S CORPORATIONS: TO TAX OR NOT TO TAX?

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S CORPORATIONS: TO TAX OR NOT TO TAX?
CORPORATIONS: TO
TO TAX OR
SS
CORPORATIONS:
OR NOT
NOTTO
TOTAX?
TAX?
GaryR.R.Trugman
Trugman CPA/ABV,
CPA/ABV, MCBA,
byby
Gary
MCBA,ASA,
ASA,MVS
MVS
Flow
through
entities
comeininmany
manyshapes
shapes and
and sizes,
Limited
Flow
through
entities
come
sizes,whether
whetheran
anSSCorporation,
Corporation,
Limited
Liability
Company,
Partnership,
etc.
This
paper
will
primarily
focus
on
S
Corporations,
butbut
Liability Company, Partnership, etc. This paper will primarily focus on S Corporations,
same
economic
theorycan
canbe
beapplied
applied to
to the
the other
asas
well.
the the
same
economic
theory
other flow
flowthrough
throughentities
entities
well.This
This
paper is not intended to cover everything that you need to know about valuing these types
paper is not intended to cover everything that you need to know about valuing these types
of entities because this subject would take up a book, not just a paper. In fact, Nancy
of entities
because this subject would take up a book, not just a paper. In fact, Nancy
Fannon wrote a book on this topic entitled Fannon's Guide to the Valuation of Subchapter
Fannon
wrote
a book
on this by
topic
entitledValuation
Fannon'sResources,
Guide to the
Valuation
of Subchapter
S Corporations,
published
Business
LLC.
It was just
recently
S Corporations,
published late published
last year. by Business Valuation Resources, LLC. It was just recently
published late last year.
Over the past few years, several Tax Court cases were decided that significantly changed
Over
past fewofyears,
Tax Court
cases were
decided
thatcases
significantly
changed
thethe
landscape
how Sseveral
Corporations
are valued.
These
Tax Court
have now
also
the had
landscape
of how
Corporations
valued.
These
cases
also
an influence
onSnon-tax
cases asare
well.
Without
goingTax
intoCourt
a lot of
detailhave
aboutnow
each
theinfluence
Tax Courtoncases,
here
is a quick
snapshot
of the
problem:
hadofan
non-tax
cases
as well.
Without
going
into a lot of detail about each
of the Tax Court cases, here is a quick snapshot of the problem:
•
•
•
•
•
•
Gross v. Commissioner, T.C. Memo. 1999-254, affd. 272 F.3d 333 (6th Cir. 2001).
In this
case, the taxpayer's
argued
that the
S corporation
earnings
of G&J
Gross
v. Commissioner,
T.C.expert
Memo.
1999-254,
affd.
272 F.3d 333
(6th Cir.
2001).
Pepsi-Cola
Bottlers,
Inc.
(G&J)
should
be
tax-effected
and
that
its
C
corporation
In this case, the taxpayer's expert argued that the S corporation earnings of G&J
equivalent earnings should be capitalized with an after-tax discount rate based on
Pepsi-Cola
Bottlers, Inc. (G&J) should be tax-effected and that its C corporation
the Capital Asset Pricing Model. The expert for the Internal Revenue Service
equivalent earnings should be capitalized with an after-tax discount rate based on
argued that G&J's earnings were after corporate taxes, particularly since an S
thecorporation
Capital Asset
Pricing
Model.
expertpersonal
for the taxes
Internal
Revenue
Service
does not
pay any
taxes,The
and before
of the
shareholders.
argued
that G&J's
earnings
were
afterthe
corporate
taxes,
particularly
since an
Consequently,
according
to this
expert,
appropriate
discount
rate applicable
to S
corporation
does
not
pay
any
taxes,
and
before
personal
taxes
of
the
shareholders.
the S corporation's earnings was an after-tax discount rate. The Court agreed with
Consequently,
to this
expert,The
the appropriate
discount
rate applicable
this argumentaccording
in its written
opinion.
valuation subject
consisted
of small, to
theminority
S corporation's
earnings
interests of
G&J. was an after-tax discount rate. The Court agreed with
this argument in its written opinion. The valuation subject consisted of small,
Wall v.interests
Commissioner,
minority
of G&J.T.C. Memo 2001-75, March 27, 2001. This case involved
several small gifts of S corporation stock. Both experts tax-affected the income
stream
in the application
of Memo
the income
approach,
although
at different
rates.involved
The
Wall
v. Commissioner,
T.C.
2001-75,
March
27, 2001.
This case
Tax Court
and determined
that Both
the income
stream
should not
taxseveral
smallcited
giftsGross
of S corporation
stock.
experts
tax-affected
thebeincome
effected.
stream in the application of the income approach, although at different rates. The
Tax Court cited Gross and determined that the income stream should not be taxHeck v. Commissioner, T.C. Memo. 2002-34, Filed February 5, 2002. In this case,
effected.
the expert for the taxpayer used a discounted cash flow method in which the
pre-tax, flow through earnings of F. Korbel & Bros., Inc. (Korbel) were considered.
Heck
Commissioner,
Memo.
Filed
February
5, 2002.
case,
Thev.discount
rate that T.C.
he used
was2002-34,
an after-tax
weighted
average
cost In
of this
capital.
theThe
expert
forforthe
a discounted
flow methodology
method in which
expert
thetaxpayer
IRS usedused
a similar
discounted cash
cash flow
and anthe
pre-tax,
flow
throughaverage
earnings
of of
F. capital.
Korbel The
& Bros.,
Inc.opinion
(Korbel)
were
considered.
after-tax
weighted
cost
Court's
cited
Gross
on the
The
discount
he used
was
an after-tax
weighted
average
cost
of capital.
issue
of therate
costthat
of capital.
The
finding
of The Court
in this
case was
based
on
The
expert
for
the
IRS
used
a
similar
discounted
cash
flow
methodology
and
discounting the pre-tax earnings of Korbel with an after-tax cost of capital. In this an
after-tax
weighted
averageminority
cost ofinterest
capital.was
Thebeing
Court's
opinion cited Gross on the
instance,
a 39.6 percent
valued.
finding
Florida issue of the cost of capital. The New
Jersey of The Court in this case was based on
discounting
the
pre-tax
earnings
of
Korbel
with
an after-tax
capital. In this
8751 W. Broward Blvd. • Suite 203 • Plantation, FL 33324
2001 Rte.
310 • Parsippany,
NJ 07054 cost of 844-TRUGMAN
Page
1 46
of• Suite
34
instance,
a 39.6 percent minorityO:interest
www.trugmanvaluation.com
O: 954-424-4343
• F: 954-424-1416
973-983-9790was being valued.
- 2 •
•
andvemployees,
all T.C.
offering
accounting
and professional
services
on
Adams
Commissioner,
Memo.
2002-80, Filed
March 28, 2002.
In this case,
the behalf
tax-effecting
issue became extremely important. In this case, the taxpayer’s
of T&A.
expert, rather than proposing that the S corporation earnings of Waddel Sluder
Adams & Co., Inc. (WSA) be tax-effected, developed an after-tax discount rate
using a build-up method and converted the corresponding capitalization rate (after
11. subtraction
At all times
relevant
hereto,
held
itself out torate.
theHe
public,
andthis
of expected
growth)
to aT&A
pre-tax
capitalization
deemed
discount
rate applicable
the S corporation
earnings
WSA.
This stream
represented
to the to
Plaintiffs
herein, that
it wasofan
accounting
firm of
income was before corporate taxes and any distributions that may have been
distributed
to the shareholders
pay theirand
personal
incomeconcerning
taxes. The IRS
expert
which possessed
special to
expertise
knowledge
correct
argued that an after-tax discount rate was applicable to the S corporation earnings
and lawful
for with
purposes
of the
formation
and to
of WSA.
While fair
this market
seems tovaluations
be consistent
Gross and
Heck,
with respect
the establishment
issue of pre-tax earnings
andso
an that
after tax
rate, the appraisal
subject
of ESOPs
anydiscount
such valuation
would be
in
in Adams was a 61.6 percent, controlling interest.
conformance with all Generally Accepted Accounting Practices, and
Dallas v. Commissioner, T.C. Memo 2006-212, September 28, 2006. After a long
all applicable
laws, including
but not
ERISA
hiatus
in cases involving
S corporations,
thislimited
case hitto,our
radar. § In406,
this 29
case
involving
Dallas
Group of America, Inc. (DGA), one of the issues related to the taxU.S.C.
§ 1106(a).
affecting of the income. The first taxpayer valuation analyst tax-affected S
corporation earnings using a 40% tax rate and the second taxpayer valuation
analyst used a 35% tax rate. According to the Court, the testimony of the taxpayer’s
12. analysts
At all was
times
relevant
hereto, Stephen
(hereinafter
“Jones”)
was its
that
they tax-affected
under theJones
assumption
that DGA
would lose
S corporation
status
after or
as a result
of the hypothetical
sale of
its stock. The
a licensed,
certified
public
accountant
and a partner,
shareholder
Court said there was no evidence that DGA expected to lose its S corporation
status.
Theemployee
Court also noted
that DGA had a history of distributing sufficient cash
and/or
of T&A.
for the shareholders to pay their taxes on their share of S corporation earnings and
there was no evidence that this practice would change. The Court gave little weight
taxpayer’s valuation analysts’ testimony. The bottom line is that The Court
13. to the
At all
times relevant hereto, Jones held himself out to the public, and
said, “We conclude there is insufficient evidence to establish that a hypothetical
buyer
and seller to
would
tax-affecting who
DGA’s
represented
the tax-affect
Plaintiffs DGA’s
herein,earnings
that he and
wasthat
an accountant
earnings is not appropriate.”
possessed special expertise and knowledge concerning correct and
These cases caused an absolute uproar in the valuation community. Almost everyone
lawful fair market valuations for purposes of the formation and
thought that the Tax Court was nuts. After the dust settled, an entire new way of thinking
was born. establishment
Relying on theof
same
old theory
always
tax-effecting
earnings
doesn’t
ESOPs
so thatofany
such
ESOP valuation
would
be fly
anymore.
in conformance with all Generally Accepted Accounting Practices, and
However, with that being said, the above four cases could result in bad law if all valuation
all applicable laws, including but not limited to, ERISA § 406, 29
analysts assume that the Tax Court was correct in its rulings and that the same rules
should apply
to a different
set of circumstances. In fact, as a result of the rulings, it would
U.S.C.
§ 1106(a).
appear that an S corporation election has value. Why should it have value to the entity?
This would make an S corporation worth more than an equivalent C corporation. Besides
defying basic economic theory, this lacks the common sense that Revenue Ruling 59-60
14.
At all times relevant hereto, Michael Axelrod (hereinafter “Axelrod”)
suggests that we apply in the valuation process.
was a licensed, certified public accountant and a partner, shareholder
and/or employee of T&A.Page 2 of 34
- 3 15. haveAtbeen
all times
relevant
hereto,
Axelrodover
heldthe
himself
out to the
public,
and
There
numerous
articles
published
past several
years
in Business
Valuation Update,
Business
Valuation
Review,
Business
Appraisal
and Financial
represented
to the
Plaintiffs
herein,
that
he
was
anPractice
accountant
who
There
have
been
numerous
articles
published
over
the
past
several
years
in Business
Valuation and Litigation Expert. Furthermore, there have been an abundance
of
Valuation Update,
Business
Appraisal
Practice
and
possessed
special
expertise
andBusiness
knowledge
concerning
correct
and to
conference
presentations
onValuation
this
topicReview,
as well.
In order to
save
space,
I am
notFinancial
going
Valuation
Litigation
Expert.in all
Furthermore,
been what
an abundance
of
repeat the and
information
included
of that otherthere
stuff.have
However,
seems to be
lawful
fair
market
valuations
for
purposes
of
the
formation
and
conference
presentations
on
this
topic
as
well.
In
order
to
save
space,
I
am
not
going
abundantly clear is that the empirical data does not support the notion that an to
S
1
repeat
the
information
included
in
all
of
that
other
stuff.
However,
what
seems
to
be
Corporation sells for more of
than a C Corporation.
so data
that any
would
abundantlyestablishment
clear is that theESOPs
empirical
doessuch
not ESOP
supportvaluation
the notion
that be
an S
1
Corporation
sells
than
aallCGenerally
Corporation.
conformance
with
Accepted Accounting Practices, and
So Wherein
Do
Wefor
Gomore
From
Here?
all
laws,
including but not limited to, ERISA § 406, 29
So Where
Doapplicable
We
Go From
Every
valuation
analyst
faces Here?
the question of what to do about taxes when valuing an entity
that has elected
to§ be
treated as an S Corporation under the Internal Revenue Code.
U.S.C.
1106(a).
Every
valuation
analyst
faces
the question
of what to adds
do about
taxes
when
valuing
Some analysts believe that being
an S corporation
value
to the
entity
sinceanit entity
does
that
has
elected
to
be
treated
as
an
S
Corporation
under
the
Internal
Revenue
not pay income taxes. Others believe that making an S election reduces the valueCode.
of an
Some analysts
believe
that being
an S corporation
adds
valueontoprofits
the entity
since
it does
ownership
interest
because
of personal
taxes that will
be paid
that are
allocated
17.
In
November
1993,
Fisher
and
Jones
met
with
Plaintiffs
for
the
not
pay
income
taxes.
Others
believe
that
making
an
S
election
reduces
the
value
of an
to the shareholder, without the benefit of receiving distributions that enable the individual
ownership
interest
because
ofthey
personal
taxes
will be
paid on
that arethe
allocated
to pay personal
taxes
come
due. that
In
this
section,
weprofits
willforming
explore
neverpurposes
ofwhen
presenting
Plaintiffs
with
the
benefits
of
an ABC
to
the
shareholder,
without
the
benefit
of
receiving
distributions
that
enable
the
individual
ending question of, does an S election increase or decrease value?
to pay personal
taxes when they come due. In this section, we will explore the neverESOP.
endingIsquestion
of, does an S election increase or decrease value?
What
An S Corporation?
What
SisCorporation?
on income
laws,ABC
a good
begin a discussion
Although
this
notabout
a treatise
18.Is An
On
or
December
7,tax
1993,
byplace
and tothrough
Plaintiffs, about
as
the value of an S corporation is to understand the rules regarding this type of entity. The
on
tax on
laws,
a good
place
to begin
a discussion
Although
this
is not ameans
officers
oftreatise
ABC,
inincome
reliance
the
advice
and
representations
of
term
S corporation
a small
business
corporation
for which
an election
to be about
taxed
2of entity. The
the
value
of
an
S
corporation
is
to
understand
the
rules
regarding
this
type
under Subchapter
S ofSmith,
the Internal
Revenue
CodeJones,
is in effect
for that
year. an
Once
made,
Green and
Fisher,
T&A,corporation
and
decided
to election
form
ESOP.
term
S corporation
means
a small
which an
to
be taxed
this election
remains
in effect
untilbusiness
it is revoked.
To beforclassified
as a small
business
2
under
Subchapter
S of theofInternal
Revenue
is in effect
formeet
that year.
Once
made,
corporation
for purposes
Subchapter
S, aCode
corporation
must
all of the
following
this
election remains in effect until it is revoked. To be classified as a small business
requirements:
corporation
for ESOP
purposes
of formally
Subchapter
S, a corporation
must meet
of the following
20.
The
was
established
on December
23,all1993.
requirements:
•
The corporation must be a domestic corporation.
•
It must not be an ineligible corporation.
The
corporation
be
a domestic
corporation.
•• 22. It
must
not have
more
than
100 shareholders.
Based
uponmust
Fisher’s
advice,
Plaintiffs
also retained the services of
••
It
must
not
be
an
ineligible
corporation.
Only individuals, decedents’ estates, estates of individuals in bankruptcy, and
•
It must
not
have
more
100 shareholders.
T&Atrusts
and
Jones
tothan
perform
a correct
and lawful
fair market
valuation
certain
may
be shareholders.
Partnerships,
corporations,
and many
types of
•
Only
individuals,
decedents’
estates,
estates
of
individuals
in
bankruptcy,
and
trusts
may
not
be
shareholders.
of
ABC
for
purposes
of
the
ESOP.
certain
trusts may
be be
shareholders.
Partnerships,
corporations, and many types of
•
No
shareholder
may
a nonresident
alien.
trusts
may
not
be
shareholders.
•
The corporation may have only one class of stock but different voting rights are
3
•
No shareholder
may be a nonresident alien.
allowed.
• 24. TheJones
corporation
have
only
one class
of stockto
butPlaintiffs,
different voting
gave may
advice
and
provided
services
both inrights
theirare
3
allowed.
1
1
25.
2
capacities
as Trustees of the ESOP and officers of ABC.
John Phillips wrote a terrific article in Business Valuation Update, March 2004 summarizing
several other articles including a discussion of empirical data.
John Phillips wrote a terrific article in Business Valuation Update, March 2004 summarizing
several
other
articles
a discussion
of empirical
data.
Code Sec.
1361(a)(1)
on including
the advice
of Fisher
and Jones,
and Fisher and
Plaintiffs
relied
2
3
1361(a)(1)
Code were
Sec. 1361(b)
Jones
well aware that they relied on their advice when the
3
Code was
Sec. 1361(b)
of 34 and Jones represented to the
ESOP
formed. In Page
fact, 3Fisher
Page 3 oftheir
34 advice and counsel, the ESOP
Plaintiffs that if Plaintiffs followed
- 4 would
with allanapplicable
laws,
including
but not limited
tothe
A corporation
can conform
elect to become
S corporation
by filing
the appropriate
form with
Commissioner
of the
Internal
This election can also be revoked, voluntarily or
ERISA
§ 406,
29 Revenue.
U.S.C. § 1106(a).
involuntarily under certain circumstances. Once elected, a corporation will remain an S
corporation until such time as a revocation takes place. One thing worth noting is that the
election is free. Therefore, why would a willing buyer pay more for the S election, if he or
she27.
could One
elect itpurpose
for free? of the ESOP was to effectuate the purchase of the
outstanding ABC shares of Clifford Morris (hereinafter “Morris”), a co-
Keeping this discussion of the tax law simple, an S corporation is a pass-through entity.
founder
ABC,
personally
along
with
various family
This means
that the of
profits
andwho
losses
are passedand
through
to the
shareholders,
and any
tax that is payable, will be paid by the shareholders, and not the corporation. The original
atwas
that
time,these
owned
47% (forty-seven
purpose ofmembers,
an S election
to allow
smallapproximately
business corporations
to be treated as
if they were
a
partnership,
while
continuing
to
provide
the
shareholders
with the legal
percent) of ABC’s shares.
protection of operating in a corporate form.
Being an S corporation provides the shareholders with certain tax benefits. These include,
purpose
of the ESOP was to restructure ABC’s corporate
but28.
are notAnother
limited to,
the following:
debt, whereby the ESOP would, for practical purposes, assume said
•
Not being questioned by the Internal Revenue Service about reasonable
debt to take
of certain tax benefits.
compensation
foradvantage
shareholder/employees.
•
Not being subjected to the accumulated earnings tax if dividends are not paid to the
shareholders.
those
• 31. Avoids
double
upon retained
sale of thetocorporation’s
Jones
andtaxation
T&A were
perform a assets
correct(other
fair than
market
assets that may be subject to the built in gains tax–see discussion below).
valuation of ABC so that the ESOP did not unlawfully pay more than
While there are certain tax advantages to electing S corporation status, there are also
adequate
for Morris’
or the that
newly-issued
disadvantages.
The consideration
major disadvantage
relatesABC
to Cshares
corporations
convert to S
corporations.
Any
gain
that
the
corporation
recognizes
within
the
10
years
ABC shares pursuant to ERISA § 406, 29 U.S.C. § 1106(a). after the
election is made to convert a C corporation to an S corporation is taxed as if the asset was
owned at the time of the conversion to S status. This is known as the “built in gains tax.”
Not only does the corporation pay tax on these items, but the shareholders will also be
32.
Jones and T&A’s final valuation was dated March 15, 1994, and
taxed on the income that is flowed through after corporate taxes are paid. This constitutes
double taxation.
should have incorporated information available to them as of that
date.
Another tax
consideration relating to the S election is the shareholder’s income tax basis
in the corporation’s stock. Whereas in a C corporation, the income tax basis is generally
the purchase price of the stock, an S corporation’s shareholders will constantly be
adjusting
income
tax basis
their shares.reviewer
The S corporation’s
shareholders
33. the
Axelrod
served
as anofindependent
of the valuation
preparedwill
increase their basis for all earnings reported by the company that are not distributed. A
by Jones.
simplified basis
calculation is as follows:
34.
Original Investment
$ 1,000
On March 15, 1994, based upon the valuation performed by T&A and
+ Profit- Year 1
500
Jones, and reviewed by Axelrod, and arrangements made by Green
- Distributions- Year 1
( 200)
and Smith and Crain and Crain, the two SPAs (Stock Purchase
4 offor34clarification) were closed. The
Agreements - added byPage
author
Plaintiffs, as Trustees, participated in the closing of the SPAs in
- 5 reliance of theBasis
representations
of said $Defendants
that the ESOP
- End of Year 1
1,300
transaction comported
with
all 1applicable
laws, including but not
+
Profit- End
- Year
800
Basis
of 2
Year
$ 1,300
limited to, ERISA
§ 406,
29-2U.S.C.
- Distributions
Year 2 § 1106(a).
( 400)
+
Profit
- Year
800
- End of -Year
-Basis
Distributions
Year22
$( 1,700
400)
39.
On September 14, 1998,
Thomas
al. v. Robert B. Jackson,
- Endbasis
of
Year
2 Sacks,
$ et
1,700
The tax implication of theBasis
adjusted
is that
the amount
of tax that is paid by the
shareholder
upon
the
eventual
sale
of
the
corporate
stock
will
depend
onDivision,
whether the
sale
et al. United States District Court, W.D.KY, Jacksonville
Civil
The
tax
implication
of
the
adjusted
basis
is
that
the
amount
of
tax
that
is
paid
by
the
is for a greater or lesser amount than the tax basis. While a tax basis adjustment, in and
Action
(hereinafter
“Sacks
Complaint”
or “Sacks
shareholder
upon
the 3:WP-591-C,
eventual
saleofofthe
thecorporate
corporatethe
stock
will
on whether
the
of itself, does
notNo.
affect
the value
stock,
the depend
shareholder’s
return
willsale
be
is
for
a
greater
or
lesser
amount
than
the
tax
basis.
While
a
tax
basis
adjustment,
in
and
affected. Investment decisions may vary depending upon the shareholders’ goals relating
litigation”)
was
filed,
with
claims
in shareholder’s
relevant part,
outwillofbe
of a
itself,
does
not
affect
theThis
value
of
thediscussed
corporatearising,
stock, the
return
to
particular
investment.
will
be
later.
affected. Plaintiffs’
Investmentroles
decisions
may vary
depending
the shareholders’ goals relating
as former
Trustees
of upon
the ESOP.
to a particular
investment. This will be discussed later.
Valuation
Issues
Valuation
Issues
In the valuation
of an interest in an S corporation, two main issues arise. First, do the
41.
The
Sacks
Complaint alleged that Plaintiffs violated their fiduciary
income tax advantages of the S election create value? This gets carried one step further
In the
valuation
of an interest
in an
S
corporation,
issues arise.
First,
do the
by
raising
the questions
of value
whom,
and
howtwo
do
we
account
for the
incremental
duties
by agreeing
to to
cause
the
ESOP
tomain
purchase
ABC
stock
from
income
tax
advantages
of
the
S
election
create
value?
This
gets
carried
one
step
further
value in the valuation process? The second issue is, if we value an S corporation by
by raisingMorris
the
offamily
value
to
whom,
and
dothan
we account
for
the incremental
andtohis
and
ABC
at how
more
the fairare
market
value,
comparing
thisquestions
entity
non-S
corporation
entities,
what
adjustments
necessary
in the
value
in
the
valuation
process?
The
second
issue
is,
if
we
value
an
S
corporation
by
valuation process?
causing
financial
loss
to
the
ESOP
and
Plaintiffs
in
the
Sacks
litigation
comparing this entity to non-S corporation entities, what adjustments are necessary in the
valuation
process?
Many appraisers
feel beneficiaries
that an S corporation
who were
of the should
ESOP.be valued in the same fashion as they
would value a C corporation. This is because:
Many appraisers feel that an S corporation should be valued in the same fashion as they
would
value
a C corporation.
