope of this discussion. Some analysts have considered incorporating these risk factors into one or more of the following business and security valuation variables:

1. The development and final selection of the present value discount rate or the direct capitalization rate in the application of the business valuation income approach.
2. The assessment, adjustment, and final selection of valuation pricing multiples (whether capital-market-derived or transaction-derived) in the application of the business valuation market approach.
3. The identification and measurement of goodwill (or of the recognition of some type of deferred tax liability) in the application of the business valuation asset-based approach.
4. The recognition (a) of some increment in the assessment and measurement of an entity level value adjustment for illiquidity or (b) of a security level value adjustment for lack of marketability in the valuation synthesis and conclusion process.
5. Other adjustments (a) to the valuation variables applied or (b) to the value indications concluded.

The only best practice recommended by this discussion is that the analyst (and the business owner, the financial or estate planner, the legal counsel, and any other professional advisers) should consider both the following risks (i.e., economic disadvantages) as well as the above-described benefits (i.e., economic advantages) in any analysis of the S corporation.

Restrictions on the Number and Type of S Corporation Shareholders

Internal Revenue Code Section 1361 provides the limitations and restrictions regarding the permissible S corporation shareholders. A company or practice elects to become an S corporation under the provisions of Section 1362. The most common of the Section 1361 limitations and restrictions are listed below:

1. The company/practice has to be a domestic corporation or other entity.
2. The company/practice may have no more than 100 shareholders at any one time. (An individual and his or her spouse are considered to be one shareholder.)
3. Each of the S corporation shareholders has to be an individual, estate, trust, tax-exempt organization, or another S corporation (a C corporation or a partnership cannot be an S corporation shareholder).
4. The company/practice may not have a nonresident alien as a shareholder.
5. The corporation may only have one class of stock. All of the company stock should have the same rights with regard to profit distributions and liquidation distributions.
6. The company/practice may not be an ineligible corporation, including a financial institution, an insurance company, or a domestic instruction sales corporation (DISC).
7. The company/practice has to have to adopt either a December 31 tax year-end (the most common) or a natural business year-end, an ownership tax year, or a 52- or 53-week tax year.
8. The company/practice has the consent of each of the shareholders. (If two spouses have a community interest in the S corporation stock, then both spouses need to consent.)

First, to be an S corporation, the business should be a corporation or entity based in the United States.

Second, the company or practice may have no more than 100 shareholders at any one time. Shareholders may buy and sell the S corporation stock during the year. So, in total, the company/practice may have more than 100 recorded shareholders throughout the year. But the company/practice may not have more than 100 shareholders at any one point in time.

Members of a family may be treated as one shareholder. A husband and wife (the terms used in Section 1361(c)(1)(A)(i) and their estates are treated as one shareholder. Also, all members of a family (and their estates) are treated as one shareholder. Section 1361(c)(1)(B)(i) states: “The term ‘members of a family’ means a common ancestor, any lineal descendant of such common ancestor, and any spouse or former spouse of such common ancestor or any such lineal descendant.”

Third, the Internal Revenue Code prohibits most types of entity from being shareholders of an S corporation. Even individuals have to meet the qualifications to be shareholders of an S corporation. To be an S corporation shareholder, an individual has to meet one of the following two qualifications:

1. Be a U.S. citizen
2. Be a permanent resident of the U.S.

So, individuals who are not U.S. citizens or U.S. residents cannot be shareholders in an S corporation.

Fourth, the following types of taxpayers are not allowed to own stock in an S corporation:

1. A C corporation
2. A partnership
3. A nonresident alien
4. A foreign trust
5. A multiple-member limited liability company
6. A limited liability partnership
7. An individual retirement account (IRA)

Fifth, Section 1361(b)(1)(D) clearly indicates that an S corporation may not have more than one class of stock. However, Section 1361(c)(4) provides for differences in common stock voting rights as follows: “For purposes of subsection (b)(1)(D), a corporation shall not be treated as having more than one class of stock solely because there are differences in voting rights among the shares of common stock.”

Sixth, an “ineligible corporation” cannot be an S corporation shareholder. The term “ineligible corporation” is defined in Section 1361(b)(2) as follows:

For purposes of paragraph (1), the term “ineligible corporation” means any corporation which is:

1. A financial institution which uses the reserve method of accounting for bad debts described in Section 585,
2. An insurance company subject to tax under subchapter 2, or
3. A DISC or former DISC.

