So-called “pass-through” entities — including partnerships, limited liability companies (LLCs) and S corporations — generally aren’t required to pay entity-level taxes. So, when it comes to valuing a small business structured as a pass-through entity for tax purposes, people often wonder: Would investors pay a premium for an interest in this business compared to an interest in an otherwise identical C corporation? And, if so, how much is this favorable tax treatment worth? This is the crux of the tax-affecting debate.
Much of the litigation regarding this issue comes from the IRS and tax courts. But a recent Tennessee Court of Appeals decision discusses this issue in the context of a shareholder buyout. (Raley v. Brinkman, No. 2018-02002, Tenn. App., July 30, 2020)
Upsides and Downsides of Pass-Through Status
For pass-through entities, all items of income, loss, deduction and credit pass through to the owners’ individual tax returns, and taxes are paid at the personal level. Distributions to owners generally aren’t taxable to the extent that owners have positive tax basis in the entity.
For the most part, operating as a pass-through entity is a smart tax-saving strategy. However, this favorable tax treatment is less advantageous if the business doesn’t distribute enough cash to cover the owners’ tax obligations related to the company — or if the business no longer qualifies (or plans) to operate as a pass-through entity.
If a pass-through entity distributes just enough of its earnings to cover the owners’ tax liabilities, there may be little potential valuation difference at the investor level between the pass-through entity and a taxable entity, assuming similar tax rates at the entity and the investor levels. If the pass-through entity distributes larger amounts of earnings to the owner, the interest becomes potentially more valuable than an equal interest in a taxable entity, all other things being equal. If the pass-through entity distributes less than the tax liability amount, an interest in the taxable entity could potentially be more valuable in the hands of the owner.
Court Allows Tax Affecting
The tax-affecting issue took center stage in a recent buyout case involving two equal partners in a restaurant that generated roughly $3.4 million in gross annual income in 2016. When the owners disagreed about how to manage their business, a Tennessee trial court ordered a buyout of one of the owner’s interest at “fair value” under applicable state law.
The business operated as an LLC that elected to be treated as an S corporation for income tax purposes. The trial court allowed the buyout price to include a hypothetical 38% corporate income tax rate to the restaurant’s earnings. But the seller (plaintiff) appealed, arguing that tax affecting wasn’t appropriate for a pass-through business that wasn’t subject to entity-level tax.
The buyer (defendant) contended that tax affecting was appropriate because the income from an S corporation passes through to the owners’ individual tax returns and is taxed at the owners’ personal tax rates. He also argued that valuation experts commonly use after-tax income values to calculate the capitalization rate under the income approach.
The appellate court explained that the problem with using the income approach to value a pass-through entity is that it’s designed to discount cash flows of C corporations, which are taxed at both the entity and the shareholder level. Income from an S corporation is taxed only at the shareholders’ personal level.
Citing the landmark Delaware Open MRI Radiology Associates case, the appellate court concluded that declining to tax affect an S corporation’s earnings would overvalue it, but charging the full corporate rate would undervalue it by failing to recognize the tax advantages of S status. The court also determined that it was appropriate to use an after-tax earnings stream because the expert’s capitalization rate was based on after-tax values.
Finally, the appellate court cited the Estate of Jones. In this U.S. Tax Court case, the court concluded that the cash flows and discount rate should be treated consistently when valuing a pass-through entity.
Did You Know…Roughly three-quarters of small businesses operate as “pass-through” entities, according to the National Federation of Independent Businesses, a small business advocacy group. In addition to the tax benefits of operating a pass-through business, limited liability companies (LLCs) and S corporations provide limited liability protection for owners. Likewise, limited partners may enjoy limited liability from actions taken by general partners.Which entity type is right for your business? Contact your tax and legal advisors to discuss the options. |
IRS Job Aid Provides Insight
The debate over tax affecting pass-through entities has persisted for decades. To help clarify matters, the IRS has published a job aid entitled “Valuation of Non-Controlling Interests in Business Entities Electing To Be Treated As S Corporations for Federal Tax Purposes.” This document helps IRS valuation analysts evaluate appraisals of minority interests in S corporations for federal tax purposes.
However, the job aid provides useful guidance on the issue of tax affecting that may be applied more generally to all types of pass-through entities that are appraised for any purposes, not just for tax reasons. Business valuation experts may use this job aid as a reference tool to help support their decisions to apply tax rates to the earnings of pass-through entities when projecting future cash flows.
According to the job aid, if a valuator tax affects a company’s earnings, he or she must provide valid reasons that a hypothetical investor would discount the earnings for entity-level taxes. The job aid points out that, while avoiding entity-level taxes is an important benefit to consider when valuing an S corporation, experts also must consider the downsides to owning a minority interest in an S corporation. Disadvantages include how much the company distributes to shareholders, and whether there’s a differential between tax rates at the corporate level and the investor level.
The job aid lists the following factors to consider when deciding how to handle entity-level taxes:
- Size and composition of the pool of hypothetical buyers,
- Economic interests of the hypothetical seller,
- Actual revenues available and the actual expenses to be paid by the entity that has elected to be taxed as an S corporation,
- Availability at the entity level of equity and debt capital, and
- Probable holding period of the transferred interest.
Whenever possible, the job aid recommends comparing a pass-through entity to other pass-through entities in the valuation process. But that’s often difficult, because much of the data used to value private businesses comes from the public markets, which are made up primarily of C corporations.
No Bright-Line RulesWhen it comes to tax affecting pass-through entities, there’s no clear-cut guidance that prescribes a specific tax rate — or denies tax affecting altogether. Rather, tax affecting may be permitted on a case-by-case basis, depending on the facts and circumstances.