This is because:
1.
C corporations
are in substance
nearly identical to S corporations.
58.
After
a
bench
trial
lasting
overinten
which tospanned
the
2.
S corporations may lose their S status
the trial
futuredays,
and convert
C corporations.
1.
C
corporations
are
in substance
nearly identical
S corporations.
3.
Most
measures
of corporate
performance
used
into
valuation
such
as growth
period
of April
16,
2001
tostatus
February
26,
2002,
onmodels,
or about
July
30,
2.
S
corporations
may
lose
their
S
in
the
future
and
convert
to
C
corporations.
and discount rates, are derived from C corporations; therefore, S corporations
3.
Most
measures
ofas
corporate
performance
used in
valuation
such
as growth
should
beUnited
valued
C corporations
to maintain
consistency
with these
measures.
2002,
States
District
Court
Judge
Jennifer models,
Ronstadt
issued
a 4
and discount rates, are derived from C corporations; therefore, S corporations
Memorandum,
Opinion
and Order
in theconsistency
Sacks litigation
which
held 4
should
be Internal
valued as
C corporations
to maintain
with these
measures.
According
to the
Revenue
Service,
inter
thatRevenue
PlaintiffsService,
had violated their duties as Trustee of the
According
to thealia,
Internal
S Corporations
lend themselves
readily to valuation approaches comparable
to ESOP.
those used
in valuing
closely
held
corporations
(Cdid
corporations).
You
However,
at that
time
Judge
Ronstadt
not decide whether
S
Corporations
lend themselves
readily
valuation
approaches
need
only to adjust
the earnings
fromtothe
business
to reflectcomparable
estimated
to the
thoseESOP
used inhad
valuing
closely held
corporations).
You and
sustained
anycorporations
monetary (Closs
as a result,
need only to adjust the earnings from the business to reflect estimated
appointed a Special Master to determine damages, if any.
60.
4
Simpson, William
E. andthe
Wrobel,
Peter D.,
“Income
in Valuing
S Corporations”,
issued
On January
26, 2004,
Special
Master
inTax
theIssues
Sacks
litigation
4
NJ.
Simpson,
William
and Wrobel,that
Peterthe
D., “Income
Tax Issues
in Valuing
Corporations”,
an Opinion
whichE.estimated
damages
sustained
to Sthe
ESOP
CPA Expert, Spring, 1996, American Institute of Certified Public Accountants, Jersey City,
CPA Expert, Spring, 1996, American Institute of Certified Public Accountants, Jersey City,
NJ.approximately 9.9 Page
were
million
dollars,
plus interest and attorneys
5 of
34
fees.
Page 5 of 34
- 6 Accordingcorporate
to the Order
of the
United
States
District
District of Arkansas,
income
taxes
that would
have
been Court,
payableWestern
had the Subchapter
S election
notdated
been December
made. (Added
for clarification).
Jacksonville
Division,
1, 2004,
and signed
the
Jennifer B.
corporate
income
taxes that would
have been
payableby
had
theHonorable
Subchapter
5
not
been
made.
(Added
foral.
clarification).
Some S
appraisers
believe
that the
tax benefits
havingJackson
made anetSal.,
election
shouldNo.
Ronstadt
inelection
the matter
of Thomas
Sacks,
et
v.ofRobert
Civil Action
5
increase the value of the entity. Many of the fundamental issues that affect the appraisal
97-123-C.
Some appraisers
that as
the well,
tax benefits
of having made
S election
process
must be believe
considered,
for the determination
of an
whether
or notshould
an S
increase theelection
value ofadds
the entity.
fundamental
issues that affect the appraisal
corporation
value. Many
Someofofthe
these
factors include:
process must be considered, as well, for the determination of whether or not an S
adds this
value.
Some
of these
include:
OnStandard
Julyelection
29,of2002,
court
found
the factors
defendants
liable for breach of
•corporation
value
in their roles as trustees of an employee stock ownership plan
• fiduciary
Controlduty
vs. minority
Standard
value
•• (“ESOP”)
Distributing
vs.
non-distributing
in of
violation
of ERISA § 406,29 U.S.C. § 1106. Sacks v. Jackson.
•• The
Control
vs.
minority
Holding
of the investment
court period
determined
that in the case of such a breach, ‘loss will be
••
Distributing
vs.Snon-distributing
Time
value
of
corporation
benefits what the ESOP paid for the ABC stock
measured as the difference between
•
Holding period of the investment
its fair
market value at the time of transaction, plus interest.’ Id. at 881.
• and
Time
Standard
ofvalue
Valueof S corporation benefits
(footnote omitted).
Standard
of Value
The standard
of value in any business valuation assignment can have a significant impact
on the final
estimate
of value. Valuing
an entity
that has
elected
S status
is no different.
A Special
Master
was appointed
to review
the reports
and
testimony
of several
valuation
The standard
valuesignificant
in any business
valuation
can have
significant
impact
Probably
the ofmore
differences
willassignment
arise between
fair amarket
value
and
professionals,
Mr.
Jones
being
one
of
them.
The
Court
adopted
the
Special
Master’s
on
the
final
estimate
of
value.
Valuing
an
entity
that
has
elected
S
status
is
no
different.
investment value.
Probably the more significant differences will arise between fair market value and
findings and commented “Having found the special master’s final report, with its
investment
value. of fair market value is located in Revenue Ruling 59-60. This revenue
A common definition
supplement
to be
and as
well reasoned, the court will adopt the special master’s
ruling defines
fairthorough
market value
A common definition of fair market value is located in Revenue Ruling 59-60. This revenue
findings
their entirety.”
ruling in
defines
fair market
value
...the price
at which
the as
property would change hands between a willing
buyer and a willing seller when the former is not under any compulsion to buy
...the
price
at which
property
would change
hands
between
willing
and the
latter
is not the
under
any compulsion
to sell,
both
partiesa having
The Court’s
Order,
Special
Master’s
report
wasany
extremely
critical
of
buyer
and aciting
willingthe
seller
the
former
is
not under
compulsion
to buy
reasonable
knowledge
ofwhen
relevant
facts. Court
decisions
frequently
state
in the T&A
and
the
latter
is
not
under
any
compulsion
to
sell,
both
parties
having
able,
as valuation
addition that
the
hypothetical
buyer and
seller
arecredible”
assumedand
to bethat
report. Findings
were
that
theofconclusions
were
“not
“the
reasonable
knowledge
relevant
facts.
Court
decisions
frequently
state
in
well as willing, to trade and to be well informed about the property and
6
able,
as
addition
that
the
hypothetical
buyer
and
seller
are
assumed
to
be
methods concerning
were applied
improperly
in his
report SMR at 7,19.” While discussing the
the market
for such
property.
well as willing, to trade and to be well informed about the property and
6 noted “The special master found Jones’
“discounted
future
earnings”
method,
The
Court
concerning
themarket
market
for such
property.
This definition
of fair
value
is widely
used in valuation practice. Also implied in this
1
definition
is that
thean
value
is to be stated
cash or cashnot
equivalents
thatatthe
property
testimony
that
such
adjustment
was in
unnecessary
credible.and
SMR
16.”
This
definition
of
fair
market
value
widely
usedfor
in valuation
practice.
Also
this
would have been exposed on the is
open
market
a long enough
period
ofimplied
time toinallow
definition
that thetovalue
is totobe
stated inthe
cash
or cash equivalents and that the property
the
marketis forces
interact
establish
value.
would have been exposed on the open market for a long enough period of time to allow
Wethe
aremarket
not going
to reiterate
theestablish
Court’s or
Special Master’s findings in this report by
forces
thethe
Investment
value to
is interact
defined to
as the “value
tovalue.
a particular investor based on individual
investment
requirements,
as distinguished
from the
concept our
of market
value, which
is of
analyzing
the Order
or the Special
Master’s report.
However,
independent
analysis
Investment value is defined as the “value to a particular investor based on individual
theinvestment
T&A reportrequirements,
indicates thatasthere
were substantially
more problems
were
pointed
distinguished
from the concept
of market than
value,
which
is
out in the earlier litigation. We will highlight these problems as we proceed in this report.
5
IRS Valuation Guide for Income, Estate and Gift Taxes, Commerce Clearing House
56
Rev.Valuation
Rul. 59-60
(1959-1
C.B. 237).
IRS
Guide
for Income,
Estate and Gift Taxes, Commerce Clearing House
6
1
Rev. Rul. 59-60 (1959-1 C.B.Page
237). 6 of 34
The adjustm ent had to do with the subtraction of debt from the value to determ ine the
Page 6 of 34
equity value of ABC.
- 7 7
Clearly,
Mr. Jones’
opinions
were
as lacking
validity aand
impersonal
and detached.”
While
thisdiscarded
definition comes
from realcredibility,
estate terminology,
similar
application
used 7in While
business
Investment
valueestate
may differ
from fair
reasonableness.
aisfootnote
on page
7definition
of the Order,
The
stated:
impersonal
andIndetached.”
this valuation.
comes
fromCourt
real
terminology,
a
market
value for a number
of business
reasons. valuation.
Among these
reasons are:
similar application
is used in
Investment
value may differ from fair
market value for a number of reasons. Among these reasons are:
1.
Differences in estimates of future earning power.
With
regard
to Jones’intestimony,
the
court
in itsof
liability
2.
Differences
perception
offuture
the
degree
risk. opinion expressed its
1.
Differences
in
estimates
of
earning
power.
own3. concerns
aboutin tax
thestatus.
credibility of Jones’ testimony, including his
Differences
2.
Differences
in
perception
the degreeconcerning
of risk.
8
downplaying
of timewith
restraints,
hisoftestimony
the
existence of a
4.
Synergies
other
operations
owned
or
controlled.
3.
Differences in tax status.
lower draft valuation, the vagueness of his testimony, and his inability to
4.
Synergies with other operations owned or controlled.8
recall
whether
evidence
of preliminary
wasthe
contained
in the
files.of a
If the
purpose
of the
valuation
assignmentcalculations
is to determine
fair market
value
controlling
interest
in an
S corporation
for purchasing,
selling, or
the corporation,
If
the purpose
of the
valuation
assignment
is to determine
themerging
fair market
value of a
the
corporation's
tax
structure
may
have
little
or
no
impact
on
value.
If
the
most
probable
controlling interest in an S corporation for purchasing, selling, or merging the corporation,
"willing
buyer" is an
(i.e.ora no
C corporation),
then that
will
the corporation's
taxineligible
structureshareholder
may have little
impact on value.
If theshareholder
most probable
not
pay
for
income
tax
benefits
that
it
cannot
take
advantage
of.
Therefore,
corporate
"willing buyer" is an ineligible shareholder (i.e. a C corporation), then that shareholder will
income
shouldtax
bebenefits
a part of
theit valuation
calculations.
if the
“willing
not pay taxes
for income
that
cannot take
advantage Conversely,
of. Therefore,
corporate
buyer”
can
qualify
for
the
S
election,
that
buyer
may
pay
for
the
benefits
that
will be
income taxes should be a part of the valuation calculations. Conversely, if the “willing
received,
and
no corporate
taxes
be appropriate
the benefits
determination
of the
buyer” can
qualify
for the Sincome
election,
thatmay
buyer
may pay forinthe
that will
be
benefit
stream
to
the
investor.
received, and no corporate income taxes may be appropriate in the determination of the
benefit stream to the investor.
An important component of determining fair market value is the determination of who will
Samuel
Newhouseof9 where
it
be
"willingcomponent
buyer." This
evident
in the Estate
An the
important
of became
determining
fair market
value of
is the
determination
who will
was
demonstrated
that
different
classes
of
investors
would
pay
different
amounts
under
be the "willing buyer." This became evident in the Estate of Samuel Newhouse9 where it
the
market valuethat
scenario.
this
logical foundation,
an appraiser
must under
make
wasfair
demonstrated
differentFollowing
classes of
investors
would pay different
amounts
certain
assumptions
about
who
the
most
likely
purchaser
will
be.
However,
care
must
be
the fair market value scenario. Following this logical foundation, an appraiser must make
exercised
not to fall into
a tax
trap
bymost
identifying
a specific buyer.
Tax Court
gone
certain
assumptions
about
who
the
likely purchaser
will be. The
However,
carehas
must
be
on
record
to
state:
exercised not to fall into a tax trap by identifying a specific buyer. The Tax Court has gone
on record to state:
We need not identify directly who the buyer would be or even what class of
investors
belong
The “willing
is supposed
to be
We
need the
not buyer
identifywould
directly
who to.
the buyer
wouldbuyer”
be or even
what class
of
a
hypothetical
amalgam
of
potential
buyers
in
the
marketplace.
Although
we
investors the buyer would belong to. The “willing buyer” is supposed to be
have,
in prior opinions,
types
of hypothetical
buyers, we
did so only
a hypothetical
amalgamidentified
of potential
buyers
in the marketplace.
Although
we
to
determine
which
valuation
approach,
among
several
reasonable
have, in prior opinions, identified types of hypothetical buyers, we did so only
approaches,
in the highest
bid, among
and therefore
one most
to determinewould
whichresult
valuation
approach,
severalthereasonable
10
acceptable
to
a
willing
seller.
The
question
is
not
so
much
“who”
but
“how.”
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.”10
7
The Dictionary of Real Estate Appraisal, 3rd ed. (Chicago: Appraisal Institute, 1993).
7
8
The
Dictionary
of Real
Estate
Appraisal,
3rd ed.
(Chicago: Valuing
Appraisal
Institute, 1993).
Shannon
P. Pratt,
Robert
F. Reilly,
and Robert
P Schweihs.
a Business:
The Analysis
and Appraisal of Closely Held Companies, 3rd ed. (New York: McGraw-Hill, 1996). pp. 25.
Shannon P. Pratt, Robert F. Reilly, and Robert P Schweihs. Valuing a Business: The Analysis
and Appraisal of Closely Held Companies, 3rd ed. (New York: McGraw-Hill, 1996). pp. 25.
8
9
9
10
10
Estate of Samuel Newhouse, 94 T.C. 193
Estate of Samuel Newhouse, 94 T.C. 193
Estate of Mueller v. Commissioner, TC Memo. No. 1992-284 at 1415, 63 TCM
3027-16
omitted).
Estate of(citations
Mueller v.
Commissioner, TC Memo. No. 1992-284 at 1415, 63 TCM
3027-16 (citations omitted).
Page 7 of 34
Page 7 of 34
- 8 -
OPINIONS
The issue of who the most likely purchaser
of the property will be is an essential element
of the determination of the “highest price” that would be offered to a prudent seller. During
The issueofofindustry
who the most
likely purchaser
of the are
property
will be
is an essential
periods
consolidation,
companies
offered
greater
amounts element
(higher
of
the
determination
of
the
“highest
price”
that
would
be
offered
to
a
prudent
seller.
During
premiums) than they might get from “non-synergistic” buyers. If there is the
expectation
periods
of industry
areof offered
greater
amounts
by
the seller
that his orconsolidation,
her company companies
will sell to one
the industry
players,
then it (higher
seems
premiums)
than
they
might
get
from
“non-synergistic”
buyers.
If
there
is
the
expectation
In our
T&A,value
Steven
Jonesthe
andvaluation
Michael Axelrod
(hereafter
referred
thatopinion,
fair market
warrants
to be performed
in collectively
this fashion.
This to
by
the
seller
that
his
or
her
company
will
sell
to
one
of
the
industry
players,
then
it
seems
argument
can
be carried
one step further
by stating that
when
reviewsservices
market in
as T&A,
Mr.market
Jones
or Mr. warrants
Axelrod)
have
breached
their
dutyan
toappraiser
render
various
that fair
value
the
valuation
be performed
in this
fashion.
This
data,
a determination
is generally
made
as toto who
is buying up
these
companies.
argument
can
carried
one
step
further
by stating
that
when
market
Therefore,
the
issue
of who
the
willing
buyer
is most
likely
toan
be
needs
to reviews
be addressed.
a manner
that
is be
consistent
with
the
standard
of
care
required
ofappraiser
professional
accountants
data, a determination is generally made as to who is buying up these companies.
andFor
advisors
the
rendering
of valuation
services
ABC
theeasily
ABC
ESOP.
Therefore,
the
issue
of subjects,
who the
willing
buyer
is mosttolikely
toand
be needs
to be
addressed.
smallerin
appraisal
this determination
will
be
more
made.
Small
businesses are frequently purchased by an individual, or a group of a few individuals, who
For
smaller to
appraisal
subjects,
this determination
be ofmore
easily made.
Small
will continue
qualify as
an S corporation.
For thesewill
types
businesses,
the continuity
businesses
are
frequently
byperformed
an assumption.
individual,
a group
ofeven
a few
individuals,
In our
the
valuation
by or
T&A
for ABC
and
thebusinesses
ABC who
ESOP
of
anopinion,
S election
appears
to purchased
beservices
a reasonable
However,
small
will
continue
to
qualify
as
an
S
corporation.
For
these
types
of
businesses,
the
continuity
may not qualify to be an S corporation if they are purchased. As the melting pot of the
violated
and valuation
standards.
In our opinion,
Rule
201
of businesses
the American
of
an Saccounting
election
appears
totobegrow,
a reasonable
However,
even
small
a large assumption.
influx of nonresident
aliens
are entering
the
United
States continues
may
not
qualify
to
be
an
S
corporation
if
they
are
purchased.
As
the
melting
pot
of
the
marketplace
as possible
of (AICPA)
these businesses.
It may no longer
be awas
Institute
of Certified
Public purchasers
Accountants’
Code of Professional
Conduct
a large will
influx
of nonresident
are entering the
United States
continuesthat
to grow,
reasonable
assumption
the S election
continue
after the aliens
acquisition.
marketplace
purchasers
these businesses. It may no longer be a
violated
as T&Aas
didpossible
not comply
with the of
following:
reasonable
assumption
that the
S problematic
election will than
continue
the acquisition.
Larger corporations
are even
more
smallafter
corporations
when the appraiser
must make assumptions about the willing buyer. Larger entities are more likely to be
Larger
are even
more
problematic
than smallnegate
corporations
when
theTherefore,
appraiser
A. corporations
Professional
Competence.
Undertake
only the
those
professional
purchased
by
a C corporation,
which
would immediately
S election.
must
make
assumptions
about
the
willing
buyer.
Larger
entities
are
more
likely
to
it may not be
reasonable
to assume
that
company
able to continue
in be
its
services
that the
member
orthe
thetarget
member's
firm will
canbe
reasonably
expect
purchased
by
a
C
corporation,
which
would
immediately
negate
the
S
election.
Therefore,
present taxto
status.
be completed with professional competence.
it may not be reasonable to assume that the target company will be able to continue in its
present
Purposetax
ofstatus.
The Assignment
B.
Due Professional Care. Exercise due professional care in the
of professional services.
Purpose ofperformance
The Assignment
In addition to the standard of value, the purpose of the assignment may also cause the
valuation analyst to make certain assumptions. For example, if the appraisal is being
C.
Planning
and of
Supervision.
Adequately
plan and may
supervise
the the
In addition
to the
value,
purpose
of to
the
also cause
performed
for
the standard
determination
of fairthe
market
value
beassignment
used in a matrimonial
litigation,
performance
of to
professional
services.
to make
For example,
if the
appraisal
is being
itvaluation
may be analyst
considered
unfaircertain
the assumptions.
non-business owner
spouse to
make
the assumption
performed
for the determination
of fair market
to be used
in aare
matrimonial
that
the S election
will be lost. However,
sincevalue
matrimonial
courts
courts of litigation,
equity, it
it
may
be
considered
unfair
to
the
non-business
owner
spouse
to
make
assumption
D.
Sufficient
Relevant
Data.
Obtain
sufficient
relevant
data
to afford
may be equally unfair to the business owner not to assume taxes will be the
paid
sinceathey
that paid
the Satelection
will bebasis
lost.even
However,
since matrimonial
courts are courts
of equity,
reasonable
for
conclusions
or recommendations
in relation
to it
are
the personal
level
if no distributions
are made.
may be equally
unfair
to
the
business
owner
not
to
assume
taxes
will
be
paid
since
they
any professional services performed.
11
are
the in
personal
level
even v.
if no
distributions
are made.
Withpaid
thatatsaid,
Judith E.
Bernier
Stephen
A. Bernier,
the Massachusetts Supreme
Court addressed the issue of tax-effecting an S corporation. I truly commend the court for
11
In addition,
failed
to E.
comply
the Uniform
Standards
of
Professional
Appraisal
With that
said,
in
Judith
Bernier
v.Following
Stephen
A. Bernier,
the Massachusetts
Supreme
taking
on T&A
this controversial
issue.with
the
methodology
in Delaware
Open
MRI
Court addressed the issue of tax-effecting an S corporation. I truly commend the court for
Practice
(USPAP), an industry standard that all appraisers are guided to follow in
taking on this controversial issue. Following the methodology in Delaware Open MRI
publications of the AICPA, with respect to the following:
11
Bernier v. Bernier, 2007 Mass. LEXIS 598 (May 7, 2007).
11
Bernier v. Bernier, 2007 Mass.
LEXIS
59834
(May 7, 2007).
Page
8 of
Page 8 of 34
- 9 STANDARD
9
Radiology
Associates,
P.A. v. Howard B. Kessler, et al.12, (a case that I will discuss
shortly), the court applied a methodology to determine the 12tax impact that I really like.
Radiology
Associates,
P.A. v.orHoward
B. Kessler,
et al. , (a
that I must
will discuss
In developing
a business
intangible
asset appraisal,
ancase
appraiser
be
shortly),the
thestandard
court applied
a methodology
to determine
the tax impact
thatbe
I really
When
of value
is investment
value, consideration
should
givenlike.
as to
aware of, understand, and correctly employ those recognized methods and
whether
the specific
buyer
will qualifytoas
an S corporation.
The specific buyer's goals
procedures
that are
necessary
produce
a credible appraisal.
When the standard of value is investment value, consideration should be given as to
regarding rates of return, or whether he or she wants current cash flow or capital
whether
the specific
buyer
will qualify
an S corporation.
The specific
buyer's
appreciation
must
be9-1
considered
whenas
deciding
on an S election.
More often
thangoals
not,
Standards
Rule
regarding performed
rates of return,
or whether
he or use
shepre-tax
wants earning
current streams,
cash flow
or itcapital
valuations
for transaction
purposes
since
is the
appreciation
musttax
bestatus
considered
whenbe
deciding
on aninSplace
election.
often
than not,
buyer's
expected
that should
considered
of theMore
seller's
historical
tax
In
developing
a
business
or
intangible
asset
appraisal,
an
appraiser
must:
valuations
structure. performed for transaction purposes use pre-tax earning streams, since it is the
buyer's expected tax status that should be considered in place of the seller's historical tax
structure.
(a) vs.beMinority
aware of, understand, and correctly employ those recognized
Control
methods and procedures that are necessary to produce a credible
Control
vs.appraisal;
Minority
If the business
interest being appraised is a minority ownership interest--that is, the
appraisal of the ownership interest not having the prerogatives of control--then a direct
If
the
interest
being
appraised
is
a minority
ownership
interest--that
is, the
comparison
with
values a
of substantial
other
minority
interests
is the
most
method
of
(b) business
not
commit
error
of omission
or appropriate
commission
that
appraisal
of
the
ownership
interest
not
having
the
prerogatives
of
control--then
a
direct
valuation. In
essence, if the
minority
interest cannot effectuate a change in the company's
significantly
affects
an appraisal;
comparison
values
of other
minority
interests is the most appropriate method of
tax
structure,with
no such
change
should
be assumed.
valuation. In essence, if the minority interest cannot effectuate a change in the company's
notno
render
appraisal
services
in a careless or negligent manner, such
tax (c)
structure,
such
should
be assumed.
An
argument
could
be change
made that
a minority
shareholder could, in fact, cause a change to
as a series of errors that, considered individually, may not significantly
an S election by selling the shares to a non-qualified shareholder of the S corporation.
affect the
results
of an
appraisal,
but which, when
considered
in the to
An argument
made
that
a minority
shareholder
in fact,
cause a change
therefore
changing
This
violation could
of thebe
rules
regarding
ownership
could kill could,
the election,
aggregate,
would
be
misleading.
an
S
election
by
selling
the
shares
to
a
non-qualified
shareholder
of
the
S
corporation.
the status involuntarily. However, a valuation analyst should also consider the likeliness
therefore
This
of the rules
regarding
ownership
could
the election,would
of
theviolation
shareholders’
actions.