Seventh, there are several requirements related to the selection of the S corporation’s tax year. To be an S corporation, the business has to change to or adopt one of the following tax years:

1. The calendar year ending December 31
2. A period of 12 consecutive months that ends during a low period of business activities
3. An ownership tax year
4. A tax year selected pursuant to Section 444
5. A 52- or 53-week tax year, if the company’s fiscal year is maintained on the same basis
6. Any other tax year for which the company demonstrates a valid business purpose

Eighth, Section 1362 describes the shareholder election requirements related to an S corporation. Section 1362(a)(2) states that all shareholders must consent to the S election, as follows: “An election under this subsection shall be valid only if all persons who are shareholders in such corporation on the day in which such election is made consent to such election.”

Given the above-listed restrictions, then, who can be an S corporation shareholder? With respect to individual shareholders, we know that any U.S. citizen or U.S. permanent resident can be an S corporation shareholder. However, many types of entities are prohibited from being the owner of an S corporation. The types of entities that are permitted to be S corporation shareholders fall into three general categories:

1. Single-member businesses
2. Estates of recently deceased S corporation shareholders
3. Bankruptcy estates of S corporation shareholders who have recently filed for bankruptcy

In many of the above-noted instances, the entity is allowed to only hold the S corporation stock on a temporary basis. That is, the Internal Revenue Code allows such temporary ownership in order to prevent the collapse of the S corporation due to the bankruptcy or the death of the S corporation shareholder.

In addition to the above types of entities, the following list includes some of the entities that can be an S corporation shareholder:

1. Single-member S corporations, the owners of which are U.S. citizens or U.S. permanent resident
2. Certain S corporations called Qualified Subchapter S Corporations
3. Grantor trusts (also known as living trusts)
4. Some testamentary trusts
5. Some tax-exempt organizations (including not-for-profit entities)
6. Some voting trusts
7. Some irrevocable trusts

Accordingly, there are a number of types of individuals and types of entities that may own S corporation stock. This discussion is not intended to imply that there is no liquidity related to the S corporation or the S corporation shares. That said, when measuring the impact of liquidity (or the lack thereof) on the value of the S corporation business entity or the S corporation shares, the analyst should consider that the following types of individuals and entities may not own S corporation stock: all foreign individuals (who are not permanent U.S. residents), all partnerships, all C corporations, all multi-member limited liability companies, all limited liability partnerships, all business trusts, all foreign trusts, and all IRAs.

Analyst Considerations Regarding S Corporation Liquidity

Ignoring the investment risks associated with S corporation inadvertent disqualification (in part two of this discussion) and other risk factors, the analyst should appreciate that S corporation stock is generally less liquid than identical C corporation stock. Let’s assume that the subject S corporation has the same owner legal protections and the same other legal benefits of the hypothetical comparable C corporation. Let’s assume that the subject S corporation has the same entity size, expected growth rate, profit margin, return on investment, and other financial and operational attributes as the hypothetical comparable C corporation. The fact is, there are simply fewer market participants available that would qualify to be a willing buyer to transact with the S corporation current owner/willing seller.

There is a smaller pool of willing buyers who could own (and, therefore, who could buy) the S corporation stock—compared to the otherwise identical C corporation stock. The analyst should consider this more limited population of potential market participants somewhere and somehow in the valuation analysis. The analyst may incorporate these considerations in the individual valuation analyses. That is, the analyst may account for these considerations within the valuation approaches and methods developed within the analysis. Or the analyst may incorporate these considerations as a component of a discount for lack of marketability (DLOM) or of some other type of valuation adjustment when reconciling the various value indications into a final value conclusion.

These considerations should be accounted for in valuations developed for accounting, taxation, litigation, and planning purposes—as well as for other purposes. In addition, these considerations have practical implications for S corporation transaction pricing and structuring purposes. That is, the limitations and restrictions regarding the number and the type of S corporation shareholders may directly impact the exit strategies available to the S corporation owners seeking an ownership transition.

Impact of Limitations on S Corporation Exit Strategies

Most owners of either private companies or professional practices must eventually plan for an ownership transition. This statement applies to most family-owned businesses. And, this statement generally applies to most private companies or professional practices, whether or not they are closely held by family members. The current manager/owners eventually want to retire. And, eventually, all manager/owners face the inevitable end of life.

Many owners of successful private companies or professional practices may consider an initial public offering of the company stock as a potential exit strategy. Other owners may consider the sale of the company or the practice to a strategic competitor, a sale to a private equity sponsor, a sale through a roll-up transaction involving several companies, a sale to the company non-owner management team, or a sale to the general employees through an employee stock ownership plan (ESOP) or other structure. Even those business owners who are planning to “keep the company in the family” are de facto considering an ownership transition transaction. Such an ownership transfer to the next generation could be accomplished by sale, gift, or bequest.