It would
seem that
thekillshareholder
havechanging
to have
the
status
involuntarily.
However,
a
valuation
analyst
should
also
consider
the
likeliness
Standards
Rule
9-2
special motivations to intentionally kill the S election for the balance of the shareholders.
of
the shareholders’
actions.
seem
that the
have value.
to have
These
special motivations
mayItbewould
enough
to violate
theshareholder
definition ofwould
fair market
special
motivations
to
intentionally
kill
the
S
election
for
the
balance
of
the
shareholders.
In developing a business or intangible asset appraisal, an appraiser must
These
special motivations
may be
enough
toshareholders
violate the definition
of fair
market
The S election
may have been
made
by the
for reasons
that
have value.
nothing
observe the following specific appraisal guidelines:
to do with value. For example, an S election may be made so that the issue of reasonable
The S election may
may be
have
been made
by
theby
shareholders
reasonsService.
that have Another
nothing
compensation
avoided
uponbusiness
audit
the Internalfor
Revenue
(a)
adequately
identify
the
enterprise,
assets,
or
equity
under
to do with
For example,
antoS avoid
election
may taxation
be madeat
sothe
thattime
the that
issuethe
of reasonable
reason
forvalue.
an S election
may
be
double
consideration,
define
theaudit
purpose
and
theRevenue
intended
use company
of Another
the is
compensation
may
be
avoided
upon
by
the
Internal
Service.
sold. For aappraisal,
shareholderconsider
to want tothe
intentionally
violate
the Sappraisal
election, the
company could
elements
of the
investigation,
reason
for an
election
be tothus
avoid
doubleitstaxation
the
time that
the company
is
be exposed
to Sgreater
riskmay
of loss,
reducing
value. at
The
prudent
shareholder
would
consider
anytospecial
limiting
conditions,
and
identify
thethe
effective
date
sold.
For
a
shareholder
want
to
intentionally
violate
the
S
election,
company
could
not want to diminish the value of the investment. In fact, many shareholder agreements
appraisal;
be exposed
tothe
greater
loss, thus reducing
its value. entity.
The prudent shareholder would
prohibit
theoftransfer
byrisk
theofshareholder
to an unqualified
not want to diminish the value of the investment. In fact, many shareholder agreements
prohibit
transfer
byshareholder
the shareholder
to an the
unqualified
entity.
(b) the
define
the
value
beingcan
considered.
Although
the
minority
cause
S election
to be involuntarily terminated,
it does not seem logical to assume that this will occur. However, the facts and
Although the
shareholder
canconcerns
cause the a
S election
to be
involuntarilyorterminated,
(i) minority
if the
appraisal
business
enterprise
equity
it does not seem logical to assume that this will occur. However, the facts and
12
12
interests, consider any buy-sell agreements, investment letter
stock restrictions, restrictive corporate charter or partnership
agreement clauses, and any similar features or factors that
Delaware Open MRI Radiology Associates, P.A., Petitioner, v. Howard B. Kessler, et al.,
may have
influence
on value.
Respondents.
and an
Howard
B. Kessler,
et al., Plaintiffs, v. George J. Broder, et al.,
Delaware
Open
MRI
Radiology
Associates,
P.A.,ofPetitioner,
B. Kessler,
et al.,
Defendants,
in the
Court
of Chancery
of the State
Delaware,v.
in Howard
and for Newcastle
County,
Respondents.
and No.
Howard
Consolidated, C.A.
275-N.B. Kessler, et al., Plaintiffs, v. George J. Broder, et al.,
(ii) Defendants,
if the in
appraisal
the
appraiser
consider
the Court ofconcerns
Chancery ofassets,
the State of
Delaware,
in andmust
for Newcastle
County,
whether
the
are:
Consolidated,
C.A.
No.assets
275-N.
Page 9 of 34
(1)
(2)
appraised separately; or
Page
9 ofof34
appraised as
parts
a going concern.
- 10 (iii) of the
if the
appraisal
concerns
equity
in a
circumstances
situation
must dictate
whether
or notinterests
to make such
anbusiness
assumption.
enterprise, consider the extent to which the interests do or do
not
contain elements of ownership control.
Distributing vs. Non-Distributing
An S
corporationRule
may 9-3
be favorable or unfavorable depending upon whether the corporation
Standards
has the ability to distribute its earnings to its shareholders. If only some, or possibly none
of the
canabebusiness
distributed,
result can
be extremely
theequity
investor.
In earnings
developing
or the
intangible
asset
appraisalunfavorable
relating totoan
Let interest
me illustrate
this
point
by
using
a
real
example.
This
appears
as
exhibit
1.
Our
firm did
with the ability to cause liquidation of the enterprise, an appraiser
a critique
another valuation
analyst’sthat
workthe
for abusiness
litigation. enterprise
One of the many
issuesawas
must of
investigate
the possibility
may have
that we tax-affected the earnings and he did not. This is an excerpt from our critique
higher value in liquidation than for continued operation as a going concern
(names have been changed to protect the guilty!)
absent contrary provisions of law of a competent jurisdiction. If liquidation is
the indicated basis of valuation, any
real1estate or personal property to be
Exhibit
liquidated must
be
valued
under
the
appropriate
standard.
To Tax or Not To Tax- Critiquing Another’s
Report
Rule 9-4
TaxStandards
Affecting Earnings
TheInissue
of tax affecting
the earnings
of S corporations
or other
entities
developing
a business
or intangible
asset appraisal,
anpass-through
appraiser must
such
as general
limited appraisal
partnerships,
or limitedwhen
liabilityapplicable:
companies, is a highly
observe
thepartnerships,
following specific
guidelines
debated issue in business valuation. The conventional wisdom used to be that you would
tax (a)
affect the
earnings
a pass through
entity because
theand
willing
buyer may not be able
consider
allofappropriate
valuation
methods
procedures.
to avail itself of the non-taxable status of the seller. Appraisal theory has stated that it is
essential
to
matchand
theanalyze
earnings
streamdata
being
capitalized, when using the income
(b)
collect
relevant
regarding:
approach, with the correct capitalization rate. Since publicly traded companies report their
(i)
the nature and history of the business;
earnings on an after-tax basis, sources that compile this data for use by appraisers in
financial
and economic
conditions
the business
determining(ii)
discount
and capitalization
rates consider
these affecting
rates to be applicable
to afterenterprise,
its
industry,
and
the
general
economy;
tax earnings streams (or cash flow). The most widely used source in the appraisal field is
(iii)by Ibbotson
past results,
current
operations,
future
of the
data publish
Associates.
Ibbotson
data is and
clearly
after prospects
tax at the entity
level.
business enterprise;
or othertoownership
in the
(iv) first past
sales
capital
stock
The argument
started
to beofraised
about
after-taxes
the entity ininterests
the Tax Court
case
enterprise
beingIt appraised;
Estate of Gross. business
I will address
this shortly.
is not uncommon for an appraiser to tax
affect the earnings
of
S
corporations
by
applying
C corporation
tax ratesheld
to their
(v)
sales of similar businesses marginal
or capital
stock of publicly
earnings. This is similar
consistent
with the approach employed in our reports.
businesses;
(vi)
prices, terms and conditions affecting past sales of similar
Contrary to Mr. Smith’s
assertion
that we reduce available cash flow by a “hypothetical”
business
assets;
corporate income tax, this adjustment does not assume that The Companies will indeed
incur a tax, but rather is a necessary adjustment when applying historical Ibbotson return
Standards Rule 9-5
data (which is presented on an after-tax basis) to the subject earnings stream. The
following are additional reasons for tax affecting S corporation earnings:
In developing a business or intangible asset appraisal, an appraiser must;
1.
(a)
(b)
The S election has no impact on the operating cash flows of the business.
select and employ one or more approaches that apply to the specific
appraisal assignments.
consider and reconcile the indications of value resulting from the
various approaches to arrive at the value conclusion.
Page 10 of 34
- 11 10 of the S election are shareholder benefits and therefore capitalizing
2.STANDARD
The benefits
these benefits would overstate the value of the enterprise since the benefits can be
taken away
involuntarily
S election isorbroken.
In reporting
the
results ofif the
a business
intangible asset appraisal an
appraiser must communicate each analysis, opinion, and conclusion in a
3.manner
S corporations
pass through a sufficient portion of their earnings to their
that is notusually
misleading.
shareholders to allow them to pay their taxes which leaves the S corporation in
almost the same position after taxes as if it were a C corporation.
Standards Rule 10-1
4.
The public stock markets tend to price the earnings of publicly traded partnerships
Eachonwritten
oral business
or intangible
asset
appraisal
report
must:
a basisor
equivalent
to the after
tax earnings
of publicly
traded
C corporations
in
(a)
5.
(b)
6.
the same lines of business.
clearly and accurately set forth the appraisal in a manner that will not
Most
the likely buyers of S corporations are C corporations or groups of investors
beofmisleading.
who may need to organize as C corporations. There is no apparent advantage for
S corporation buyers to C corporation buyers.
contain sufficient information to enable the intended user(s) to
understand
it. Any
specific
conditions
Every
C corporation
(with
eligiblelimiting
shareholders)
wouldconcerning
either make information
the S election
should
be
noted.
or would have the option to convert if this was desirable. If a higher value is
attainable following the S election, corporate sales of companies would reflect this
(c) value.
clearly
and
accurately
extraordinary
assumption
that
There
is no
logic for thedisclose
existenceany
of two
levels of corporate
value for eligible
entities
when
there are
logical orand
practical
barriers
directly
affects
theno
appraisal
indicate
its prohibiting
impact onelection
value. to obtain
the higher value.
7.
It has been suggested that buyers will pay no more for an S corporation than an
Standards
Rule 10-2
equivalent C corporation; therefore there are no S corporation premiums.
written
business
asset
appraisal
mustperspective,
comply withwe
ToEach
address
the tax
treatmentorofintangible
pass through
entities
from an report
independent
the following
specific
reporting
guidelines:
consulted
textbooks
and articles
written
and published by some of the leading practitioners
in the business valuation field. In general, well-known business valuation authorities
including
Shannonand
Pratt,
Christopher
and
Roger Grabowski
there
(a)
identify
describe
the Mercer,
business
enterprise,
assetsall
oragree
equitythat
being
is no hard-and-fast
rule
that
applies
to
treatment
of
pass-through
entities
in
all
cases.
appraised.
There is a general consensus among these individuals that the issue of whether or not to
tax affect the earnings of a pass-through entity is one that must be addressed on a case(b)
state the purpose and intended use of the appraisal.
by-case basis.
(c) debate
define
the value
to be estimated.
This
has also
been highlighted
in four recent Tax Court Cases:
1.(d)
2.
3.(e)
4.
th
Gross
Commissioner,
T.C.
Memo.
1999-254,
affd.
272
F.3d
333
Cir.
2001)
set v.
forth
the effective
date
of the
appraisal
and
the
date
of(6the
report.
Wall v. Commissioner, T.C. Memo. 2001-75, filed March 27, 2001
Heck
v. Commissioner,
Memo.
2002-34,
filed Feb.
5, 2002
describe
the extentT.C.
of the
appraisal
process
employed.
Adams v. Commissioner, T.C. Memo. 2002-80, filed March 28, 2002
(f)
set forth all assumptions and limiting conditions that affect the
(g)
set forth the information considered, the appraisal procedures
Page 11 of 34
followed, and the reasoning
that supports the analyses, opinions and
conclusions.
In all four of these cases, the Court ultimately determined that it was appropriate to
opinions,
and
conclusions.
capitalizeanalyses,
S corporation
earnings
using
an after tax rate. In each case, the valuation
- 12 (h)
set
anywithout
additional
information
that may
appropriate
toMr.
show
conclusion
wasforth
reached
tax-affecting
earnings,
whichbe
is consistent
with
Smith’s
approach. compliance with, or clearly identify and explain permitted departures
from, the requirements of Standard 9.
However, in response to the Tax Court rulings, Christopher Mercer argues that in Gross,
Heck
“Thethe
Taxrationale
Court hasfor
rendered
opinions based
on unsound
economic and
(I)and Adams,
set forth
the valuation
methods
and procedures
financial theory.”
Mercer,
with
agreement from Dr. Shannon Pratt, concludes that:
considered
and
employed.
•
S corporations are worth the same as otherwise identical C corporations at the level
of the enterprise. Their operating cash flows are identical, and there is no rationale
that suggests
thatwill
their
values
should
be anything
but identical.
Each of these
provisions
beenterprise
addressed
in detail
within
our report.
•
Interests in S corporations may be worth more or less than otherwise identical
interests in otherwise identical C corporations. The cash flows to shareholders may
But for the negligence of T&A, Mr. Jones and Mr. Axelrod, the plaintiffs have suffered
be different between S and C corporations, and these differences, considered in the
context
of thedamages.
riskiness of Judge
their receipt,
can create
in value.
significant economic
Ronstadt
found differences
that the ABC
ESOP overpaid
$8,139,116
for the
stock,
based discount
on a valuation
$26.31 million.
In addition,
In determining
the
appropriate
rate forat
capitalizing
pretax earnings,
an prejudgment
analogous
situation
drawntotothis
municipal
bonds. Yields on municipal bonds are significantly
interest
wasmay
alsobe
added
amount.
lower than yields on taxable bonds. This is due to the favorable tax treatment received by
investors holding municipal bonds (i.e. no federal taxes and in some cases no state or
municipal taxes). In order to convert the yield on a municipal bond to its taxable equivalent
for comparison purposes, analysts divide the tax-free yield by (1 – tax rate), where the tax
rate is the investor’s effective
personal
rate
for both
state and federal taxes. The term (1
BASIS
FOR
OUR
OPINIONS
– tax rate) is simply the factor used to convert pretax dollars to after-tax dollars.
Upon issuance, both municipal bonds and taxable bonds are issued at par value. Thus,
the trading price (or par value) of a municipal bond is a function of its tax-free yield, as
investors
theValuation
present value
of future cash
at the
tax-free
rate.inIn this
essence,
In order
for discount
Trugman
Associates,
Inc. flows
to form
our
opinions
matter,
the investment community prices municipal bonds as if taxes have been prepaid on interest
numerous
documents
were
reviewed.
In addition,
R. Trugman
CPA/ABV,
MCBA,
and principal
payments
received
by investors.
Thus,Gary
if a business
is valued
using pretax
earnings
the applied
earningsofmeasure
rather than after-tax
earnings,
then an additional
ASA,
MVS, as
principal
in charge
this engagement,
attended
the deposition
of Steven
adjustment is also necessary to the discount or capitalization rate. Accordingly, the future
cash
of the
business
should
discounted
or capitalized
at a pretax
which
is
Jones
onflows
January
24,
25, 27 and
28,be
2005.
The documents
reviewed
in thisrate,
matter
include
calculated by dividing the after-tax discount rate by (1 – tax rate). Mr. Smith does not make
the any
following:
such adjustment.
In addressing the issue of taxation in light of recent tax legislation, we conducted our own
1. analysis
Second
Amended
Complaint
Petition
Declaration
of Rights
the matter of
of the
differences
between and
holding
stockfor
in The
Companies
under ain
tax-affecting
Robert
Jackson and
Milton D. versus
Thompson,
Jr. v. Goldberg
and taxation
Simpson,
scenario
(CB.corporation
assumption)
the current
pass-through
of P.S.C.
the
and Steven
A. Crainagainst
and John
J. Fox andthe
Sherry
P. Crain
Prison Systems,
entities.
The argument
tax-affecting
earnings
of anand
S corporation
or otherLtd.
pass-through
entity
is predicated
uponP.S.C.
the belief
the shareholder
of Stephen
an otherwise
and Tennet
Axelrod
& Bressler,
andthat
Michael
Axelrod and
Jones
identical
C corporation
is burdened
by “double-layer”
taxation
at both the
entity
and the12in Washington
Circuit
Court, Division
1, Jacksonville,
Arkansas,
Case
Number
shareholder
levels.
Mr.
Smith
claims
that
since
The
ABC
Organization
will
end
up
owning
123456.
2.
The Companies, the S Corporation assumption should be continued into the future. The
Valuation report of ABC Jail Company, Inc. as of November 30, 1993 as prepared
by Tennet & Axelrod, P.S.C. (TA
15912- TA
218).
Page
of 34
- 13 3. argument,
Letter of
March
15,although
1994 from
& Axelrod, P.S.C.
of Directors
and
here,
is that
TheTennet
ABC Organization
may be to
anBoard
S Corporation,
there
Trustees
of ABC Jail
Company,
Inc.,
updating
valuation
of ABC
Jail as
Company,
is
no
guarantee
will
ultimately
beOrganization
sold to athe
buyer
thatancan
qualify
an
S
argument,
here, isthat
that italthough
The ABC
may be
S Corporation,
there
Inc.guarantee
to March
15, 1994
Corporation,
and therefore
is a155).
flawedbe
assumption
think that
that a
buyer
will pay
for S
a
is no
that
it willit(TA
ultimately
sold to a tobuyer
can
qualify
as an
benefit
that it and
will not
realize.it is a flawed assumption to think that a buyer will pay for a
Corporation,
therefore
4. benefit
Memorandum
Steve Jones dated December 1, 1993 regarding ABC Jail
that it will notfrom
realize.
Another
argument,
forward, ofpursuant
to thestock
Jobsownership
and Growth
Relief
Company,
Inc.’s going
establishment
an employee
plan Tax
(TA 676
- TA
Reconciliation
Act
of
2003,
effective
January
1,
2003,
dividend
income
to
C
corporation
694). argument, going forward, pursuant to the Jobs and Growth Tax Relief
Another
5.
6.
7.
8.
9.
shareholders
taxed
at the same
rateJanuary
as capital
a maximum
rate
percent),
ReconciliationisAct
of 2003,
effective
1, gains
2003,(for
dividend
income
to of
C 15
corporation
while
shareholders
in
pass-through
entities
continue
to
be
taxed
at
personal
tax
rates on
A representation
letter
March
7, 1994gains
to Tennet
& Axelrod,
P.S.C.
shareholders
is taxed at
the dated
same rate
as capital
(for a maximum
rate
of 15referencing
percent),
13
S
corporation
earnings.
,Jail
thusCompany,
minimizing
differences
liabilities
at the
shareholder
while
shareholders
pass-through
entities
continue
toin
betax
taxed
at personal
tax rates
on
the
valuation
ofinABC
Inc.,
Inc. (no
specific
valuation
report
indicated)
13level of earnings distributed to shareholders.
level
regardless
of
the
Although
this
S corporation
earnings.
,
thus
minimizing
differences
in
tax
liabilities
at
the
shareholder
signed by J. Clifford Morris, Milton Thompson and Robert B. Jackson on March 10,
reduction
was notof
in effect
as ofoftheearnings
valuationdistributed
date in thisto
case,
given the ongoing
litigation
level1994.
regardless
the level
shareholders.
Although
this
associated
with
this
assignment
and
the
anticipated
transfer
of
ownership
interests
in The
reduction was not in effect as of the valuation date in this case, given the ongoing litigation
Companies,
we this
believe
this factor
is the
particularly relevant.
associated
with
assignment
and
transferof
of ownership
The
Valuation
Report
Checklist
from anticipated
the workpapers
Tennet & interests
Axelrod,in P.S.C.
Companies,
we
believe
this
factor
is
particularly
relevant.
to the valuation
as of November
30, 1993
dated March
7, and
1994
(TA 485 For relating
each company,
we incorporated
the recent decline
in dividend
tax rates,
examined
TA
489).
the
available
to a shareholder
or member
under
the twotax
scenarios.
taxable
For cash
each flows
company,
we incorporated
the recent
decline
in dividend
rates, andFor
examined
income,
used
the adjusted
income from
our reports
before
taxes,
while the
assumed
the
cash we
flows
available
to a shareholder
or member
under
the two
scenarios.
For
taxable
Report
of
the
Special
Master
in
the
matter
of
Thomas
Sacks,
et
al.
v. Robert
payout
of distributions
is based
onfrom
actual
levels
for each
income,ratio
we used
the adjusted
income
ourdistribution
reports before
taxes,
whileentity.
the assumed
Jackson,
al. in the United
States
District
Court, Western
of Arkansas at
payout
ratio ofetdistributions
is based
on actual
distribution
levels forDistrict
each entity.
Jacksonville
Division,
Civil
Action:
6:97:CV-123-C.
The importance of this calculation is that distributions make a big difference in determining
the
difference in
value
of theseis that
two distributions
types of entities.
In difference
this case,inthe
level of
The importance
of this
calculation
make a big
determining
indebtedness,
and
the Master
need
for
reinvestment
new
assets,
does
not
enable
the
report
the matter
of Thomas
etthe
al. level
v. Robert
the Amended
difference Special
in value
of these
twointypes
ofinto
entities.
In thisSacks,
case,
of
shareholders
to
receive
significant
distributions.
It
is
important
to
note
that
in
the
Estate
Jackson, etand
al. in
United
Districtinto
Court,
District
Arkansas
indebtedness,
thethe
need
for States
reinvestment
newWestern
assets, does
notofenable
the at
of
Gross,
distributions
tosignificant
shareholders
were
at about
percent.
Jacksonville
Division,
Civil Action:
6:97:CV-123-C.
shareholders
to receive
distributions.
It is 100
important
to note that in the Estate
of Gross, distributions to shareholders were at about 100 percent.
Memorandum Opinion and Order in the matter Thomas Sacks, et al. v. Robert
Jackson, et al. in the United States District Court, Western District of Arkansas at
Jacksonville Division, Civil Action: 97-123, signed by the Honorable Jennifer B.
Ronstadt on July 29, 2002.
10.
Order in the matter of Thomas Sacks, et al. v. Robert Jackson, et al. in the United
States District Court, Western District of Arkansas at Jacksonville Division, Civil
Action: 97-123, signed by the Honorable Jennifer B. Ronstadt on December 1,
2004.
11.
Correspondence dated April 26, 1996 from Stephen D. Jones to Steve Crain (GS
106-0900).
12.
Deposition transcript of Stephen D. Jones in the matter of Thomas Sacks, et al. v.
Robert Jackson, et al. in the United States District Court, Weston District of
Arkansas
at Jacksonville Division, Civil Action: 3:WS-667-C dated February 25,
13
Anthony J. DeChellis, CPA, CFP® and Sheila Owen, CPA, “A Closer Look at Qualified
2000.
Dividends under the 2003 Act,” PPC National Tax Advisory®, September 9, 2003.
13
Anthony J. DeChellis, CPA, CFP® and Sheila Owen, CPA, “A Closer Look at Qualified
Dividends under the 2003 Act,” PPC National Tax Advisory®, September 9, 2003.
Page 13 of 34
Page 13 of 34
- 14 13.
Deposition transcript of Stephen
D. Jones
the matter of Thomas Sacks, et al. v.
Company
One,in
Inc.
Robert Jackson, et al. in the United States District Court, Western District of
Comparison of Tax Scenarios
Arkansas at Jacksonville Division, Civil Action: 3:WS-667-C dated March 23, 2000.
14.
Trial transcript, Day II, in the matter of Thomas Sacks and Ferman Houston v.
Robert
E. Jackson
the United States District
Court,
Debt
Free Pre-Tax
Income and Milton Thompson, in 84,166
84,166
Western District of Arkansas at Jacksonville Division, Case Number 3:97-CV-1234
Corporate
Income
Tax
(21,866)
0
from April
17, 2001,
testimony of26%
Stephen Jones.
15.
16.
Net Income Available to Shareholders
S Corporation
62,300
84,166
Trial transcript, Day VIII, in the matter of Thomas Sacks and Ferman Houston v.
Robert
and Milton Thompson, in(62,300)
the United States District
Court,
Less:
AdditionE.to Jackson
Retained Earnings
(62,300)
Western District of Arkansas at Jacksonville Division, Case Number 3:97-CV-1234
Distributions
0%
26%
21,866
from July 18, 2001, testimony of Stephen
Jones. 0
Trial transcript, Day IX, in the matter of Thomas Sacks and Ferman Houston v.
15%
0
40%
(33,666)
Robert E. Jackson and Milton Thompson, in the United States District Court,
of Arkansas at Jacksonville Division,0 Case Number 3:97-CV-1234
NetWestern
Cash FlowDistrict
to Shareholders
(11,800)
from October 9, 2001, testimony of Stephen Jones.
Less: Personal Taxes
Net
Disadvantage
to Company
One Shareholders
Copies
of the proposed
regulations
of the Department
(11,800)
of Labor, Pension
Welfare
Benefits Administration, 29CFR Part 2510 faxed from Steve Crain to Stephen Jones
(TA 490 - TA 501).
17.
18.
19.
C Corporation
Company
LLC
An engagement letter between
TennetTwo,
& Axelrod,
P.S.C. and ABC Jail Company,
Inc. regarding the possibility
of
forming
an
employee
Comparison of Tax Scenarios stock ownership plan, dated
November 30, 1993 and signed on December 13, 1993.
C Corporation
S Corporation
A presentation for ABC Jail Company, Inc. about the employee stock ownership
Debtplan,
Free Pre-Tax
Income
73,046
dated December
6, 1993 as faxed from Steve
Crain to Stephen Jones73,046
(TA 695
- TA 707).
Corporate Income Tax
25%
(18,192)
0
20.Net Income
Various
research
materials regarding valuation
of stock for an ESOP (some
Available
to Members
54,854
73,046 of
which appears to be from Tax Management, Inc.) (TA 708 - TA 715).
Less: Addition to Retained Earnings
21.
22.
0
0
Hand written notes from Tennet & Axelrod, P.S.C.’s workpapers regarding a
100%
54,854
100%
73,046
meeting on November 30, 1993 (TA 750 - TA 752).
Distributions
Less: Personal Taxes
15%
(8,228)
40%
(29,218)
Deposition transcript of the testimony of Stephen Jones in the matter Robert v.
Jackson,
etMembers
al. v. Green and Smith, P.S.C., et al.,46,626
Washington Circuit Court,43,828
Division
Net Cash
Flow to
One, Case Number 12-123456 dated January 24, 2005.
Disadvantage
to Company
Two’s
Membersof Stephen Jones in the matter Robert
(2,798) v.
23. Net
Deposition
transcript
of the
testimony
Jackson, et al. v. Green and Smith, P.S.C., et al., Washington Circuit Court, Division
One, Case Number 12-123456 dated January 25, 2005.
Page 14 of 34
- 15 24.
Deposition transcript of the testimony
of Stephen
Jones in the matter Robert v.
Company Three,
LLC
Jackson, et al. v. Green and
Smith, P.S.C., et al., Washington Circuit Court, Division
Comparison of Tax Scenarios
One, Case Number 12-123456 dated January 27, 2005.
25.
Deposition transcript of the testimony of Stephen Jones in the matter Robert v.
Debt
Free Pre-Tax
244,353
244,353
Jackson,
et al.Income
v. Green and Smith, P.S.C., et al.,
Washington Circuit Court,
Division
One,
Case Number 12-123456 dated
January(91,963)
28, 2005.
Corporate Income Tax
38%
0
26.
NetFinancial
Income Available
to Members
results
of Prison
27.
Less: Addition to Retained Earnings
28.
29.
C Corporation
S Corporation
152,390
Systems, Ltd. for the
third quarter 1993 (TA244,353
4 - TA 18).
0
0
Illegible workpaper indicating market price of Prison Systems, Ltd. from March 2,
1994
(TA 19).
Distributions
100%
152,390
100%
244,353
Less: Personal of
Taxes
15%
(22,859)
Prospectus
Esmor Correctional
Services, Inc.
(TA 5440%
- TA 112).
Net Cash Flow to Members
129,532
(97,741)
146,612
Research materials faxed from Smith Barney to Stephen Jones on March 7, 1994
regarding the Esmor initial public offering.
Net Advantage to Company Three’s Members
17,080
30.
Two page summary of financial highlights of Prison Systems, Ltd. for the period
ended December 31, 1993 and
1992 (TA 116 - TA 117).
Company Four, LLC
31.
Information about ABC Jail Company, Inc. entitled ABC - A Public/Private
Partnership (TA 118 - TA 153).
C Corporation
S Corporation
32.
Debt
Free Pre-Tax Income
68,813
68,813 Inc.
Correspondence
from Stephen D. Jones to Gary
Harper at ABC Jail Company,
Comparison of Tax Scenarios
dated July 12, 1994 (TA 154).
Corporate Income Tax
33.
Fax
transmittal
form
with
Net
Income
Available to
Members
34.
Less:
Addition to
Retained Earnings
Business
valuation
processing
35.
36.
37.
Distributions
24%
(16,848)
0
confirmation dated April
22, 1997 (TA 156 - TA
157).
51,965
68,813
0
instructions (TA 158).
100%
51,965
0
100%
68,813
Cover letter dated December 17, 1993 from Milton Thompson to Stephen Jones
Less: Personal Taxes
15%from the company
(7,795) (TA
40%220).
(27,525)
transmitting
requested information
Net Cash Flow to Members
41,288
Balance Sheet of ABC Jail Company, Inc. as of 44,170
October 31, 1993 with building
and
land at appraised values (TA 221 - TA 222).
Net Disadvantage to Company Four’s Members
(2,882)
Balance Sheet of ABC Jail Company, Inc. as of October 31, 1993 (TA 223 - TA
As shown,
224). in three out of the four scenarios, the shareholders actually would receive less
cash assuming that the company was not taxed at the entity level. By tax affecting the
earnings
of The
Companies,
cash
flow
to ownersInc.
is not
reduced
on 31,
an aggregate
38.
Income
Statement
of ABC
Jail
Company,
as of
October
1993 (TA basis.
225 - TA
231).
39.
Page 15 of 34
Audited financial statements of ABC Jail Company, Inc. for December 31, 1992 and
1991 as audited by We Do Numbers, CPAs (TA 232 - TA 243).
- 16 40. In fact,
Audited
statements
of ABC
Jailtax
Company,
for December
31, fails
1991toand
cashfinancial
flow to owners
is higher
after
affecting Inc.
earnings.
Mr. Smith
1990this
as audited
by WebyDo
Numbers,
CPAsof(TA
244 - taxes
TA 253).
consider
in his analysis
ignoring
the impact
personal
on the shareholders
and by ignoring the recent reduction in tax rates on C corporation dividends, which has
41. seriously
Audited
financial
of ABC
Jail Company,
Inc.
for December
31, 1990 as
weakened
thestatements
argument that
double-layer
taxation is
a detriment
to C corporation
shareholders.
audited by We Do Numbers, CPAs (TA 254 - TA 23).
42.
Audited financial statements of ABC Jail Company, Inc. for February 28, 1990 and
In the
above
example,by
the
analyst
on the other
side(TA
of the
case
1989
as audited
We
Do Numbers,
CPAs
264
- TAthought
277). that by not taxaffecting the earnings, he could support a higher value for his clients. By the way, the
in financial
our valuations
due to the
taxesJail
was
$14 million.
43. difference
Audited
statements
of ABC
Company,
Inc. for February 28, 1989 and
1988 as audited by We Do Numbers, CPAs (TA 278 - TA 290).
44.
It is readily accepted that an investor in common stock of any corporation makes an
economic investment for three reasons. They are:
Form 1120S, U.S. Income Tax Return for an S Corporation for ABC Jail Company,
for 1993 cash
(TA 292
TA 329).
1) Inc.Immediate
flow-(dividends),
2)
Future cash flow (capital appreciation), and
45. 3) Form
1120S, U.S.
Return for an S Corporation for ABC Jail Company,
A combination
ofIncome
1 and 2 Tax
above.
Inc. for 1992 (TA 330 - TA 372).
The total expected return to the shareholder consists of a part that is currently taxable, and
a
that1120S,
is tax deferred
until the
time
of sale.
Under
the current for
tax ABC
law, the
46. part
Form
U.S. Income
Tax
Return
for an
S Corporation
Jaildeferred
Company,
portion
be subject
to favorable
gains taxschedules
rates. Although
discount rate
Inc.may
for 1991
(TA 373
- TA 376)capital
(all attached
are notthe
included).
used in the application of a discounting model ignores personal tax rates, the investor does
47. not.Form 1120S, U.S. Income Tax Return for an S Corporation for ABC Jail Company,
Inc. for 1990 (TA 377 - TA 380) (all attached schedules are not included).
If the shareholders have control of the company, they will generally do everything possible
to insure that distributions are made in sufficient amounts to cover personal taxes. They
48. do not
Form
1120S,
U.S.
Tax
Return
for an
S Corporation
ABC
Company,
want
to reach
intoIncome
their own
pockets
to pay
taxes
on profits thatfor
they
did Jail
not receive.
Inc. forshareholders
1989 (TA 381
386) (all attached
are notposition,
included).
However,
of a-CTA
corporation
will usuallyschedules
take the opposite
as they
generally want to avoid paying tax on dividend distributions. However, the new tax law
49. favors
Miscellaneous
Schedules
K-1, out
Form
for 1992over
(TAthe
387
- TA 392).from an
the tax treatment
of dividends
of a1120S
C Corporation
distributions
S Corporation.
50.
Hand written notes from the Tennet & Axelrod, P.S.C. workpapers (TA 394 - TA
Since
shareholders of an S corporation will frequently attempt to pass through dividends
395).
to themselves in an amount at least equal to the estimated tax obligation, the actual
may appear to
attractive.
could
the appearance
of a
51. dividend
Stockdistributions
Purchase Agreement
bybe
and
betweenThis
ABC
Jailgive
Company,
Inc. Employee
company
is a “great”
payer.
It makes
the investment
appear
as if it has
Stock that
Ownership
Plandividend
and Trust
and ABC
Jail Company,
Inc. as
of December
1993
excellent
liquidity.
The
opposite
is
true
with
the
shareholders
of
a
C
corporation.
They
will
(no date) (TA 396 - TA 422).
generally do everything possible to avoid dividends. This would give the appearance of an
investment with far less liquidity. This contrasting position of the shareholders makes
52. dividend
Handpaying
writtencapacity
notes from
theattractive
Tennet &manner
Axelrod,
P.S.C.tofile
relating
to consulting and
a more
in which
assess
value.
non compete agreement of Cliff Morris (TA 424).
53.
Consulting and Non-Competition Agreement by and between ABC Jail Company,
Inc. and J. Clifford Morris dated January 1, 1994 (TA 425 - TA 429).
54.
Employment Agreement by and between ABC Jail Company, Inc. and Milton
Page
16431
of 34
Thompson as of January 1, 1994
(TA
- TA 436).
- 17 55. David
Employment
Agreement
and between
ABCthese
Jail Company,
Inc.states:
and J. Clifford
C. Dufendach
raises an by
interesting
point about
returns.14 He
Morris as of January 1, 1994 (TA 437 - TA 442).
14
David C. Dufendach raises an interesting point about these returns. He states:
Research has shown that the slope of the actual security market line is less
15
56.
Employment
Agreement
bytheand
between
ABC
Jaillower
Company,
Inc.
and Robert
than
predicted
by the that
CAPM.
Riskier
stocks
have
required
returns
Research
has
shown
slope
of the
actual
security
market
line
is less
15(TA
than predicted,
whereas
less
risky
stocks
from
Jackson
as of January
1994
443 stocks
-suffer
TA 448).
than
predicted
by
the 1,
CAPM.
Riskier
havehigher
lower required
requiredreturns.
returns
One
possible
explanation
is
that
riskier
stocks
provide
relatively
more
of their
than predicted, whereas less risky stocks suffer from higher required returns.
return
in thewritten
form
ofworkpapers
non-taxable
One
study
suggests
that 449 - TA
57.
Various
hand
from appreciation.
Tennet
& Axelrod,
P.S.C.’s
files
(TA
One
possible
explanation
is that price
riskier
stocks provide
relatively
more
of their
16
this
is
the
case.
If
true,
then
investors
who
wish
to
avoid
current
tax
liability
454).
return in the form of non-taxable price appreciation. One study suggests that
16
on dividend
income
would
prefer
higherwho
risk/lower
dividend
stocks,
driving
this
is the case.
If true,
then
investors
wish to avoid
current
tax liability
down
their
required
return
below
that
predicted
by
the
CAPM.
Another
study and The
on dividend income
prefer
higherbetween
risk/lower
dividend
driving
58.
Correspondence
datedwould
March
11, 1994
the
Bank ofstocks,
Jacksonville
supported
this view,return
are
undesirable
(presumably
down
required
below
thatdividends
predicted
by the
Another
study
ABC
Jailtheir
Company,
Inc.implying
and
thethat
ABC
ESOP (TA
468CAPM.
- TA 478).
because
of
their
immediate
taxability),
and
that
stocks
with
higher
dividends
supported this view, implying that dividends are undesirable
(presumably
17
are
penalized
in immediate
the form oftaxability),
higher required
returns.
because
of their
and that
stocks with higher dividends
59.
Transmittal letter with correspondence dated March17 8, 1994 from Stephen Jones
are penalized
in the form Bank
of higher
required returns.
James
C. Ferran
of Jacksonville,
providingthat
an given
opinion
the risk
value
Thetovarious
studies
citedatbythe
Dufendach
lead to the conclusion
all of
other
of the
ABC
Jail aCompany,
Inc. stock
to becausing
acquired
the ESOP.
factors
being
equal,
stock that pays
a dividend,
an by
immediate
tax consequence,
The various studies cited by Dufendach lead to the conclusion that given all other risk
is
worthbeing
less than
a stock
that
provides
appreciation,
is tax tax
deferred
and then
factors
equal,
a stock
that
pays acapital
dividend,
causing anwhich
immediate
consequence,
60. possibly
Fax transmittal
sheet
and account
workpapers
under
cover
dated
March
14, 1994
taxed
at
more
favorable
rates.
The
factor
that
causes
the
difference
in
value
is
is worth less than a stock that provides capital appreciation, which is tax deferred and
then
to Stephen
from
Charles
T. The
Mitchell
Company
481
- TA 484).
apparently
personal
taxes.
Since
we
accept
the
premise
that a(TA
prudent
investor
considers
possibly
taxed
atJones
more
favorable
rates.
factor
that causes
the
difference
in
value is
personal
income
taxes
in
investment
decisions
(otherwise,
if
all
else
were
equal,
why
would
apparently personal taxes. Since we accept the premise that a prudent investor considers
anyone
buy
tax taxes
free in
bonds?),
we decisions
should
not
ignore
the
tax
effect
of
theJail
61. personal
An engagement
letter
between
Tennet
& Axelrod,
P.S.C.
the
income
investment
(otherwise,
if allpersonal
else
wereand
equal,
whyABC
would
investment.
The
difficulty
is
determining
which
tax
rates
to
use.
Company,
December
6, 1993
valuation
the common
anyone
buy taxInc.
freedated
bonds?),
we should
not regarding
ignore thethe
personal
tax of
effect
of the
equity in The
ABCdifficulty
as of November
30, 1993
503 -toTA
504).
investment.
is determining
which (TA
tax rates
use.
Corporate or Personal Income Tax Rates
62. Corporate
ABC Jail
Inc. ESOP
(TA 508 - TA 510).
orCompany,
Personal Income
Tax summary
Rates
One of the difficulties that faces the appraiser is the determination of which set of income
taxes
appropriate
tothat
usefaces
in valuing
the S corporation.
This will most
likely depend
on the
ofisthe
difficulties
the appraiser
is the
determination
of which
set of income
63. OneResearch
material
from CCH
- Standard
Federal
Tax Reporter
regarding
interest
standard
of value. However,
this canthe
beSmore
trouble than
its worth.
taxes is appropriate
to use in valuing
corporation.
This will
most likely depend on the
on certain loans used to acquire employees’ securities (TA 522 - TA 535).
standard of value. However, this can be more trouble than its worth.
If the standard of value is fair market value, the appropriate income tax rates should be
64. those
Miscellaneous
workpapers
from
& Axelrod,
filesproblem
(TA 536is-that
TA we
538).
rates thatof
willvalue
be
applicable
in theTennet
handsthe
of
the
willingP.S.C.’s
buyer.
The
If the standard
is fair market
value,
appropriate
income
tax rates should
be
65.
66.
those rates that will be applicable in the hands of the willing buyer. The problem is that we
Cover letter dated March 7, 1994 from Paul E. Donough to James C. Ferran at the
14 of Jacksonville regarding real estate appraisals (TA 539).
Bank
Dufendach, David C., “Valuation of Closely Held Corporations: ‘C’ v. ‘S’ Differentials”,
Business Valuation Review, December 1996, page 176-179, American Society of Appraisers,
Dufendach,
David C., “Valuation of Closely Held Corporations: ‘C’ v. ‘S’ Differentials”,
Herndon, Va.
Correspondence
dated Review,
MarchDecember
4, 19941996,
from
Charles
Brown,
Jr. of
toAppraisers,
James C.
Business Valuation
page
176-179,A.
American
Society
regarding real estate appraisals (TA 540 - TA
Ferran,
Jr.Herndon,
at the Bank
ofF.Jacksonville
15
Va.
Brigham, Eugene
and Louis C. Gapenski, Financial Management: Theory and Practice,
14
552).
15
16
Sixth Edition, pp. 156-157.
Brigham, Eugene F. and Louis C. Gapenski, Financial Management: Theory and Practice,
Sixth
Edition,
pp. 156-157.
Copeland,
Thomas
E. and J. Fred Weston, Financial Theory and Corporate Policy, Second
67.
Miscellaneous workpapers from Tennet & Axelrod, P.S.C.’s files (TA 553 - TA 554).
68.
A
69.
Personal Taxes and Dividends on Capital Asset Prices: Theory and Empirical Evidence,”
17
Correspondence
dated
January
7,June
1994
from
Steven
Crain to Stephen
Jones
Ibid,
pp.of515-6.
Refers
to a study
by R.
Litzenberger
and A.
K. Ramaswamy,
“The Effect
of
Journal
Financial
Economics,
1979,
pp. 163-196.
Personal
Taxes
and
Dividends
on
Capital
Asset
Prices:
Theory
and
Empirical
Evidence,”
regarding a preliminary offer to purchase the business of ABC Jail Company, Inc.
June 1979, pp. 163-196.
(TA 557).Journal of Financial Economics,
Page 17 of 34
Edition, p. 513. Refers to a study by I. Friend and M. Puckett, “Dividends and Stock Prices,”
Copeland,
Thomas E.Review,
and J. Fred
Weston,
Financial
Theory and Corporate Policy, Second
American Economic
September
1964,
pp. 656-682.
Edition,
p. 513.facility
Refers operations
to a study by I. (TA
Friend
and -M.TA
Puckett,
summary
of ABC
555
556).“Dividends and Stock Prices,”
17
American
Economic
Review,
September
1964,
pp.
656-682.
Ibid, pp. 515-6. Refers to a study by R. Litzenberger and K. Ramaswamy, “The Effect of
16
Page 17 of 34
- 18 70. do not
Proposal
to recapitalize
ABC Jail
Company,
(TA 558).another S corporation
know who
that specific buyer
will be.
Will it beInc.
an individual,
or a C corporation? Once again, there is no distinct answer. Depending upon the facts
71. andWorkpapers
regarding
ABC revenue/cost
from
the an
periods
1991 through
1996,
both
circumstances,
the appraiser
may be able to
make
assumption
about the
most
actualwilling
and projected
(TA 559of- TA
572).
probable
buyer (or category
buyer).
standard of valuedated
is investment
value,
appraiser
should consider
theMilton
tax rates
of
72. If the
Correspondence
December
10,the
1993
from Stephen
Jones to
Roberts
the relating
specific buyer.
In this instance,
the appraiser
is estimating
value to(TA
a particular
buyer.
to additional
items needed
to complete
the valuation
573 - TA
574).
This makes this task a little bit easier.
73.
Schedule of officers’ compensation from 1989 through 1992 (TA 575).
76.
A partial contract relating to facilities in Arkansas (TA 596 - TA 634).
Once the standard of value has been identified, the appraiser is still faced with the choice
of which rates to use. If corporate tax rates are used, the valuation analyst, with or without
74. the Article
entitled “Are ‘Doing Well’ and ‘Doing Good’ Contradictory Goals of
help of the local CPA, can calculate the taxes based on the sliding rates applicable at
Privatization?”
576 - TA
586).
the time. However,(TA
if personal
rates
are to be used, this calculation can become even
more complicated due to factors such as personal exemptions, itemized deductions,
75. phaseout
Depreciation
report
ABCor
Jail
Company,
Inc. (TAactivities
587 - TAthat
595).
rules and
otherfor
income
losses
from unrelated
could affect the
income tax rates that may be applicable. This could be a nightmare.
The practical application of income tax rates is up to the valuation analyst. If the rates can
If personal
in a relatively
straight forward
manner,
the analystofshould
do so.from
77. be calculated
A memorandum
of understanding
with
the Department
Correction
the State
tax rates
are
involved,
most
analysts
believe
that
there
is
little
to
be
gained
by
factoring
in
of Florida dated November 9, 1993 (TA 635 - TA 637).
personal exemptions and itemized deductions. If the valuation analyst represents a
individual,
these
items may
taken
consideration if they are material.
78. specific
A copy
of Florida
Legislation
(TAbe638
- TAinto
640).
Common sense and reasonableness should prevail.
79.
Correspondence from Robert Studebaker of Mahoney & Company, P.C. to Stephen
Jones regarding the ESOP valuation of privately operated prisons (TA 641 - TA
645).
Many
valuation analysts feel that both S and C corporations should be valued on an afterHolding Period of the Investment
tax basis. Many subscribe to the premise that the “after-tax” is to the corporation and not
80. the individual.
Hand written
notes
from the rates
workpapers
of Tennet
& market
Axelrod,
P.S.C. (TA
646on- TA
Since
capitalization
are determined
from
evidence,
usually
651).
a pre-tax basis to the individual, more comparability can be achieved in the selection of
these rates. Adjusting the income returns for personal taxes would make the discount rate
more
difficult, information
particularly since
ratesform
of return
the empirical literature
81. selection
A blank
valuation
request
(TA reported
652 - TAin657).
are based on pre-tax returns to the investor.
82.
Life insurance cost summary for ESOP plan (TA 658 - TA 660).
Some analysts adjust the benefit stream of an S corporation for the amount of distribution
to makearticles
the shareholders
whole after
the672).
personal taxes. It is fairly
83. needed
Newspaper
regarding prisons
(TA paying
661 - TA
common to see distributions being made in at least the amount necessary to pay the
personal taxes so that the shareholders do not pay taxes from monies that they have not
84.
Agenda for November 30, 1993 ESOP meeting (TA 675).
received. The problem with this approach is that the tax law provides that the shareholders
of an S corporation can increase their income tax basis in the S corporation for monies that
85. are Workpaper
from
Tennet &comparability
Axelrod, P.S.C.
files
dated
June 30,
1994 (TA
taxed and notcontents
distributed.
Therefore,
cannot
truly
be achieved
between
- TA 862).
the 753
S corporation
shareholders and the C corporation shareholders.
P.S.C.
files dated
86. Another
Valuation
workpapers
from
Tennet
consideration
related
to this
is that&SAxelrod,
corporation
shareholders
are December
permitted to 31,
take1994
subsequent
(TA 863distributions
- TA 1016).from the S corporation without current tax implications.
87.
Page 18 of 31,
34 1994 (TA 865 - TA 920).
Valuation report of ABC as of December
- 19 88. Shareholders’
Valuation undistributed
report checklist
dated
Junefrom
21,previous
1995 (TA
1017
- TA 1021).
taxable
income
years
is available
for distribution
since the shareholders have already paid tax on the profits in the year that it was earned.
Shareholders’
undistributed
taxable
incometo
from
previous
years
available
distribution
89. This
Miscellaneous
relating
1995
and of
1996
(TA
1022the
- TA
also causes
a workpapers
significant
difference
in
the
timing
the isvaluations
cash
flowsfor
between
since
the shareholders
have already
tax on the profits in the year that it was earned.
1269).
shareholders
of these different
typespaid
of entities.
This also causes a significant difference in the timing of the cash flows between the
shareholders
of these
different
types
of entities.
An argument can
be made
that the
difference
between a perpetual S corporation and a C
90.
Workpapers of Tennet & Axelrod, P.S.C. relating to the ABC forecast engagement
corporation
is the
present
value
of -the
corporate tax savings. The analyst must
from 1994
to be
2003
(TA
1270
TAannual
1349).