Implicitly or explicitly, analysts incorporate exit strategies (whether well-developed or amorphous) into their business valuation analyses. All generally accepted business valuation approaches and methods incorporate some type of residual value, reversionary value, or terminal value. Such value components may be implicit in the analysis. But even the assumption that the company or practice will generate income forever implicitly assumes that, at some point, there will be a new owner to enjoy the benefit of that expected future income.

However, if the company or practice wants to retain its S corporation status, several typical ownership transition or exit strategies may not be available to it. For example, the S corporation cannot be a publicly traded company. Some private equity or other types of investors may not be interested in buying the S corporation (unless it converts to a C corporation first). The same reluctance to purchase may be the case with a large C corporation strategic acquirer (whether it is public or private). The C corporation buyer cannot be an S corporation shareholder.

Other exit options may be available but may be limited with regard to implementation or structure. Typically, an ESOP can own an S corporation. However, many ESOP acquisitions involve multiple classes of equity. The ESOP sponsor company employees may buy one class of stock through the ESOP trust. The sponsor company management may buy a different class of stock. Certain founding family members may retain a different class of stock—at least for a period. However, such a more complex (but typical for an ESOP acquisition) capital structure would violate the one class of common stock restriction for the S corporation.

Again, one way or the other, the analyst may have to accommodate these exit strategy restrictions in the S corporation business valuation. And, the current business owners, the legal counsel, and other professional advisers should consider these restrictions in their transaction, taxation, litigation, or planning deliberations.

Summary

Valuation analysts are regularly retained to value S corporations and S corporation ownership interests for taxation, financial accounting, personal financial planning, litigation, and many other purposes.

The TPE economic benefits of S corporation status are generally well known to analysts—and to S corporation shareholders, estate planners, tax counsel, and other professionals. Over the years, analysts have developed generally accepted methods and procedures for incorporating the value increment (often called a value premium) associated with these TPE benefits into the valuation analysis.

There are statutory restrictions and limitations on the type of—and the number of—S corporation shareholders. These restrictions may impact the DLOM—or other valuation adjustments—related to the S corporation stock. Such restrictions may impact the company owners’ retirement exit planning, and ownership transaction strategies. These restrictions may impact the liquidity—or other value adjustment—related to the S corporation business enterprise. These risks were discussed in part one of this two-part article.

Part two summarizes some of the other risks associated with S corporation ownership. Many of these risks relate to an inadvertent disqualification and termination of the S status. These risks typically impact both the S corporation itself and the company shareholders. Some of these risks are specific to the transfer of S corporation ownership interests at the time of the shareholder’s death. Even these shareholder-death-related risks can impact the S corporation as well as the deceased shareholder’s estate.

Analysts should also recognize that S corporations are subject to a state level TPE income tax in many states. Some states apply the regular corporation tax rate to the TPE. Some states apply a reduced income tax rate to the TPE. As discussed in part two of this article, analysts—and other interested parties—should not ignore state income tax considerations in the valuation of an S corporation.

The opinions and materials contained herein do not necessarily reflect the opinions and beliefs of the author’s employer. In authoring this discussion, neither the author nor Willamette Management Associates, a Citizens Company, is undertaking to provide any legal, accounting or tax advice in connection with this discussion. Any party receiving this discussion must rely on its own legal counsel, accountants, and other similar expert advisors for legal, accounting, tax, and other similar advice relating to the subject matter of this discussion.

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Robert Reilly, CPA, ASA, ABV, CVA, CFF, CMA, is a Managing Director in the Chicago office of Willamette Management Associates, a Citizens company. His practice includes valuation analysis, damages analysis, and transfer price analysis.

Mr. Reilly has performed the following types of valuation and economic analyses: economic event analyses, merger and acquisition valuations, divestiture and spin-off valuations, solvency and insolvency analyses, fairness and adequacy opinions, reasonably equivalent value analyses, ESOP formation and adequate consideration analyses, private inurement/excess benefit/intermediate sanctions opinions, acquisition purchase accounting allocations, reasonableness of compensation analyses, restructuring and reorganization analyses, tangible property/intangible property intercompany transfer price analyses, and lost profits/reasonable royalty/cost to cure economic damages analyses.

Mr. Reilly has prepared these valuation and economic analyses for the following purposes: transaction pricing and structuring (merger, acquisition, liquidation, and divestiture); taxation planning and compliance (federal income, gift, estate, and generation-skipping tax; state and local property tax; transfer tax); financing securitization and collateralization; employee corporate ownership (ESOP employer stock transaction and compliance valuations); forensic analysis and dispute resolution; strategic planning and management information; bankruptcy and reorganization (recapitalization, reorganization, restructuring); financial accounting and public reporting; and regulatory compliance and corporate governance.

Mr. Reilly can be contacted at (773) 399-4318 or by e-mail to RFReilly@Willamette.com.