An argument
can
that
the difference
between
a perpetual
S corporation
and athe
C
face
the question
in made
each appraisal
assignment
regarding
an S corporation
of what
corporation
is
the
present
value
of
the
annual
corporate
tax
savings.
The
analyst
must
period of theworkpapers
investment will
be Tennet
while the&corporation
keeps its files
S election.
Some
91. holding
Miscellaneous
from
Axelrod,anP.S.C.’s
(TAwhat
1410
- TA
face
thebelieve
question
in aeach
appraisal
regarding
corporation
the
18
authors
that
corporation
willassignment
lose its S election
at someS point.
This of
means that
1472).
holding
period
of the
investment
will valued
be while
the
keeps for
its S
election. Some
the interest
in the
corporation
being
will
becorporation
an S corporation
18certain years and
authors
that afor
corporation
will lose
then a Cbelieve
corporation
its remaining
life. its S election at some point. This means that
interest inofthe
corporation
being
valued
will be an S corporation
certain
years and
92. the Printout
the
schedules
from
the ValuSource
computer for
system
relating
to the
then
a aCvaluation
corporation
for its
remaining
life.
November
30,analyst
1993
valuation
(TA
1464 - TAthe
1561).
When
is
requested
to determine
fair market value of an enterprise,
one of the factors to be determined by the analyst is who, or what group of investors, would
amost
valuation
analyst
requested
to30,
determine
market
value
of
an enterprise,
93. When
Valuation
report
as ofisbuyer.”
November
1993
Tennet
& Axelrod,
P.S.C.
(TA
1563 be the
likely
“willing
Another
factorby
tothe
befair
considered
in the
“willing
buyer”
one
of
the
factors
to
be
determined
by
the
analyst
is
who,
or
what
group
of
investors,
would
TA
1623).
scenario is will the willing buyer qualify to be an S corporation. Once it is determined that
be the
most
likelycan
“willing
Another the
factor
to question
be considered
in the “willing
buyer”
buyer
be anbuyer.”
S corporation,
next
to be answered
is for
how
the
willing
scenario
is
will
the
willing
buyer
qualify
to
be
an
S
corporation.
Once
it
is
determined
that
As with statement
many otherprocessing
decisions confronting
thefor
valuation
analyst,
is no clear
94. long?
Financial
instructions
the year
endedthere
December
31,cut
1995
the willing buyer can be an S corporation, the next question to be answered is for how
answer.
with
for the
ABC Jail
Inc.’s ESOP
1626cut
- TA
long?
Asfinancial
with manystatements
other decisions
confronting
theCompany,
valuation analyst,
there is(TA
no clear
1634).
answer.
Timing of the Valuation
95. Timing
A checklist
for financial reporting regarding defined contribution retirement plans (TA
of thewisdom
Valuation
Conventional
dictates that when a business valuation is performed for an interest
1635 - TA 1641).
in a corporation, the value determined is based on the value of the interest without regard
Conventional
dictates
thatwhen
whenwe
a business
valuation
is performed
for an interest
to
the investor.wisdom
This means
that
value shares
of stock
in a corporation,
it does
in a Other
corporation,
the
value
determined
is
based
on
the
value
of
the
interest
without
96. not
Tennet
&
Axelrod,
P.S.C.
workpapers
relating
to
services
performed
matter who the shareholder is, nor do we consider the tax implications of a saleregard
of for
thethe
to
the
investor.
This
means
that
when
we
value
shares
of
stock
in
a
corporation,
it
does
ABCbyESOP
(TA 1642 - TA
8799).taxes generally have no impact in the valuation of
interest
that shareholder.
Personal
not
matter
who
the
shareholder
is,
nor shareholder
do we consider
the individual).
tax implications
of a salenot
of the
corporate stock (assuming that the
is an
Obviously,
all
interest
by
that
shareholder.
Personal
taxes
generally
have
no
impact
in
the
valuation
of
shareholders are individuals, and not all shareholders are tax paying entities. Pension
corporate
stock (assuming
that
the shareholder
is an individual).
Obviously,
not be
all
plans, for example,
do not pay
taxes.
Therefore, should
the value of a
share of IBM
In order
to address
the
variousand
issues
in the
T&A reports,
as paying
well asentities.
the conduct
of this
shareholders
are
individuals,
not
all
shareholders
are
tax
Pension
different if an individual owns it or if a pension plan owns it?
plans, for example, do not pay taxes. Therefore, should the value of a share of IBM be
assignment
that individual
are problematic,
we awill
cite the page
reference, where possible, based
different
if anwe
ownsalmost
it or if full
pension
owns it? about willing buyers. The
At this point,
have come
circle inplan
our discussion
on the
batespublic
stamp
on eachrates
page.
investing
calculates
of return on an after-tax basis. Since different classes of
At this point,
wedifferent
have come
full circle
in our discussion
about will
willing
investors
have
tax almost
structures,
the required
rates of return
varybuyers.
amongThe
the
investing public
calculates an
rates
of return on
an after-tax
different
classes.
In determining
appropriate
discount
rate basis.
for theSince
net cash
flowclasses
of an of
S
investors
have
different
tax
structures,
the
required
rates
of
return
will
vary
among
the
Firstcorporation
and foremost,
thea lack
of qualifications
of the appraiser
must
noted.
Inincreased
our opinion,
versus
C corporation,
it is reasonable
to assume
thatbe
there
is an
classes.
appropriate
discount that
ratethe
forenterprise
the net cash
flow
of an
S
relativeIntodetermining
the net cashan
flow
of the S corporation
may at
some
point
risk
versus
a Cand
corporation,
it is reasonable
to assume
there is an
T&Acorporation
and Messrs.
Jones
Axelrod lacked
the requisite
skills, that
knowledge
andincreased
credentials
risk relative to the net cash flow of the S corporation that the enterprise may at some point
that demonstrate professional competence required to perform the valuation portion of their
18
Duffy, Robert
andT&A
George
L. Johnson,
“Valuation
engagement. According
toE.the
report
(TA 173):
18
of ‘S’ Corporations Revisited: The
Impact of the Life of an ‘S’ Election Under Varying Growth and Discount Rates”, Business
Duffy, Robert
E. and
George1993,
L. Johnson,
“Valuation
of ‘S’
Corporations
Revisited:
The
Valuation
Review,
December
pp. 155-167,
American
Society
of Appraisers,
Herndon,
Impact of the Life of an ‘S’ Election Under Varying Growth and Discount Rates”, Business
Va.
Valuation Review, December 1993, pp. 155-167, American Society of Appraisers, Herndon,
Va.
Page 19 of 34
Page 19 of 34
- 20 QUALIFICATIONS
OFThis
APPRAISER
in time pay taxes and have
a lower cash flow.
could be justification for a different
discount rate for the two entities. The question to be raised is, by how much?
in time
payfounding
taxes and
a lower
cash
flow. This
could
beperformed
justificationnumerous
for a different
Since
inhave
1980,
Tennet
& Axelrod,
PSC
has
discount
rate
for
the
two
entities.
The
question
to
be
raised
is,
by
how
much?
Without
empirical
in theheld
marketplace,
difficult,
if not of
impossible,
to quantify
valuations
of data
closely
entities. itAbecomes
significant
number
valuations
are
the performed
exact level of
Mathematical
quantification
cannotoffices
be usedfor
asclients
readily as
in adjustment.
our Jacksonville
and Lexington,
Arkansas,
Without
empirical
dataof
in pre-tax
the marketplace,
it becomes
difficult,
if not impossible,
tocontinue
quantify
it is throughout
for the
conversion
and
after-tax
discount
rates.
Valuation
analysts
the
region.
Valuation
opinions
have
been
rendered
for
a
variety
thestruggle
exact level
adjustment.
Mathematical
quantification
cannot
as readilyare
as
to
withof
the
notion ofmergers
whether
the corporate
cashemployee
flows
frombe
anused
S corporation
of
purposes
including
and
acquisitions,
stock
ownership
it
is
for
the
conversion
of
pre-tax
and
after-tax
discount
rates.
Valuation
analysts
continue
after
tax. Authors
have
argued that
should
a tax
tax equivalency
made to reflect the
plans,
marital
dissolutions
andthere
estate
andbe
giftcash
purposes.
19 S corporation are
to
struggle
with
the
notion
of
whether
the
corporate
flows
from
an
personal taxes that will have to be paid by S corporation shareholders. The reality of the
after
tax. isAuthors
have argued
there
should
be aortax
equivalency
made
reflect
situation
that personal
taxes that
will be
paid
whether
not
distributions
are to
made
to the
the
19 closely held
Our
clients
include
other
business
professionals,
individuals,
and
personal
taxes
that
will
have
to
be
paid
by
S
corporation
shareholders.
The
reality
of
the
shareholder. It seems reasonable to consider these taxes in a similar fashion as corporate
entities
representing
many
of distributions
industries.
Industries
situation
is that
personal
taxes
will is
bedifferent
paid to
whether
or not
are
to the
taxes.
Either
way,
the government
going
gettypes
paid.
There
is not going
to made
be a benefit
shareholder.
It
seems
reasonable
to
consider
these
taxes
in
a
similar
fashion
as
corporate
represented
include
professional
to the
shareholder other
than as
an adjustmentpractices,
to his or her financial
basis in the institutions,
corporate stock.
taxes.
Either way, the
going to getretail
paid.industries,
There is not
going
to beother
a benefit
manufacturing
andgovernment
distributionisconcerns,
and
various
to
the
shareholder
other
than
as
an
adjustment
to
his
or
her
basis
in
the
corporate
stock.
service have
industries.
Arguments
been raised for years regarding the built in gains tax. For a long time,
the
position of the Tax Court has been that no discount would be permitted for a built in gains
Arguments
have
been &
raised
for real
years
regarding
thethem
built
in
tax.
For a long
time, the
tax,
even though
investors
in the
world
consider
in gains
making
investment
decisions.
Several
Tennet
Axelrod
personnel
have
completed
various
courses
20
position
of the of
Tax
Court has
that Commissioner,
no discount would
be permitted
for a built
gains
D. been
Davis
part
of the
discount
for inlack
of
In
the
Estate
Artemus
concerning
the
valuations
of v.closely
held businesses
and
professional
tax,
even
though
investors
in
the
real
world
consider
them
in
making
investment
decisions.
marketability
was attributed
to to
the this
built in
gains tax. training,
This
couldwe
influence
future
valuations
practices.
addition
have
substantial
20
D. those
Davis
v. technical
Commissioner,
part
of the
discount
forthe
lack
of
In
Estate ofInArtemus
of Sthe
corporations,
particularly
that
have
exposure
to
the
built
in
gains
tax
in
postexperience
with
respect
to built
the buying
and
selling
of influence
businesses
through
marketability
was
attributed
to
the
in
gains
tax.
This
could
future
valuations
conversion
This
raises
the
issueThis
of the
S election having
a possible
discount
ofperiod.
working
with
our
clients.
combination
provides
ustax
with
the
of
Syears
corporations,
particularly
those
thatthat
have
exposure
to the
in the
postassociated
with it because
of the
taxes
potentially
could
bebuilt
paidinatgains
the corporate
level.
combination
of This
technical
and
experience
dealing discount
with
conversion
period.
raisestraining
the issue
of practical
the S election
having of
a possible
"willinginwith
buyers
andofsellers"
andofthe
ability
to value
businesses.
associated
because
of the
taxes
that
potentially
could
paid at the corporate
Valuation
the ithands
the
owner
the investment
in an be
S corporation
may resultlevel.
in a
more realistic valuation. However, that is clearly not fair market value. Personal tax rates
Valuation
in &
theAxelrod,
hands
ofPSC
the
of
the investment
in
an and
S corporation
may
result in a
personnel
have
qualified
asinvestment.
expert
mayTennet
vary depending
upon
tooowner
many
factors
that have
nothing
to testified
do with the
more
realistic
valuation.
However,
that
is
clearly
not
fair
market
value.
Personal
tax rates
witnesses
in numerous
Additionally,
have
many
large
A valuation
analyst
cannot becourts.
expected
to considerthey
items
suchassisted
as personal
exemptions
maylegal
vary depending
upon Certainly,
too
manythroughout
factors
that S
have
nothing to
do be
with
the
investment.
anddeductions.
accounting
firms
the
country
with
their
valuation
and
itemized
the
smaller
corporations
can
affected
by these
A
valuation
analyst
cannot
be
expected
to
consider
items
such
as
personal
exemptions
experience.
reports are
in accordance
withitems
standards
as the
items.
Larger SOur
corporations
mayprepared
not be influenced
by these
because
and
itemized
deductions.
Certainly,
the
smaller
S
corporations
can
be
affected
by
these
shareholders
are more
likely
to be in higher
tax brackets
where Public
these items
do not matter.
promulgated
by the
American
Institute
of Certified
Accountants.
items.
Larger
S
corporations
may
not
be
influenced
by
these
items
because
the
Does
these mean
that
valuation analysts
should
two standards,
one for is
small
Biographical
and
qualifications
information
onhave
our individual
professionals
shareholders
areone
more
be in higher tax brackets where these items do not matter.
companies
and
forlikely
largetocompanies?
available
upon that
request.
Does
these mean
valuation analysts should have two standards, one for small
companies
and
one for large companies?
Back To The
Future
At the time of the acceptance of this engagement, it is our belief that none of the
Back
To we
Thehave
Future
Now that
gone through numerous illustrations that tell us to look at the facts and
personnel,
and particularly the partner in charge of the engagement, Steven Jones, had
circumstances of each situation on its own, let’s step back to where the Tax Court has
Now that we have gone through numerous illustrations that tell us to look at the facts and
us and where
the future
needs to be.
In Adams,
The Court
stated
net cashflow
anytaken
credentials
in business
valuation.
When
questioned
about
his "The
qualifications
at his
circumstances of each situation on its own, let’s step back to where the Tax Court has
and the capitalization rate used to compute the fair market value of the WSA stock should
taken us Mr.
andJones
where responded
the future needs
to be. In
Adams, 24,
The2005,
Court stated
"The at
netpage
cashflow
deposition,
as follows
(January
beginning
22, line
and the capitalization rate used to compute the fair market value of the WSA stock should
18):
19
19
Q.
20
20
See Cassiere, George G., “The Value of S-Corp Election – The C-Corp Equivalency Model”,
Business Valuation Review, June 1994, pp 84 -91, American Society of Appraisers, Herndon,
See
VA. Cassiere, George G., “The Value of S-Corp Election – The C-Corp Equivalency Model”,
Business Valuation Review, June 1994, pp 84 -91, American Society of Appraisers, Herndon,
Okay.
Now, on the time – at the time you took on this assignment to
VA.
Estate of Artemus D. Davis v. Commissioner, 110 T.C. 35
value ABC Jail Company, were you a certified business appraiser
Estate of Artemus
Davis v.
Commissioner,
T.C. 35
designated
by theD.Institute
of 20
Business
Page
of 34 110Appraisers?
Page 20 of 34
- 21 A. the same
No. tax character; i.e., before corporate tax or after corporate tax."21 The
have
opinion
have thestated:
same tax character; i.e., before corporate tax or after corporate tax."21 The
Q.
At the time you took on the valuation assignment of ABC, were you
opinion stated:
accredited
senior appraiser
designated
the American
Society
We an
disagree
that Shriner
(the taxpayer’s
expert) by
properly
converted
the
capitalization
rate
theretaxpayer’s
was no need
to doproperly
so. Theconverted
parties agree
of
Appraisers?
We
disagree
that because
Shriner (the
expert)
the
that
Shriner's
estimated
capitalization
rate
(before
he
converted
it
to
before
capitalization rate because there was no need to do so. The parties agree
corporate
tax)estimated
is an aftercapitalization
tax corporaterate
tax(before
rate. Thus,
as in Gross,
tax
A. that
No.
Shriner's
he converted
it to the
before
character
of
Shriner's
estimate
of
WSA's
prospective
net
cashflows
matches
corporate tax) is an after tax corporate tax rate. Thus, as in Gross, the tax
of the
capitalization
because
both
are after
character
Shriner's
of WSA's
prospective
net cashflows
matches
Q. that
At
theofunconverted
time
youestimate
took
on
the rate
valuation
assignment
forcorporate
ABC Jail
tax.
It
follows
that
Shriner
should
not
have
converted
the
capitalization
rate
that Company,
of the unconverted
capitalization
rate because
both
are after
corporate
Inc., were
you a certified
valuation
analyst
designated
by
from
corporate
tax to before
corporate
tax because
the
tax character
of
tax. the
Itafter
follows
that
Shriner
should
not
have
converted
the
capitalization
rate
National Association
of Certified
Valuation
Analysts?
both
his estimated
for WSA tax
andbecause
unconverted
from after
corporatenet
tax cashflows
to before
corporate
the taxcapitalization
character of
22
rates
is after
corporate
both his
estimated
net tax.
cashflows for WSA and unconverted capitalization
A.
No.
rates is after corporate tax.22
Every valuation treatise or course that I have ever read discusses the importance of
Q matching
At the the
time
you stream
took on
valuation
for
ABC
JailI will
properly
benefit
withthe
discount
orassignment
capitalization
rate.
In fact,
Every valuation
treatise
or course that
I the
have
ever read
discusses the
importance
of
Company,
Inc.,
did
you hold
a degree
from
any university
or college
discuss
very fact
text,
Understanding
Business
The
reason
for Ithis,
properly this
matching
the my
benefit
stream
with the
discount
orValuation.
capitalization
rate.
In fact,
will
simply
is
forfact
consistency.
If the numerator
is changed
in a capitalization
model,
the
in very
valuation
discussstated
this
mysciences?
text, Understanding
Business
Valuation.
The reason
for this,
denominator
also change in
order
to maintain
the same
Clearly,model,
the value
simply
stated must
is for consistency.
If the
numerator
is changed
in avalue.
capitalization
the
different
benefit
stream
to
be
capitalized.
does
not
change
as
a
result
of
using
a
A.
No.
denominator must also change in order to maintain the same value. Clearly, the value
does not change as a result of using a different benefit stream to be capitalized.
The Tax Court has now taken the position through these opinions that while they are not
Not disputing
only did our
Mr. theory,
Jones
nottaken
have
anyposition
credentials
in these
business
valuation,
did
not
belong
they
find that
benefit
stream
of an opinions
S corporation
ishe
higher
the
The Tax Court
has now
the the
through
that while
theythan
are not
benefit
stream
of
a
similar
C
corporation
due
to
the
non
payment
of
taxes
at
the
entity
disputing
our theory,
they find at
that
thetime
benefit
stream
of an S corporation
is higher
the
to any
appraisal
organizations
the
of this
valuation.
His testimony
was than
as follows
level.
attempting
to reach an
value,
shouldn’t
we at
consider
all
benefit Since
streamweofare
a similar
C corporation
dueeconomic
to the non
payment
of taxes
the entity
economic
activities
that
impact
value?
In
almost
every
case,
S
corporations
distribute
at
(January
2005,
beginning
on page
24, an
lineeconomic
12):
level. 24,
Since
we are
attempting
to reach
value, shouldn’t we consider all
least
enough
of theirthat
earnings
that their
shareholders
can pay
their taxes based
on the
economic
activities
impactso
value?
In almost
every case,
S corporations
distribute
at
amount
of
profits
that
flow
through
to
the
shareholders.
This
can
almost
be
thought
of
as
least enough of their earnings so that their shareholders can pay their taxes based on the
entity-related
taxes.
Therefore,
corporations
didThis
not
distribute
cashflow
toofpay
amount
that
flow
through
toSthe
shareholders.
can
almostof
beABC,
thought
as
Q. of profits
Now,
at
the
time
you iftook
on
the valuation
assignment
did
individual
income
taxes,
the
shareholders
would
most
likely
revoke
the
S
election,
entity-related
Therefore,
if S that
corporations
distributeincashflow
youtaxes.
have any
credentials
qualified did
younot
specifically
the field to
of pay
assuming
they taxes,
had thethe
ability
to do so. would most likely revoke the S election,
individual that
income
shareholders
business valuation?
assuming that they had the ability to do so.
If you have learned anything as a result of reading this paper, it is probably that the
A. ofNo
specific
credentials,
no.
question
an
S election
adding
a discount
to the value
of an investment
If you have
learned
anything
as aapremium
result of or
reading
this paper,
it is probably
that the
does
not have
easy answer.
there appears
to be atopossible
benefit
the willing
question
of an an
S election
addingWhile
a premium
or a discount
the value
of an ifinvestment
Q. can At
the time
took into
on the
thefuture,
assignmentis to
ABC, what
buyer
continue
theanswer.
Syou
election
no value
guarantee
will
does not
have
an easy
While there
appears there
to be a possible
benefitthat
if thethis
willing
professional
business
valuation
organizations
did
you belong
to?
that
value
in this
making
happen.
be given
all future,
of
the factors
buyer
canConsideration
continue theshould
S election
into tothe
there is
noinfluence
guarantee
that
will
a
determination.
The
premium
or
discount
issue
must
be
examined
on
a
case
by
case
happen. Consideration should be given to all of the factors that influence value in making
basis
there
no
other--way
to dorecall
it. issue
In many
instances,
the increase
or decrease
A. because
At the
time,
I don't
in '93
what,
if any,
weonbelonged
a
determination.
Theis premium
orI don't
discount
must
be examined
a case
bytocase
in
value
will
be
based
on
the
manner
in
which
the
benefit
stream
is
taxed.
at that
point
time.way to do it. In many instances, the increase or decrease
basis because
there
is noinother
in value will be based on the manner in which the benefit stream is taxed.
Q.
A.
21
21
22
22
Sitting here today, you can't think of any organizations you belonged
Adams,
p. 13.
to in
1993?
Adams,
13.
Ibid., pp.p.14-15.
Not from a valuation standpoint.
Ibid., pp. 14-15.
Page 21 of 34
Page 21 of 34
- 22 Q.
Okay.
Did you belong, in 1993, upon taking this assignment to value
S Corporation
Models
ABC in 1993, belong to the Institute of Business Appraisers?
Over the past several years, various S corporation models have surfaced. The purpose
A. models
No. is to calculate the tax differential relating to the S corporation. Valuation
of these
analysts seem to agree that there is little or no difference in the market values of controlling
interests
S and C
under
most circumstances.
If there
is a difference
Q. between
Upon taking
oncorporations
this valuation
assignment
in 1993, did
you belong
to
in the values,
it
depends
on
finding
a
buyer
that
can
take
advantage
of
the
potential
tax
the American Society of Appraisers?
savings. However, the valuation community also seems to agree that there may be
differences
in value at the shareholder level for noncontrolling interests. All of the models
A.
No.
appear to have been constructed to address the valuation of noncontrolling shareholder
interests in S corporations.
Q.
Upon taking on this assignment in 1993, did you belong to the
National
Certified
The four models
thatAssociation
I have seen of
include
thoseValuation
that were Analysts?
designed by Roger Grabowski,
Chris Mercer, Dan Van Vleet, and Chris Treharne. I cannot possible cover all of these
A. in No.
models
the detail that they deserve. Each is solid in its quest to determine the tax
impact of an S election. Some are much more complicated that others. Various articles
When
about discuss
business
valuation
Mr. Jones
unableis to
provide
andquestioned
chapters in books
these
modelseducation,
in detail. However,
this was
discussion
beyond
the scope of this paper.
any information about the courses that he had taken to get educated in this field. His
model that
like the
probably because it is the
However,
that being
response
waswith
(January
24, said,
2005,the
beginning
at Ipage
25,most,
line 13):
most simple, is Chris Treharne’s model. I used that model in the critique that was included
in Exhibit 1. It was also the model that was referenced in Delaware Open MRI Radiology
Q.
Now,
the in
time
this assignment
to value
what
Associates.
The at
judge
thatyou
casetook
did aon
fabulous
job in explaining
whatABC,
he did.
I have
business
valuation
courses
had
you
attended,
if
any?
excerpted a portion of that opinion for you in Exhibit 2.
TheA.
only complaint
that
I have
heard
other analysts
make
about
the Treharne
model
is that
Oh, we -yes,
I had
attended
some that
were
sponsored
by either
the
it does notArkansas
take into consideration
the
potential
value
that
is
attributable
to
the
reduced
Society of CPAs and/or the AICPA. And probably others.
taxes that Ithe
shareholder
don't
recall thewill
-- pay due to the build up in the tax basis of the stock. My
attitude about that is, does it really matter when the underlying assumption is that the
willing
has you
a long
horizon
investment.
The present
value
the tax
Q. buyer
Need
to term
list them
for for
me,the
Mr.
Jones. I need
the year
you oftook
savings 20 or 30 years from now will be relatively small. I really do not believe that this is
business valuation courses that you attended prior to November
a major concern, but who am I to decide that?
1993.
The two things that jump out at me about the S corporation issue is that distributions make
A. of difference
I don't know
we have
records
still at thebenefit
-- in our
files
at the
a world
as toifwhether
or those
not there
is a shareholder
in an
S corporation
office.in Ithe
cantax
check.
and the change
law in 2003 brought the rates so much closer that there is no
longer as much of a difference as there was when the Gross decision was issued.
Q.
Is there anything in your work papers that would show you that?
A.
No.
Q.
Now, you mentioned the Arkansas Society of CPAs. Do you recall
anybody from the Arkansas Society of CPAs who put on such a
course?
Page 22 of 34
- 23 A.
Well, most of their courses Exhibit
are, I'll say
2 national courses developed by
23
the AICPA
that the Associates,
various state
societies contract with to have
Delaware Open
MRI Radiology
ExhibitP.A.
2 v. Howard B. Kessler, et al. ,
instructors come down and give the courses.
23
Delaware Open MRI Radiology Associates, P.A. v. Howard B. Kessler, et al. ,
The issue was should we tax the S Corp. earnings, and by what rate? Sound familiar? In
The
Court’s
opinion,
Chancellor
Strine
the issue
of rate?
“Is It Appropriate
To Tax
The that
issue
was
shouldthere
we tax
the S
Corp.addressed
earnings,
by what
Sound
familiar?
During
time
frame,
were
a limited
number and
of courses
that were
sponsored
byInthe
Affect
The
Earnings
Of
Delaware
Radiology
In
Order
To
Determine
Its
Fair
Value?
The Court’s opinion, Chancellor Strine addressed the issue of “Is It Appropriate To Tax
AICPA,
turn, the
state CPA
societies
offered
limited educational
courses in
Affectand
The in
Earnings
Of Delaware
Radiology
In Order
To Determine
Its Fair Value?
The expert on one side of this litigation treated Delaware Radiology as if it were a regular
business
valuation.
Arkansas Society
CPAs only
offered one
during
1992
tax-paying
entity ( aThe
C corporation)
when he of
performed
the valuation
thatcourse
the Broder
Group
The expert on one side of this litigation treated Delaware Radiology as if it were a regular
used
to set entity
the
merger
price.On
In September
fact,
he applied
a 40 percent
tax rate.
Not
toBroder
be
surprised,
andtax-paying
no courses
during
3, 1992,
an
course
was
offered
by the
( a C1993.
corporation)
when
he performed
theAICPA
valuation
that
the
Group
the
expert
on
the
other
side
asserted
the
proposition
that
because
Delaware
Radiology
used to set the merger price. In fact, he applied a 40 percent tax rate. Not to be surprised,
Arkansas
CPAs
entitled
Developing
Your
Valuation
Skills:
was
an Society
S on
corporation,
it faced
no corporate-level
income
taxes. Delaware
Relying on
this asAn
the expert
theof
other
side
asserted
the proposition
thatBusiness
because
Radiology
Delaware
operative
reality,
the expert income
did nottaxes.
tax affect
its earnings
in
was an S Radiology’s
corporation, Unless
it facedthere
no
corporate-level
Relying
on this
as
Engagement
Approach.
were
other
courses
that
Mr.
Jones
took,
which
he
performing
his valuation.operative
Any taxes,
he reasoned,
would
the stockholder
level
Delaware Radiology’s
reality,
the expert
did be
notpaid
taxataffect
its earnings
in
and
should
notvaluation.
be considered
in valuing
Delaware
Radiology
asalmost
an
entity.
could
not
document,
his education
during
this timewould
framebewas
nonexistent.
performing
his
Any taxes,
he reasoned,
paid
at the
stockholder level
and should not be considered in valuing Delaware Radiology as an entity.
Chancellor Strine opined
OneChancellor
more itemStrine
is worth
noting regarding the qualifications of the appraiser. T&A indicates
opined
This dispute raises an interesting question of valuation, which has elicited a
24
“Our reports
prepared
inan
accordance
with standards
as
promulgated
by After
theaAmerican
fair
amount
of
attention
from judges,
appraisers,
and
academics.
Thisare
dispute
raises
interesting
question
of valuation,
which has elicited
24
careful
consideration,
I conclude
that neither
of the
experts
has takenAfter
the
amount
of attention
from judges,
appraisers,
and
Institute offair
Certified
Public
Accountants.”
This
statement
isacademics.
not only false,
but when
most
reasonable
approach
to
valuing
Delaware
Radiology.
careful consideration, I conclude that neither of the experts has taken the
questioned
about
it, Mr. approach
Jones, once
again,
demonstrated
his lack of knowledge of
most
reasonable
to valuing
Delaware
Radiology.
The problem with Reed’s approach of treating Delaware Radiology as a C
business corporation
valuation. His
deposition
testimony
included
thesmall
following
24, 2005,
obvious.
Delaware
Radiology
is a Delaware
very
entity. (January
The as
record
The problemiswith
Reed’s
approach
of treating
Radiology
aC
reveals
set
of circumstances
which it isislikely
that
Delaware
Radiology
beginningcorporation
at pageno42,
9): DelawareinRadiology
is line
obvious.
a very
small
entity. The
record
will convert
corporation status.
highly
that
reveals
no settoofCcircumstances
in whichIt itisis alikely
thatprofitable
Delaware entity
Radiology
generates
and
distributes
income
well
in
excess
of
the
stockholder
level
will convert to C corporation status. It is a highly profitable entity that
taxes its stockholders
mustincome
pay. The
status
is a highly
distributes
wellSincorporation
excess
of tax
the
stockholder
level
Q. generates
Okay. and
Now,
continuing
with Exhibit
307
on the
page
of qualifications
valuable
attribute
to
the
shareholders
of
Delaware
Radiology,
given
its
taxes
its
stockholders
must
pay.
The
S
corporation
tax
status
is
a
highly
of appraisal -- appraiser, page 173, last paragraph, do you see where
valuable
attribute
to the"our
shareholders
of Delaware
given its
you have
written
reports are
preparedRadiology,
in accordance
with
23
A.
23
Q. 24
24
A.
standards as promulgated by the American Institute of Certified Public
Accountants."
see that?
Delaware Open Do
MRI you
Radiology
Associates, P.A., Petitioner, v. Howard B. Kessler, et al.,
Respondents. and Howard B. Kessler, et al., Plaintiffs, v. George J. Broder, et al.,
Delaware
Open
MRI
Radiology
Associates,
P.A.,ofPetitioner,
B. Kessler,
et al.,
Defendants,
in the
Court
of Chancery
of the State
Delaware,v.
in Howard
and for Newcastle
County,
Yes,
sir.
Respondents.
and
Howard
B.
Kessler,
et
al.,
Plaintiffs,
v.
George
J.
Broder,
et
al.,
Consolidated, C.A. No. 275-N.
Defendants, in the Court of Chancery of the State of Delaware, in and for Newcastle County,
Consolidated,
No.
Tell
me
I'd 275-N.
ask
you611
toA.2d
do 485
here
you list
those
See,
e.g.,--In what
reC.A.
Radiology
Assocs.,
(Del.isCh.would
1991); Adams
v. Commissioner
of Internal Revenue,
2002 WL 467235 (U.S. Tax Ct. Mar. 28, 2002); Heck v. Commissioner
standards
forre me?
See, e.g., In
Radiology Assocs., 611 A.2d 485 (Del. Ch. 1991); Adams v. Commissioner
of Internal Revenue, 2002 WL 180879 (U.S. Tax Ct. Feb. 5, 2002); Gross v. Commissioner
of Internal
Internal Revenue,
Revenue, 1999
2002 WL
WL549463
467235(U.S.
(U.S.Tax
TaxCt.
Ct.July
Mar.29,
28,1999);
2002);
Heck v.M.
Commissioner
of
Franklin
Fisher et. al.,
ofthe
Internal
Revenue,
2002
WL
180879
(U.S.
Tax
Ct.
Feb.
5,
2002);
Gross
v.
Commissioner
OffThe
top
of
my
head,
I'm
not
for
sure
I
can
quote
them
verbatim,
but
Sale of the Washington Redskins: Discounted Cash Flow Valuation of S-Corporations,
of Internal Revenue,
1999
WL 549463
(U.S. Tax Ct.
July
29, 1999);
Franklin
M.
Fisher
et. al.,
Treatment
of
Personal
Taxes,
and
Implications
for
Litigation,
10
Stan.
J.L.
Bus.
& Fin.
18
theThe
standards
that are Redskins:
outlined Discounted
in the code
of conduct
that
state
Sale
of
the
Washington
Cash
Flow
Valuation
of
S-Corporations,
(2005)
(hereinafter
“Fisher”);
Z.
Christopher
Mercer,
S
Corporation
Valuation
Issues,
The
exercise
due
care, that
youand
obviously not
on engagements
Treatment
of Personal
Taxes,
fortake
Litigation,
10Conference
Stan. J.L. (Oct.
Bus.that
&
18
American Society
of Appraiser’s
22ndImplications
Annual Business
Valuation
17,Fin.
2003)
(2005)
(hereinafter
“Fisher”);
Z.
Christopher
Mercer,
S
Corporation
Valuation
Issues,
The
you're
not
qualified
to
do,
and
that
you
follow
all
the
necessary
(hereinafter “Mercer”).
American Society
Appraiser’s 22nd
Annualin
Business
Valuation
Conference
guidelines
of theofAmerican
Institute
preparing
your
report. (Oct. 17, 2003)
(hereinafter “Mercer”).
Page 23 of 34
Page 23 of 34
- 24 The AICPA
did not have
standards
related tostockholders,
business valuation
profitability
and specific
the affluent
status ofthat
its physician
who faceassignments
top
marginal
tax
rates.
profitability
and
the affluent
statusStatement
of its physician
stockholders,
face topServices
in 1993. However,
the
AICPA
had issued
on Standards
for who
Consulting
marginal tax rates.
No.This
1 that
referenced
201
of the
AICPA
Code
Professional
Conduct.
Furthermore,
starts
to soundRule
like the
facts
in the
Gross
caseof
from
the tax court.
The Court
indicated
that
This starts to sound like the facts in the Gross case from the tax court. The Court indicated
at that
time, the AICPA had published Practice Aid 93-3, Conducting A Valuation of a
that
Under
Delaware
law, stated
an appraisal
petitioner is “entitled to be paid for that
Closely Held
Business,
which
the following:
25
which
been taken
from
him . . . .”
In this is
case,
the Kessler
Group
Under has
Delaware
law, an
appraisal
petitioner
“entitled
to be paid
for was
that
25
involuntarily
deprived
of
the
benefits
of
continuing
as
stockholders
in
a
which has been taken from him . . . .” In this case, the Kessler Group was
profitable
S deprived
corporation
benefits
that ofwere
comprised
materially of inthe
involuntarily
of the
benefits
continuing
as stockholders
a
13/115
BUSINESS
VALUATION
EDUCATION
favorable
treatment that
accompanies
S corporation
As a matter
profitable tax
S corporation
benefits
that were
comprisedstatus.
materially
of the
of
fairness,
the
merger
price
had
to
take
into
account
these
benefits
favorable
tax
treatment
that
accompanies
S
corporation
status.
As
a
matter
.01
In performing business valuation engagements, practitionersand
are
provide
fair the
compensation
forhad
the to
Kessler
Group’s
loss.these
Reed’s
approach
of
fairness,
merger
price
take
into
account
benefits
and
advised to determine whether the competency provisions of rule 201,
denied the
Group members
the value
they would
have received
as
provide
fairKessler
compensation
for the Kessler
Group’s
loss. Reed’s
approach
General
Standards
of the AICPA
Code of Professional
Conduct,
are met.
continuing
corporation
stockholders
in Delaware
and,
therefore,
denied
the SKessler
Group
members the
value theyRadiology
would have
received
as
Although
accountants
haveprice
a thorough
understanding
of financial statements
ensured
that
the
merger
was
lower
than
fair
value.
continuing S corporation stockholders in Delaware Radiology and, therefore,
andensured
relatedthat
matters,
they also need to be proficient in the area of appraisals
the merger price was lower than fair value.
to competently
complete
an engagement.
Usually,
beingand
proficient
requires
At the same time,
Mitchell’s
approach is equally
flawed
overstates
the
an value
in-depth
knowledge
of
finance,
economics,
and
security
analysis
and
to the Kessler
Group.
The value
theoverstates
S corporation
At the fairly
samebelonging
time, Mitchell’s
approach
is equally
flawedofand
thean
understanding
of appraisal
principles
and
methods.
structure
is belonging
one
that is to
experienced
the stockholder
and
that is easy
value
fairly
the
KessleratGroup.
The valuelevel
of the
S corporation
to
overstate.
If an
S is
corporation
is toatbe
for example,
willthat
receive
no
structure
is one
that
experienced
thesold,
stockholder
level itand
is easy
.02premium
In
order
for
the
practitioner
to
obtain
the
competency
required
over
a S
C corporation
corporationisiftothe
universe
of buyers
is receive
principally
to overstate.
If an
be sold,
for example,
it will
noto
26
accept
a business
valuation
engagement,
appropriate
education
is
required.
comprised
of C acorporations.
There
is an
obviousofreason
unless
premium
over
C corporation
if the
universe
buyersforisthis:
principally
26
Courses
sponsored
by the AICPA,
the
American
Society
Appraisers
the buyer
ofofthe
S corporation
can
retain
and
benefit
from that
tax
status,
comprised
C corporations.
There
is an
obvious
reason
forofthis:
unless
then
the
buyer
will
value
an
S
corporation
at
the
value
it
would
have
as
aC
(ASA),
and
The
Institute
of
Business
Appraisers
Inc.
(IBA)
will
provide
the buyer of the S corporation can retain and benefit from that tax status,
corporation.
Therefore,
itan
would
be highlynecessary
misleading
toitperform
do
a market-based
then the buyer
will
S education
corporation
at the valueto
would
have
astypes
aC
practitioners
with
thevalue
minimum
there
comparable
acquisition
valuation
of
an
S
corporation
using
sales
Therefore,
it wouldcourses
be highly may
misleading
do a market-based
of corporation.
engagements.
Self-study
help to
reinforce
a level ofof
Cacquisition
corporations
to C
corporations,
and then
assume
the of
Sof
comparable
of an
S corporation
using
sales
insufficient
as the
sole that
method
knowledge;
however,
theyvaluation
are
usually
corporation would
be sold at to
a higher
price because
of its assume
tax status.
In the
other
comparable
C corporations
C corporations,
and then
that
S
education.
words, I amwould
not trying
to quantify
theprice
value
at which
Delaware
Radiology
corporation
be sold
at a higher
because
of its
tax status.
In other
would sell
to not
a Ctrying
corporation;
I am the
trying
to quantify
value of Radiology
Delaware
words,
I am
to quantify
value
at whichthe
Delaware
A statement
thatsell
theas
report
is inconcern
accordance
with
standards
by
the the
AICPA was
Radiology
going
with
S corporation
structure
and
would
to
aa C
corporation;
I aman
trying
to quantifypromulgated
the value
of award
Delaware
Kessler Group
rata share
of S
that
value. structure and award the
Radiology
as a their
goingpro
concern
with an
corporation
T&A’s attempt
to copy
a portion
of the
certification
that is required by the appraisal
Kessler Group their pro rata share of that value.
In thisas
case,
then,
relevant
problem with
Mitchell’s approach
is that Practice
organizations,
well
as the
themore
Uniform
Standards
of Professional
Appraisal
his
failure
to
tax
affect
Delaware
Radiology’s
earnings
at
all
results
an
In this case, then, the more relevant problem with Mitchell’s approach isinthat
(USPAP),artificial
which
appeared
in
most
of
the
valuation
treatises
that
were
published
inflation
the value
of S corporation
status
to the at
Kessler
Group.
his failure
to taxofaffect
Delaware
Radiology’s
earnings
all results
in To
an at that
capture
the
precise
advantage
the
S corporation
structure
to
the
Kessler
artificial
inflation
of the
valueinofthe
Sofcorporation
status to
the93-3,
Kessler
Group.
To
time. USPAP
was
also
addressed
AICPA
Practice
Aid
where
it stated:
Group, itthe
is necessary
to use a method
considersstructure
the difference
capture
precise advantage
of the Sthat
corporation
to thebetween
Kessler
the value
that a stockholder
of Delaware
Radiology
would receive
in
Group,
it is necessary
to use a method
that considers
the difference
between
the
value
that
a
stockholder
of
Delaware
Radiology
would
receive
.06 Standards 1 through 8 of USPAP, which are broad standards, mustinbe
adhered
to when an appraisal is performed for a federally related transaction
25
Tri-Continental Corp. v. Battye, 74 A.2d 71, 72 (Del. 1950).
involving
real estate and other tangible property. The Preamble and
25
Tri-Continental Corp. v. Battye, 74 A.2d 71, 72 (Del. 1950).
26
StandardsSee
9 and
109-14.
of USPAP provide specific guidelines for developing and
Mercer
26
reporting See
business
valuations. Professional valuers recommend that
Mercer 9-14.
Page 24 of 34
Page 24 of 34
- 25 USPAP beRadiology
followed as
foraall
of engagements,
even
are not
Delaware
C types
corporation
and the value
thatifathey
stockholder
federally
related.
(Emphasis
added).
would receive in Delaware Radiology as an S corporation. By using that
method, I can make my best estimate of the value that is relevant in this case
going
an throughout
S corporation
wasT&A
taken
from
the and
As will —
be the
pointed
outconcern
in muchvalue
more in
detail
thisthat
report,
used
software
Kessler Group in the merger.
attempted to provide a business valuation report without understanding the principles of
In undertaking
this analysis,
I embrace
the reasoning
of prior decisional
lawshould
valuation,
what the correct
inputs into
the valuation
software programs
it was using
that has recognized that an S corporation structure can produce a material
have been,
whatin the
outputsvalue
fromfor
thea stockholder
software meant,
or the be
amount
research
increase
economic
and should
givenof
weight
in and
27
a proper
valuation
ofto
theproduce
stockholder’s
interest.
Thatreport.
reasoning
analysis
that was
required
a credible
valuation
Mr. undergirds
Jones, almost 11
not only holdings of the Adams, Heck, and Gross cases in the U.S. Tax
years later, sat in his deposition and was unable to answer questions about standards with
Court, but an appraisal decision of this court, which coincidentally also
28
involvedThis
a radiology
business.
The who
opinion
in Into
rehave
Radiology
Associates
any certainty.
comes from
an individual
claimed
“substantial”
experience
noted that “under an earnings valuation analysis, what is important to an
in performing business valuations. When he was asked how many appraisals
he would
investor is what the investor ultimately can keep in his pocket.”29 In that
have tocase,
do toon
have
experience,”
hisheld
response
was
“Fifteen,
twenty.”that
(January
the“substantial
record before
it, the court
that the
way
to implement
insight was to ignore tax completely.30 The In Re Radiology Associates
24, Page 37, line 19). This would equate to substantially less than a full year of experience
decision comported with decisions of the U.S. Tax Court, which has given life
assuming
thatadvantages
the average assignment
takes 60
hoursbyto refusing
complete.toThe
to the
of S corporation
status
tax American
affect theSociety
31
corporation’s earnings at all.
of Appraisers, at that time, and subsequently, The Institute of Business Appraisers,
required
full years
of business
valuation
experience
(10,000
work hours) to earn a
Myfive
difference
with
these prior
decisions
is at the level
of implementation,
rather
at thetolevel
of principle.
Certainly,
this context
when
minority
credential
(inthan
addition
passing
examinations
andinsubmitting
work
product
for peer
stockholders have been forcibly denied the future benefits of S corporation
review).status, they should receive compensation for those expected benefits and
not an artificially discounted value that disregards the favorable tax treatment
available to them. But the minority should not receive more than a fair S
Mr. Jones also could not recall which business valuation treatises he relied on. One
reason for this is because his workpapers lacked any documentation from these treatises
to support
what he did in performing the ABC valuation. An experienced appraiser knows
27
See Adams, 2002 WL 467235; Heck, 2002 WL 180879; Gross, 1999 WL 549463.
exactly what resources are in its reference library. This is especially true in business
28
In re Radiology Assocs., 611 A.2d at 495.
29
Id.
valuation because there are a limited number of authors and texts that would be regularly
referred to as reference materials. Not knowing which publications were relied on is an
30
indication thatId.
he probably did not consult any of these materials. In fact, if he did consult
31
Inhe
this
regard,
theavoided
case of Gross
v. Commissioner
a goodinexample.
In Gross,
the Tax
the materials,
may
have
making
many of the iserrors
judgement
that will
be
Court held that “[w]e believe that the principal benefit that shareholders expect from an S
pointed out incorporation
this report.
election is a reduction in the total tax burden imposed on the enterprise. The
owners expect to save money, and we see no reason why that savings ought to be ignored
as a matter of course in valuing the S corporation.”Gross, 1999 WL 549463 (page reference
WL). The Tax Court refused to allow a “hypothetical corporate tax rate in
Based on ourunavailable
review ofon
the
T&A report and workpapers, it is obvious that they did little
excess of the zero-percent actual corporate tax rate” to be considered in valuing an S
corporation
instead required
that and
no corporate
tax be applied
the S corporation’s
more than enter
data intoand
a computer
program
use management
as to
justification
for not
earnings. Id.
Page 25 of 34
- 26 fulfilling their
obligations
as a business
Throughout
the deposition,
Mr. Jones kept
corporation
valuation.
Refusing
to
at
such
corporation
valuation.
Refusing valuer.
to tax
tax affect
affect
at all
all produces
produces
such a
a windfall,
windfall,
as
next
explain.
as IIhe
next
explain. things with management, the directors or the trustees. However,
stating that
discussed
he has little-to-no
notes
of all ofCode
thesestates
supposed
tookof
The
Revenue
that
“[t]he
income
an
The Internal
Internal
Revenue
Code
states
that conversations
“[t]he taxable
taxable that
income
ofplace.
an S
S The first
corporation shall
be
computed
in
as
case
shall
be
computed
in the
the same
sameofmanner
manner
as in
in the
theparticularly
case of
of an
anwhen the
thing thatcorporation
accountants
are32
taught
is the importance
documentation,
32
individual
.
.
.
.”
This
tax,
though
assessed
at
individual
rather
than
individual . . . .”
This tax, though assessed at individual rather than
corporate
tax
rates,
dependent
the
net
data received
is oral
written.
Part solely
of the upon
standard
involving Sufficient
Relevant Data
corporate
taxversus
rates, is
is
dependent
solely
upon
the corporation’s
corporation’s
net earnings.
earnings.
Even
if
Delaware
Radiology
were
to
retain
100%
of
its
earnings
annually,
Even
if Delaware
Radiology were
to retain
100% of its
earnings
annually, its
its
is not only
gathering
the
information,
but
also
documenting
it
in
the
workpapers.
T&A failed
stockholders
still
would
owe
taxes
on
Delaware
Radiology’s
income
even
stockholders still would owe taxes on Delaware Radiology’s income even
though
in this regard.
though they
they received
received no
no distributions.
distributions. Affording
Affording a
a remedy
remedy to
to the
the Kessler
Kessler
Group
that
denies
the
reality
that
each
shareholder
owes
taxes
Group that denies the reality that each shareholder owes taxes on
on his
his
proportional
interest
in
Delaware
Radiology
would
result
in
the
Kessler
proportional interest in Delaware Radiology would result in the Kessler Group
Group
a
per
share
value
the
could
have
receiving
a higher
higher
per on
share
value from
from
the court
court
than
could
ever
havethat was
T&A didreceiving
little more
than rely
a software
program
to than
end ititup
withever
a result
33
33
realized
as
a
continuing
shareholder.
realized as a continuing shareholder.
improper, illogical and unsupported. Although there is nothing in the standards that
The
that
be
for
entire
award
Theanamount
amount
that should
should
be the
the abasis
basis
for an
an appraisal
appraisal
orpackage,
entire fairness
fairness
award
precludes
appraiser
from using
valuation
softwareor
the appraiser
must
is
the
amount
that
estimates
the
company’s
value
to
the
Kessler
Group
is the amount that estimates the company’s value to the Kessler Group as
as
S
stockholders
individual
income
highest
accept responsibility
all tools thatpaying
are used
in the application
of at
thethe
assignment.
T&A,
S corporation
corporationfor
stockholders
paying
individual
income taxes
taxes
at
the
highest
rates
— an
amount
that
more
in
than
if
rates
anAxelrod
amount failed
that is
istomaterially
materially
moreprofessional
in this
this case
case care
than by
if Delaware
Delaware
Mr. Jones
and—Mr.
exercise
due
not being
familiar
Radiology
was
a
C
corporation.
In
coming
to
a
determination
Radiology was a C corporation. In coming to a determination of
of how
how the
the
interest
Delaware
Radiology
would
valued
in
with the Kessler
tool thatGroup’s
was relied
on inin
assignment.
Furthermore,
failed
adequately
Kessler
Group’s
interest
inthis
Delaware
Radiology
would be
be they
valued
in a
atofree
free
market
comprised of
willing
buyers
and
of
corporations,
market
willing
buyers
and sellers
sellers this
of S
Sassignment.
corporations, acting
acting
supervise
eithercomprised
each otherofor
others
whiletoperforming
without
compulsion,
it
is
essential
quantify
the
actual
without compulsion, it is essential to quantify the actual benefits
benefits of
of the
the S
S
corporation
status.
That
is
also
essential
in
order
to
determine
the
value
of
corporation status. That is also essential in order to determine the value of
what
what was
was actually
actually taken
taken from
from the
the Kessler
Kessler Group
Group as
as continuing
continuing stockholders.
stockholders.
Despite Mr. Jones testifying to having substantial experience in valuation, he testified at
Assessing
taxes
to
shareholder
at
level
does
not
Assessing
corporate
taxes
to the
the
shareholder
at a
a personal
personal
level
does
not Source,
the original
trial thatcorporate
“We were
using
a package
I believe
it was just
called
Bank
affect
the
primary
tax
benefit
associated
with
an
S
Corporation,
which
is
the
affect the primary tax benefit associated with an S Corporation, which34is the
which is avoidance
nationally of
marketed,
sold
CPAs other
business
34 Thisvaluators
a
tax
in
addition
to
earnings.
avoidance
of
a dividend
dividend
taxto
in various
addition practitioners,
to a
a tax
tax on
on corporate
corporate
earnings.
This
throughout the country” (July 18, 2001, Page 50, line 24). The actual name of this software
package32
is Valusource
and
not (2005).
Bank Source. Mr. Jones was unfamiliar with the computer
32
26 U.S.C.A.
§ 1363
26 U.S.C.A. § 1363 (2005).
product 33
that was being used in his everyday practice.
33
See,
See, e.g.,
e.g., Fisher.
Fisher.
34
34
See,
See, e.g.,
e.g., Byrne
Byrne v.
v. Commissioner
Commissioner of
of Internal
Internal Revenue,
Revenue, 361
361 F.2d
F.2d 939,
939, 942
942 (7th
(7th Cir.
Cir. 1966)
1966)
(“We
agree
with
the
observation
of
the
Tax
Court
that
the
[S
Corporation]
statute
is
designed
Mr. Jones also(“We
testified
heobservation
considered
this
be that
state
the art software.
agree that
with the
of the
Taxto
Court
theof
[S Corporation]
statute is However,
designed
to
to permit
permit a
a qualified
qualified corporation
corporation and
and its
its shareholders
shareholders to
to avoid
avoid the
the double
double tax
tax normally
normally paid
paid
when
a
corporation
distributes
its
earnings
and
profits
as
dividends
and
this
is
accomplished
the software producer
suggested
that
this
package
was
not
to
be
blindly
used, and
when a corporation distributes its earnings and profits as dividends and this is accomplished
in
in a
a specified
specified manner
manner which
which does
does not
not involve
involve ignoring
ignoring the
the corporate
corporate entity.”);
entity.”); Practising
Practising Law
Law
assumed that the
practitioner
understood
enough
about
business
valuation
to make
the
Institute,
546
PLI/Tax
249
Organizing
the
Corporate
Venture
§
1301
(“This
Institute, 546 PLI/Tax 249 Organizing the Corporate Venture § 1301 (2002)
(2002)
(“This
re-inversion
of
rates
lessened
the
S
corporation
shareholder’s
advantage
of
being
taxed
re-inversion of rates lessened the S corporation shareholder’s advantage of being taxed
necessary determinations
that a income.
software
package
cannot
make for
the practitioner.
This
directly
Yet,
directly on
on corporate
corporate income.
Yet, the
the primary
primary tax
tax advantage
advantage of
of being
being an
an S
S corporation
corporation
shareholder
—
i.e.,
the
ability
to
receive
corporate
income
with
only
a
single
level
of
tax
shareholder
i.e., the to,
ability
receive corporate
income with
only
a single
of tax
would include, imposed
but not be—
limited
theto correct
methodologies
that
apply
to alevel
particular
imposed —
— remains
remains intact.
intact. This
This must
must be
be compared
compared to
to the
the double
double tax
tax paid
paid on
on a
a C
C
corporation’s
income
(i.e.,
once
atthe
corporate
level,
and
again
at
the
shareholder
level
corporation’s
income
(i.e.,
once
atthe
corporate
level,
and
again
at
the
shareholder
level
valuation, the when
correct inputsintoconsidering
determine tax
discountofrates,
whether
to use a than
weighted
when distributed)
distributed) in considering the
the tax benefit
benefit of using
using an
an S
S corporation,
corporation, rather
rather than a
aC
C
average, a simple average or some other basis to reflect probable future earnings, and
Page
Page 26
26 of
of 34
34
- 27 more. An
experienced
would
alsoemploying
understand
limitations that
this, or any,
benefit
can be practitioner
captured fully
while
an the
economically
rational
35
35
valuing
an S corporation
netthe
of personal
To
softwareapproach
package to
has.
The practitioner
wouldthat
alsoistest
software taxes.
to make certain
that
ignore personal taxes would overestimate the value of an S corporation and
the mathematical
are correct.
would leadcalculations
to a value that
no rational investor would be willing to pay to
36
36
acquire control. This is a simple premise — no one should be willing to pay
for more than the value of what will actually end up in her pocket — that can
T&A wasbest
unaware
of grasped
a major calculation
error in example.
the discounted future earnings method
be firmly
through a concrete
(discussed later in this report), blindly printed every schedule that the software package
Assume that Delaware Radiology receives $100 in annual earnings. If
had to offer,
even Radiology
if inappropriate
for the ABC
and used
inappropriate
Delaware
was organized
as avaluation,
C corporation,
its earnings
after taxvaluation
would be $60, assuming, as is the usual custom, that the effective corporate
methodologies in reaching its final conclusion.
tax rate is 40%. Then, assume that Delaware Radiology distributes all of its
post-tax earnings to its shareholders in the form of a dividend. The
shareholders would receive total post-tax distributions of $51, after an
Another assumed
major problem
with
T&Aisassignment
is that
this firm earnings.
lacked independence.
dividend
taxthe
of 15%
applied to the
$60 after-tax
That
is,
a
shareholder
would
experience
an
effective
tax
rate
of
49%
after
Furthermore, because of the valuation incompetence, the lack of independence became
corporate income and dividend taxes.
more obvious as T&A conducted several simultaneous assignments, causing it to mix
Now, and
consider
post-tax
benefits
of $100
income
to to
Delaware
assignments
violatethe
proper
appraisal
practice.
T&A in
allowed
itself
(1) help plan the
Radiology’s stockholders, using its actual status as an S corporation. In that
ESOP transaction,
(2)shareholders
value the ESOP
transaction,
and (3)
assist inas
thedistributions
forecasts that were
scenario, the
would
receive all $100
in earnings
and be subject only to one shareholder-level tax. Thus, the shareholders
required by the Bank of Jacksonville to demonstrate that ABC could pay for the financing.
would be responsible for paying taxes on the $100 at their individual tax
rates. assignments
I will also assume
that rate
be 40% because
the Broder
Kessler
inconsistently
used
These three
became
sotointertwined
that data
was and
are comprised of affluent physicians who pay at the highest marginal
betweenGroups
the37
assignments.
Foe example, the forecast for the Bank of Jacksonville has
37
rate. Therefore, every dollar of Delaware Radiology’s earnings would be
stockholder
level
the used
highest
marginal
tax rate.
TheEarnings
differenttaxable
figures at
in itthe
than
the forecast
thatatwas
in the
Discounted
Future
shareholders in Delaware Radiology, an S corporation, would be able to
method pocket
in the $60
valuation
Furthermore,
T&A represented
ABC isinclear:
some of its
after taxreport.
if all earnings
were distributed.
The difference
Delaware
status
as an S corporation
allowed
the shareholders
engagements
andRadiology’s
should have
represented
the ABC ESOP
(trustees)
in the valuation.
This is a clear conflict of interest.
An underlying
corporation, for business operations.”); Mercer 9 (“The S election relieves one layer of
taxation
at the
corporate
providing the
the potential
for greater
cash
flowupdates
at the shareholder
problem
that
exists level,
throughout
initial T&A
report
and
is that
level.”).
a
valuation was never performed as of the date of the transaction with the ESOP, which is
35
35
Fisher 22.
36
36
Id. at 18 (“[W]e demonstrate that ignoring taxes in a DCF analysis when valuing an S
the most important date that should have been used to value the ABC stock. The initial
valuation date corporation
had an effective
datetoof
1993.id. However,
theinvestor
initial will
and
potentially leads
an November
overestimation30,
of value.”);
at 22 (“A rational
only pay up to the present value of an investment’s expected cash flows, net of personal
only pay up to the present value of an investment’s expected cash flows, net of personal
subsequent valuations
leading up to the ESOP transaction only utilized financial
taxes.”).
information
through
October 31, 1993. Even the March 15, 1994 update did not use any
37
37
Currently, at the federal level, the highest personal tax rate is 35%, and the highest corporate
Currently, at the federal level, the highest personal tax rate is 35%, and the highest corporate
tax
rate isother
38%. than
Thus,distributions
taking into account
state
taxes, it is reasonable
to assume
a 40%
additional information
to the
shareholders.
T&A never
considered
personal tax rate.
the impact on the valuation of more than four months of economic and industry changes,
Page 27 of 34
- 28 nor the impact
on ABC
of removing
more than $1.5
million ofwas
cashCfrom
the company as
to
to pocket
pocket $60
$60 of
of $100,
$100, whereas
whereas ifif Delaware
Delaware Radiology
Radiology
was a
a C corporation,
corporation,
38
the shareholders
shareholders could
could pocket
pocket only
only $51
$51 of
of the
the $100.
$100.38
the
distributions.
In
In valuing
valuing Delaware
Delaware Radiology,
Radiology, therefore,
therefore, itit would
would overstate
overstate the
the value
value taken
taken
from
the
Kessler
Group
to
require
the
Broder
Group
to
pay
the
Kessler
from
the
Kessler
Group
to
require
the
Broder
Group
to
pay
the
Kessler
The balance of this report will be specifically referenced to the T&A report.
Group
Group $37.50
$37.50 for
for its
its share
share of
of every
every $100
$100 of
of future
future pre-tax
pre-tax earnings.
earnings. That
That
cash
flow,
after
the
favorable
S
corporation
tax
treatment,
would
not
be
worth
cash flow, after the favorable S corporation tax treatment, would not be worth
$37.50
to
$37.50
to the
the Broder
Broder Group,
Group, but
but only
only $22.50.
$22.50. The
The issue,
issue, though,
though, is
is that
that tax
tax
TA 160
affecting
Delaware
Radiology
at
a
40%
level
(or
C
corporation
level)
would
affecting Delaware Radiology at a 40% level (or C corporation level) would
not recognize
recognize any
any S
S corporation
corporation value
value that
that flowed
flowed to
to the
the Kessler
Kessler Group
Group or
or
not
compensate
the
Kessler
Group
for
its
involuntarily
removal
as
shareholders
compensate the Kessler Group for its involuntarily removal as shareholders
Page TAin
160profitable
is the cover
page to the valuation
report that
was issued by
T&A. The date
in a
a profitable S
S corporation.
corporation. To
To be
be consistent
consistent with
with Delaware
Delaware law,
law, II must
must tax
tax
affect
Delaware
Radiology’s
future
cash
at
that
of this report
March 7,
1994. The
report
addressed
to level
the Board
of Directors and
affect is
Delaware
Radiology’s
future
cashisflows
flows
at a
a lower
lower
level
that recognizes
recognizes
the
the full
full effect
effect of
of the
the Kessler
Kessler Group’s
Group’s ability
ability to
to receive
receive cash
cash dividends
dividends that
that are
are
Trusteesnot
of subject
ABC, but
T&A
was
only
retained
by
ABC.
The
engagement
letter was with
to dividend
dividend taxes.
taxes.
not subject to
ABC and not the trustees. There were no changes made to the engagement letter and
In
In order
order to
to accurately
accurately capture
capture the
the value
value to
to the
the Kessler
Kessler Group
Group of
of Delaware
Delaware
therefore,
the
report
should
not
be
addressed
to
the
trustees.
The
trustees
never became
Radiology’s S
S corporation
corporation status,
status, II have
have estimated
estimated what
what an
an equivalent,
equivalent,
Radiology’s
“predividend”
corporation
tax
would
be.
The
hypothetical
“predividend”
Shave.
corporation
tax rate
rate
would
be.familiar
The following
following
the clienthypothetical
even though
they shouldS
T&A should
have
been
with the ESOP
table
presents
that
calculation:
table presents that calculation:
rules about who it should represent.
According to the report, T&A valued ABC as of November 30, 1993. However, in reaching
its conclusion, T&A included information in this report that assumed that an ESOP
transaction had taken place. At November 30, no such transaction took place. That
causes this valuation to be hypothetical, although it is not labeled as such. We will
reiterate this point as we review the valuation schedules that are attached to the report.
38
38
This
This would
would not
not be
be the
the case
case ifif 1)
1) no
no distributions
distributions were
were being
being paid
paid by
by the
the S
S corporation
corporation to
to its
its
shareholders
or
only
cover
tax
were
distributed
to
The standard of
value, known
as fair market
value, to
takes
consideration
which
shareholders
or 2)
2) distributions
distributions
only sufficient
sufficient
to
coverinto
tax liability
liability
were being
being that
distributed
to is
shareholders.
shareholders. The
The relative
relative value
value of
of an
an S
S corporation,
corporation, vis-à-vis
vis-à-vis a
a C
C corporation,
corporation, to
to its
its
shareholders
is dependent
dependent
upon the
the
level The
of distributions
distributions
paid.
For T&A
a useful
useful
modelwas
and to
“known or knowable”
as of
the valuation
date.
purposepaid.
of the
report
shareholders
is
upon
level
of
For
a
model
and
analysis, see,
see, e.g.,
e.g., Chris
Chris Treharne,
Treharne, et.
et. al.,
al., Valuation
Valuation of
of Pass-Through
Pass-Through Entities,
Entities, American
American
analysis,
establish the fair
market
value of23d
theAnnual
ABC stock
to determine
the “adequate
Society
of Appraisers
Appraisers
23d
Annual
Advanced
Business Valuation
Valuation
Conferenceconsideration”
(Oct. 8,
8, 2004).
2004).
Society
of
Advanced
Business
Conference
(Oct.
As recognition
recognition of
of the
the fact
fact that
that their
their stockholders
stockholders must
must pay
pay taxes
taxes on
on non-distributed
non-distributed earnings,
earnings,
As
to be paid by the
ESOP
shares. distribute
At the valuation
date,
November
30 1993,
there
most
if not
notfor
all these
S corporations
corporations
distribute
a sufficient
sufficient
amount
of their
their profits
profits
to cover
cover
most
if
all
S
a
amount
of
to
shareholder tax obligations. Mercer at 17 (“S corporations who attempt to retain all earnings
shareholder tax obligations. Mercer at 17 (“S corporations who attempt to retain all earnings
was no ESOP. and
Using
the proposed
transaction
to value will
ABC
is circular
logic. The
and
not pass
pass
through the
theESOP
shareholders’
tax distributions
distributions
will
likely
find themselves
themselves
C
not
through
shareholders’
tax
likely
find
C
corporations again, as their shareholders arrange to become ineligible to hold S corporation
stock.”). This makes intuitive and commercial sense. If all earnings are retained, the S
corporation’s
shareholders
must
dig
own
pockets
to
the
liability.
If
corporation’s
shareholders
musttransaction,
dig into
into their
their the
own value
pocketsmay
to fund
fund
the tax
taxas
liability.
If all
all of
price to be paidearnings
for thearestock.
After
the
change
alevel
result
retained
in
a
C
corporation,
the
entity
is
responsible
for
the
corporate
earnings are retained in a C corporation, the entity is responsible for the corporate level tax.
tax.
If
shareholders
If S
S corporation
corporation
shareholders elect
elect to
to receive
receive no
no distributions,
distributions, that
that can
can be
be viewed
viewed as
as a
a
how the transaction
is consummated.
reinvestment
of
their
tax
savings
in
that
enterprise.
reinvestment of their tax savings in that enterprise.
again, as their
to become
ineligible
to hold S corporation
appraiser mustcorporations
value the
asshareholders
it and
exists
atarrange
the appraisal
date
to establish
the correct
stock.”).
Thiscompany
makes intuitive
commercial
sense. If all
earnings
are retained,
the S
Page
Page 28
28 of
of 34
34
- 29 Frequently, appraisers are requested to performCsome preliminary
valuation
S
S Corp calculations
Corp.
Corp. in this
Valuation
for the purpose of assisting a client in a decision.
For example,
instance ABC was
C
S
S Corp
Income
Before
Tax
$100
$100
$100
contemplating
the
implementation
of an ESOP.
preliminaryValuation
valuation
would be
Corp. A Corp.
Corporate
Tax Rate
40%determine
-- if it would
29.4%
requestedIncome
by management
make economic
Before
Tax of ABC to help them
$100
$100
$100
Available
Earnings
$60
$71
sense. What
appears
to have happened here
is that$100
ABC
needed
some preliminary
Corporate
Tax Rate
40%
-29.4%
Dividend
or
Personal
Incomeand
TaxT&A was
15%
40%in December
15%
numbers as
of November
30, 1993,
Available
Earnings
$60engaged
$100
$711993 to assist in
Rate
this process.
At theortime,
the October
1993 figures
figures available.
Dividend
Personal
Income Tax
15%were the
40%most recent
15%
Available After Dividends
$51
$60
$60
Rate
This was confirmed
by Mr. Jones in his deposition (January 24, 2005, beginning at page
Available
After Dividends
$51
$60
This calculation
allows me to treat the S corporation
shareholder as$60
receiving
56, line23).
the full benefit of untaxed dividends, by equating its after-tax return to the
after-dividend
a Ctocorporation
shareholder.
I will, therefore,
apply
This
calculationreturn
allowstome
treat the S corporation
shareholder
as receiving
an effective
taxofrate
of 29.4%
theby
earnings
Radiology
to
full
benefit
untaxed
dividends,
equatingofits
after-taxyou
return
the
Q. the
Okay.
Thank
you.
What
I to
don't
understand
--Delaware
maybe
cantoexplain
measure
with
the
greatest
practicable
precision
the
fair
value
of
the
Kessler
after-dividend
to a C corporation
shareholder.
will, therefore,
it -- why isreturn
the valuation
as of November
30th,I '93,
when the apply
second
Group’s
interest
theofgoing
concern
of Delaware
Radiology.
an
effective
tax in
rate
29.4%
to thevalue
earnings
of Delaware
Radiology to
paragraph says, “The information utilized to perform the valuation
measure with the greatest practicable precision the fair value of the Kessler
includes
taxinreturns
andconcern
financial
statements
of ABC
Jailrespect
Company,
I have to
commend
Chancellor
Strine
for
getting
thisofopinion
correct
with
to taxes.
Group’s
interest
the going
value
Delaware
Radiology.
Inc.
through
October
31,
'93.”
Can
you
explain
that?
Most state court judges shy away from this very complex issue and he really got it dead on.
fact,to his
opinionChancellor
was so instructive
that our
hascorrect
startedwith
following
very
IInhave
commend
Strine for getting
thisfirm
opinion
respectthis
to taxes.
A.
Well,
they
wanted
us
to
-“they”
being
the
trustees,
wanted
us
to
do
methodology.
In
fact,
I
really
like
the
logic
behind
these
calculations
because
it
is
simple
Most state court judges shy away from this very complex issue and he really got dead on.
valuation
theinstructive
latter partthat
of '93
information
thatthis
thevery
andfact,
easyhis
tothe
explain.
In
opinion
wasinso
ourbased
firm on
hasthe
started
following
company
had
available
at
that
point
in
time.
Now,
they
would
methodology. In fact, I really like the logic behind these calculations because it isnot
simple
Exhibit
3 istohave
an
actual
excerpt
from a
report prepared
for a to
shareholder
dispute. into
and
easy
explain.
the full
year-end
information
available
us until sometime
'94, so they wanted us to proceed with the information that they had
Exhibit
3
Exhibit 3 isavailable
an actual at
excerpt
from a report
prepared
for a shareholder dispute.
that time.
S Corporation Taxes - Normalized
3
Q.
Well, but by March 7, 1994,Exhibit
you certainly
had the financial information
We have recalculated income
taxes
based
on
the
fact that The Smith Entities are passS
Corporation
Taxes
Normalized
through November 30th, 1993, did you not?
through entities for income tax purposes. This means that The Smith Entities do not pay
tax at
the “corporate”
level.
Overtaxes
the past
several
years,
valuation
We
have
recalculated
income
based
on the
fact the
thatbusiness
The Smith
Entitiescommunity
are passA.
I
don't
know
if
they
had
provided
that
to
us
or
not.
We
-we
hadentities
been
has acknowledged
that the tax
conventional
of taxing
pass-through
as
through
entities for income
purposes.wisdom
This means
thatthese
The Smith
Entities do
not pay
given
the
October
number,
certainly.
if
they
were
taxpaying
C
corporations
is
no
longer
an
automatic
thing
to
do.
In
fact,
the
tax at the “corporate” level. Over the past several years, the business valuation community
39
United
States Tax Court
opened
up this issue
in of
several
Since entities
that time,
has acknowledged
that the
conventional
wisdom
taxingcourt
thesecases.
pass-through
as
Q.
Well,
I
mean,
March
7,
'94
is
about,
my
goodness,
three
months
after
many
authors
have
contributed
to
the
valuation
literature
with
ideas
about
how
to
treat
if they were taxpaying C corporations is no longer an automatic thing to do. In fact, the
39
October
31,
'93.
Didup
you
ever
ask
the November
data,time,
these
enterprises.
In
one
instance,
it was
statedcases.financial
Unitednon-taxpaying
States
Tax Court
opened
this
issue
in for
several
court
Since that
Mr.
Jones?
many authors have contributed to the valuation literature with ideas about how to treat
these non-taxpaying enterprises. In one instance, it was stated
A.
39
39
I don't remember if we asked for the November data. We ended up
getting
preliminary
December
information,
-- they
Gross some
v. Commissioner,
T.C. Memo.
1999-254,
affd. 272 F.3dwhich
333 (6ththey
Cir. 2001),
Heck v.
Commissioner,
T.C. Memo.
Filed
February
2002,not
and been
Adams any
v. Commissioner,
being
the company
also 2002-34,
indicated
that
there5, had
major
T.C. Memo. 2002-80, Filed March 28, 2002.
changes
their
operations
-- between
and
Gross v. between
Commissioner,
T.C.
Memo. 1999-254,
affd. 272 the
F.3dOctober
333 (6th Cir.31st
2001),
Heck v.
Commissioner,
T.C.
Memo.
2002-34,
Filed
February
5,
2002,
and
Adams
v.
Commissioner,
December matters.
Page 29 of 34
T.C. Memo. 2002-80, Filed March 28, 2002.
Page 29 of 34
- 30 Q. In valuing
Well, a
I'mcontrolling
just trying
to understand.
– well,
seems
ownership
interest in It’s
an Sobvious
corporation,
the itanalyst
obvious
-- the
is itprobability
true that you
issued
a full
usinginterest
financial
should
assess
that never
the
likely
of areport
controlling
In valuing
a controlling
ownership
interest
inbuyers
an S corporation,
the analyst
th
data
as to
of avail
November
30that
, of
'93?
Is thatbuyers
true?
will
be
able
themselves
continuing
the Sofcorporation
status.
In
should
assess
the
probability
the
likely
a controlling
interest
other
the likely
buyer aofqualified
S corporation
shareholder
will bewords,
able toisavail
themselves
continuing
the S corporation
status.who
In
A. could
Well,
theis--Sthe
the
November
information
have
been
continue
corporation
status
indefinitely?
Or, wouldn't
is theshareholder
likely
buyer
a C -other
words,
likely
buyer
a 30th
qualified
S corporation
who
corporation?
thecorporation
pool
of likely
buyers
is made up30th.
of qualified
S corporation
would
notIf have
been
available
November
could
continue
S
status
indefinitely?
Or,
is the likely
buyer a C
shareholders,Ifthen
thoseofbuyers
of a controlling
interest
can realize
all three
corporation?
the pool
likely buyers
is made up
of qualified
S corporation
of the
above-listed
economic
benefits
(i.e.,
double
taxation,
pass-through
Q. shareholders,
Well,
again,
you
issued
theofreport
onnoMarch
7th,
'94.realize
My
question
then
those
buyers
a controlling
interest
can
all threeis,
40
basis
adjustment,
and
increased
proceeds
upon
sale
of
assets).
anytime,
as ofeconomic
March 7th,
'94 or
thereafter,
15th, '94,
of the
above-listed
benefits
(i.e.,
no doublethrough
taxation,March
pass-through
40
basis
adjustment,
and increased
proceeds
sale of
assets).
did
you ever issue
a full report
usingupon
financial
data
as of November
In this valuation,
we
are
valuing
an
interest
in
a
going
concern
that
is
being taken from the
30th, '93?
departing
shareholder.
Fair value
value on
what
is being
taken
In
this valuation,
we are valuing
an attempts
interest intoa place
going aconcern
that
is being
taken
fromfrom
the
him.
In
this
instance,
the
remaining
shareholders
will
most
likely
continue
the
S
status
(and
departing
shareholder.
Fair
value
attempts
to
place
a
value
on
what
is
being
taken
from
A.
We did not because we used the October 31st information.
other
of the other
entities within
the likely
group),
particularly
S
him. Inpass-through
this instance,status
the remaining
shareholders
will most
continue
the S since
statusthe
(and
election
was
recently
made
as
of
January
1,
1998.
This
means
that
the
remaining
other pass-through status of the other entities within the group), particularly since the S
shareholders
will continue
the benefits
of theThis
S election.
Furthermore,
the
election was recently
madetoasenjoy
of January
1, 1998.
means that
the remaining
remaining
shareholders
have
not
expressed
any
intention
to
sell
The
Company.
Therefore,
Although
T&A was
as of November
30, 1993, Furthermore,
they never did.
shareholders
willengaged
continue to
to value
enjoy ABC
the benefits
of the S election.
the In
we
will
proceed
with
the
calculation
of
taxes
based
on
the
reality
of
the
situation.
remaining shareholders have not expressed any intention to sell The Company. Therefore,
fact,weMr.
Jones testified that he never asked for the data as of the valuation date,
will proceed with the calculation of taxes based on the reality of the situation.
In many 30,
of the
courtWhile
cases appraisers
that have addressed
issue
of tax-affecting
S corporation,
November
1993.
use datathe
near
a valuation
date, an
there
is no excuse
themany
appraisers
on opposite
sides
have
taken an
or none
position. They
have either
In
of the court
cases that
have
addressed
theall
issue
of tax-affecting
an S corporation,
the Sask
corporation
as ifsides
it was
a regular
corporation,
orThey
they
havesufficient
taken
not taxed
to atappraisers
least
for opposite
the data
that
would
impact
the
T&A
did not
request
the
on
have
takentaxpaying
an
allreport.
or C
none
position.
have
either
the
position
that since the
Sif corporation
doestaxpaying
not pay taxes
at the corporate
no
taxed
the Stocorporation
asto
itperform
was a regular
Cproperly.
corporation,
or theylevel
havethat
taken
relevant
data
allow
them
their
assignment
tax
should
be
computed.
We
do
not
believe
that
an
all
or
none
position
is
always
the position that since the S corporation does not pay taxes at the corporate level that no
warranted.
Wecomputed.
will use a simple
illustration
to help
the appropriate
of
tax should be
We do
not believe
thatdemonstrate
an all or none
position is level
always
tax
to
be
applied
to
The
Smith
Companies.
warranted. We will use a simple illustration to help demonstrate the appropriate level of
T&Atax
makes
reference to the information that they used to perform the valuation. Most
to be applied to The Smith Companies.
Assume
that The treatises
Smith Entities
a pretax profit
of $100.
100 percent
theassist
earnings
business
valuation
havehad
document
checklists
thatIf can
be usedofto
in the
was being
distributed
toEntities
the shareholders,
the
difference
being aofCthe
corporation
Assume
that
The Smith
had a pretax
profit
of $100.between
If 100 percent
earnings
and
S corporation
beshareholders,
explained
by the
table.
gathering
of
the
requiredcan
to perform
a proper
valuation.
In athe
Practitioners
was an
being
distributed
toinformation
the
the following
difference
between
being
C corporation
and an SCompany
corporation
can be
explained
by the following
table.
Publishing
(PPC)
Guide
to Business
Valuations,
Third Edition, May 1993, the
authors state:
115.14 Collect Data Appropriate for the Valuation Methods Used. In
order to establish a value for a company, a consultant must generally gather
a great deal of information about the company, its industry, the economy in
which the company operates, and other comparative companies. In order
to be useful, the information must be timely, accurate, and comparable to
similar
companies against which comparisons will be made. This information
40
Grabowski, Roger J. and McFadden, William P., “Applying the Income Approach to S
is usually
gathered during
thePass-Through
early stages
of field
work. The Handbook of Business
Corporation
and Other
Entity
Valuations,”
40
Grabowski, Roger J. and McFadden, William P., “Applying the Income Approach to S
Valuation and Intellectual Property Analysis, Robert F Reilly and Robert P Schweihs, Editors,
Corporation and Other Pass-Through Entity Valuations,” The Handbook of Business
McGraw
Hill, 2004,
p.of
97.information needed will vary from engagement
115.15 The
specific
Valuation
and types
Intellectual
Property Analysis, Robert F Reilly and Robert P Schweihs, Editors,
to engagement
are primarily
based on the valuation methods that are
McGrawand
Hill, 2004,
p. 97.
Page 30 of 34
Page 30 of 34
appropriate for a particular project. The data gathering process usually
- 31 involves an analysis of historical financial
information,S Corporation
interviews with
C Corporation
company management, and extensive research on comparative companies,
Annual Earnings
$
100
$
100
economic
and industry trends, and market price
data.
Financial
information
Tax and analyzed40%
0%in the valuation
0
must Corporate
often beIncome
adjusted
before it can40be used
process.
Comprehensive
data gathering checklists
Net Income
Available to Shareholders
$
60and questionnaires
$
100 are
presented in the Practice Aids sections in Volume 2 of the Guide.
$
60
In addition Dividends
to collecting the appropriate data, the
authors
of the $Guide100
to Business
Personal Income Tax
Valuations also advise the reader to:
40%
Net cash flow to Shareholders
Benefit of being an S Corporation
24
$
36
40%
40
$
60
$
24
115.19 Document All Work Performed and Conclusions Reached. A
consultant should prepare a set of workpapers for each valuation
Theengagement.
above table reflects
the fact thatshould
in a situation
all the
of the
after corporate
The workpapers
includewhere
not only
completed
work tax
profits
are
being
distributed
to
the
shareholders,
the
effective
corporate
tax
rate
for an S
programs, but also all data, calculations, and key assumptions made by the
corporation
is 0 percent.
At well
the valuation
date, the taxreached.
rates in effect would have required
engagement
team, as
as all conclusions
the shareholders of a C corporation to pay a 40 percent personal income tax after the
corporation would have paid the same rate. The amount of money available to the
Thisshareholders
publication was
only treatise
that
Mr. Jones
was$36.
sure that he had in T&A’s library
after the
all taxes
were paid
would
have been
at the time the valuation was performed. In fact, Mr. Jones used the report checklist from
As an S corporation, the shareholders avoid a corporate tax, but they pay personal taxes
thison
publication,
but no others.
Weofwill
report checklist
laterone
in this
report.
the “pass-through”
regardless
thediscuss
amountthe
of dividends.
Since only
40 percent
tax is paid, the shareholders would end up with $60 in their pockets after all taxes are paid.
TA Now
161 we must deal with the realities of The Smith Entities. Historically, 100 percent of the
earnings have not been paid to the owners each year. In fact, we had to analyze the
deemed dividends and distributions in order to apply the same type of tax-affecting
asreport
above.is Dividends
and deemed
distributions
follows: the fact that
Theanalysis
narrative
approximately
11 pages
beginninghave
at TAbeen
161.asBesides
there is little substance in the narrative, there is no connection between the narrative report
and the schedules that are attached to it.
The report lacks explanation, analysis,
references and almost anything else that would permit the reader to gain a proper
understanding of the basis for the appraiser’s valuation. Furthermore, there is a lack of
discussion of key assumptions and explanations, and as such, this report cannot
replicated. The narrative also is contradictory throughout, which will be pointed out as we
proceed.
The first paragraph on this page is incorrect. The valuation that was done as of November
30, 1993, was to assist management in
determining,
Page
31 of 34 as part of the implementation of an
- 32 ESOP, how much ABC and the ESOP should
transactions
with Mr. Morris
1996consummate
1997
1998
1999 for 2000
and for newly
issued
shares.
T&A states:
Financial
Statement
Dividends
$
Officers' Compensation - Addback
Officers'
Compensation
- Reasonable
The purpose
of this study
was to
(In $000)
0 $ 3,500 $ 3,500 $ 5,750 $ 5,000
4,364
(927)at
arrive
9,614
10,637
8,779
2,114
(956)
(985)
(1,016)
(1,047)
a value to be used by the ESOP
trustees
for the establishment of the ABC Jail Company, Inc. Employee
Shareholder/Partner Loan Movement:
Stock Ownership Plan, whereby immediately following the acquisition of the
ABC
(662)
(3,959) (3,669)
7,605
4,012
stock,
the ESOP
would own more
than a360fifty 1,518
percent 1,897
interest6,225
of all
Unconsolidated
Entities
1,141
outstanding corporate stock.
Total Distributions
$ 3,916 $ 8,559 $11,001 $23,015 $16,304
Since theAdjusted
ESOPPretax
did not
exist at November
30, 1993,
been$15,375
more accurate
Profits
$ 8,776
$12,219it would
$19,090have
$19,308
to state that
the purpose
the Profits
valuation was
to assist
the ESOP
once the ESOP
% Distributions
to of
Pretax
44.63%
70.05%
57.63% trustees,
119.20% 106.04%
Figures may not add due to rounding.
was formed, in establishing the adequate consideration that must be paid by the ABC
ESOP
for the were
shares
in ABCbased
as of on
thethe
transaction
date. It should
havestatements
stated thatforthis
Dividends
included
amounts reflected
on the also
financial
the may
consolidated
Excess
officers’
compensation
was
also considered
report
have to entities.
be updated
to get
closer
to the actual
transaction
date. to be a form
of dividend for this analysis. In addition, we included the year-to year movement in the
shareholder/partner loan accounts for ABC and the unconsolidated entities. These monies
flow to the owners. In reality, they are a form of distribution.
At the bottom of this page, T&A references Revenue Ruling 59-60 and indicates that this
Comparing
the“sets
totalforth
distributions
the the
adjusted
pretax
profits(not
reflects
the fact that
Revenue
Ruling
in some to
detail
following
factors
all inclusive),
which
distributions in any given year have ranged from 44.63 percent to 119.20 percent of the
generally
are
believed
to be fundamental
enough
the
valuation
of a This
closely
held
adjusted
profit.
The average
for this five year
period to
was
about
80 percent.
is the
amountstock
of distributions
that we
will now
use to recalculate
the effective
tax rate as
corporate
that analysis
of each
is required.”
The report
then proceeds
to an
listSten
corporation. The result is as follows:
factors. However, these ten factors do not all come from Revenue Ruling 59-60. In Mr.
Corporation
S Corporation
Jones’ deposition, he was asked the followingC (January
24, 2004,
beginning at page 82,
line 14):
Q.
Annual Earnings
Corporate Income Tax
40%
100
40
$
0%
100
0
Net Income Available to Shareholders
$
60
$
100
Earnings Retained in Company
$
12
$
20
$
48
$
80
And you’ve got ten items attributed to Revenue Ruling 59-60, correct?
A.
There’s
Dividends
Q.
Personal Income Tax
A.
$
ten items listed there, 80%
yes.
80%
19
40%
And my question is, where do 40%
you get this ninth
and
tenth item40if it's
Net
cash
to Shareholders
$
29
$
40
not
in flow
Revenue
Ruling 59-60?
Benefit of being an S Corporation
$
11
Well, from -- probably from other materials that we consider when we
evaluate a company because I think those are -- these are relevant
facts. 59-60 is -- Revenue Ruling 59-60 is a guideline stipulated by
the IRS.
Page 32 of 34
- 33 Q.
I agree. I'm just asking youCwhere
got theseS other
two points,
Corp. you
S. Corp.
Corp. Valuation
item 9 and 10, since it's not in Revenue Ruling 59-60. Can you tell
Income Before Tax
100
100
$S Corp. Valuation
Corp.
Corp.
me what authoritative source$C you
used$S.for
those two
items? 100
Corporate
Tax Rate
Income Before
Tax
A.
$
40%
100
$
0%
100
$
33.33%
100
$
$
48
60
$
$
80
100
$
$
80
80
$
40%
80
Off the top of my head, I'm not
--60I don't$ recall
an authoritative
source
$ 40%
100
$
80
0%
33.33%
such as an IRS Revenue Ruling.
Available
CorporateEarnings
Tax RateFor Distributions
Distributions
Available
Earnings For Distributions
Q.
Well, Income
give me
source
Personal
Taxany
Rate authoritative
Distributions
$ 40%
48
$ --. 40%
80
A.
Net Available
AfterTax
Dividends
Personal
Income
Rate
$
29
40%
$
40
40%
$
40
40%
Net Available After Dividends
$
29
$
40
$
40
Well, the --.
Q. only Doesn’t
to be
IRS.
Since
about 80have
percent
of the
pretax earnings have been distributed historically, we
used this amount in our model. Recalculating the net amount available to the shareholders
Since
only considers
about
percent
of
earnings
been
distributed
we
41 have
A.taxes
-the 80
judgment
of the
the
-- the
valuator
when
performing
a historically,
valuation
after
the benefits
ofpretax
the
S election.
For
the
purpose
of this
valuation, the
used this amount
in our
the net that
amount
shareholders
analysis.
shareholders
should
bemodel.
placedRecalculating
in the same position
theyavailable
would betointhe
after
paying tax
41
after
taxes
considers
the
benefits
of
the
S
election.
For
the
purpose
of
this
valuation,
the
as an S corporation shareholder. In the above example, they would end up with 40 cents
shareholders
should
be placed in
the same to
position
that the
theyimplied
would S
becorporation
in after paying
tax
on
the dollar. The
mathematical
calculation
determine
tax rate
Once
again,
despite Mr.
Jones’ claim
of having
substantial
experience,
he with
was40
unfamiliar
as
an
S
corporation
shareholder.
In
the
above
example,
they
would
end
up
cents
is as follows:
on the dollar. The mathematical calculation to determine the implied S corporation tax rate
with Revenue Ruling 59-60, which is a cornerstone ruling in the profession. It is the most
is as follows:
(1 - X) x (1 - 40%)] = 40%
widely cited revenue ruling by business
X appraisers,
= 33.33% and possibly the most widely cited
(1 - X) x (1 - 40%)] = 40%
document in business valuation. WhatXmakes
these responses even worse is that Mr.
= 33.33%
In order for the shareholders of The Smith Entities to be placed in a neutral tax position,
Jones
did not
knowcorporate
where he
ninth and tenth
from.
To have
give the
response
a 33.33
percent
taxtook
ratethe
is appropriate.
This factors
is the rate
that we
used
in the
In order for theprocess.
shareholders of The Smith Entities to be placed in a neutral tax position,
normalization
thata it33.33
waspercent
the judgement
of rate
the isvaluator,
further
the we
lack
of used
professional
corporate tax
appropriate.
This supports
is the rate that
have
in the
normalization process.
competence
applied in this assignment. The deposition was approximately 11 years later,
Conclusion
and he still did not know, without additional prompting in subsequent questions, that these
Conclusion
you can factors
tell, thecame
landscape
thatDepartment
we work under
has changed
dramatically.
The
old
twoAs
additional
from the
of Labor
Regulations
relating to
ESOPs.
conventional wisdom of tax-affecting all pass-through entities is gone. Each valuation must
Asheld
youitself
can
the
landscape
that we
work
has
changed
dramatically.
The oldMr.
T&Aconsider
out
as
having
substantial
experience
in
ESOP
valuations.
Throughout
thetell,
facts
and
circumstances
and
be under
performed
accordingly.
conventional wisdom of tax-affecting all pass-through entities is gone. Each valuation must
Jones’
deposition,
referring and
to the
subjectiveaccordingly.
judgment of the appraiser to
consider
the factshe
andkept
circumstances
be performed
compensate for his lack of documentation or knowledge of the appraisal literature. This
was one more instance where this took place.
41
TA 163
41
At the top of
This model does not take into consideration the added benefit that the shareholders will
receive as a result of the undistributed income of the companies. Since income taxes are
This
doesmodel
not take
into consideration
the added
benefit
that theofshareholders
will
paid, model
and in this
calculated,
on the available
earnings,
regardless
whether they are
receive as
a result or
of not,
the the
undistributed
income
companies.
Since income
taxes are
actually
distributed
shareholders
of theofS the
corporation
can remove
the undistributed
paid, and
in thistaxation
model calculated,
on the
available
earnings,
whether theythey
are
profits
without
in subsequent
periods.
If they
do notregardless
remove theofdistributions,
actually
distributed
or
not,
the
shareholders
of
the
S
corporation
can
remove
the
undistributed
receive
a
step-up
in
the
basis
of
their
investment
and
will
pay
less
capital
gains,
if
and
when
this page, the T&A report states:
profits
without
taxationininThe
subsequent
periods. If they do not remove the distributions, they
they
sell
their interest
Company.
receive a step-up in the basis of their investment and will pay less capital gains, if and when
they sell their interest in ThePage
Company.
33 of 34
Page 33 of 34
- 34 We have relied
heavily
our valuation
upon known
operating
results and the
GARY
R. in
TRUGMAN
CPA/ABV,
MCBA,
ASA, MVS
financial condition of ABC for the prior five fiscal years. Additionally, we have
projections
asPublic
prepared
by management
for future
WeYork,
Garyanalyzed
R. Trugman
is a Certified
Accountant
licensed in the states
of Newyears.
Jersey, New
Connecticut
is Accredited
in Businessmethod
Valuationofbyvaluing
the American
Institute
believeand
thatFlorida.
this isHethe
most satisfactory
the stock
ofofaCPAs
and closely
is a Master
Certified
Businesssuch
Appraiser
as designated by The Institute of Business Appraisers
held
corporation
as ABC.
Inc. He is also an Accredited Senior Appraiser in Business Valuation by the American Society of
Appraisers. Gary is regularly court appointed and has served as an expert witness in Federal court
and state
courts
in several
jurisdictions,
oninbusiness
matters,
However,
T&A
ultimately
used
valuationtestifying
methods
its finalvaluation,
analysis matrimonial
that are inconsistent
business and economic damages and other types of litigation matters.
with this statement. This will be pointed out as we review the schedules at the back of its
Gary is currently on the American Institute of CPAs’ ABV Examinations Committee and he is a
former member of the AICPA's Subcommittee Working with the Judiciary, ABV Credentials
report.
Committee, Executive Committee of the Management Consulting Services Division, and the
Business Valuation and Appraisal Subcommittee. He is currently Chairman of the Florida Institute
of CPAs’ Litigation, Valuation, Forensic Accounting and Litigation Services Section and was
Beginning
on the
thisNew
page,
theSociety
T&A report
to Services
addressCommittee,
the 10 items
fromValuation
Revenue
formerly on
Jersey
of CPAs’begins
Litigation
Business
Subcommittee (past-chairman) and Matrimonial Committee.
Ruling 59-60 and the Department of Labor Regulations. Each of these sections is woefully
Gary is Chairman of the Ethics and Discipline Committee, and formerly served on the Qualifications
inadequate
to accomplish
itsformer
intended
purpose.
In the
History
and Nature
the Business
Review Committee
and is the
Regional
Governor
of the
Mid-Atlantic
Region of
of The
Institute
of Business Appraisers Inc. He has received a “Fellow” Award from The Institute of Business
section
thereInc.
is very
little
information
to allow
a reader
to truly understand
thereceived
historyan
and
Appraisers
for his
many
years of volunteer
work
in the profession.
Gary has also
AICPA
Fame”
for hisnarrative
service tosection
the accounting
profession
assisting
the
nature
of “Hall
ABC.of In
fact, Award
this entire
only takes
up oneinhalf
of onein page.
accreditation in business valuation process. Gary formerly served on the Business Valuation
the International
Board
Examiners
of the
Society
of
items such
asofthe
legal form
of American
the entity,
the state
TheEducation
valuationSubcommittee
report omitsand
important
Appraisers. He is currently a faculty member of the National Judicial College, educating judges
around the country.
of incorporation,
information about company management, competition, information about
lectures nationally
valuation
topics.
He isand
the author
of a and
textbook
entitled
keyGary
employees,
sensitivityontobusiness
seasonal
or cyclical
factors,
strengths
weaknesses.
Understanding Business Valuation: A Practical Guide to Valuing Small to Medium-Sized
Businesses, published by the American Institute of CPAs. He has also developed numerous
educational courses, including but not limited to, a six day business valuation educational series
Theand
small
amount
of information
that Business
is included
in the for
report
includes
of the
a seminar
entitled
"Understanding
Valuation
the Practice
of the
Law"ownership
for the Institute
of Continuing Legal Education. Gary also serves as an editorial advisor for The Journal of
corporation
including
theExpert,
proposed
which Litigation
as of November
30, 1993
Accountancy,
The CPA
and transaction,
formerly for National
Consultants’
Reviewshould
and thenot
CPA Litigation Service Counselor. He has lectured in front of numerous groups and has been
be considered
in the valuation of ABC. The process of valuing ABC was to determine what
published in The Journal of Accountancy, FairShare and The CPA Litigation Service Counselor.
the value should be for a transaction. Including information about the transaction makes
Gary was born in New York and received his undergraduate degree from The Bernard M. Baruch
College
of the
City UniversityHypothetical
of New York. He
was the first
business
appraiser
in the
United
States
this valuation
hypothetical.
valuations
are
defined
as those
that
are contrary
to earn a Masters in Valuation Sciences from Lindenwood College. His Masters Thesis topic was
"Equitable
Closely Heldof
Businesses
and Professional
Practices".
Gary's
to fact.
ThereDistribution
is nothingValue
in theofDepartment
Labor Regulations
that permits
hypothetical
appraisal education also includes various courses offered by The Institute of Business Appraisers,
appraisals
to beSociety
performed
for an actual
ESOPInstitute
transaction.
is one He
more
the American
of Appraisers,
the American
of CPAsThis
and others.
hasinstance
taught
federal income taxation at Centenary College, financial statement analysis in the masters degree
where
T&Aatmixes
up its College,
assignments.
Either
thisat report
is forNational
planning
program
Lindenwood
and several
topics
the AICPA.
Taxpurposes
School in to
Champaign, Illinois. He is a member of The Institute of Business Appraisers Inc., the American
demonstrate
what would
after
the ESOP
transaction
takes place,
it is a Institute
valuation
Society of Appraisers,
thehappen
American
Institute
of Certified
Public Accountants,
theorFlorida
of Certified Public Accountants, the New Jersey Society of Certified Public Accountants and the
of ABC
stockState
for the
purpose
of meeting
the adequate consideration requirements in an
New York
Society
of Certified
Public Accountants.
actual transaction. The same report cannot be used for both purposes.
Page 34 of 34

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