Valuation professionals often debate the complex issues involving the confusing and controversial aspects of tax issues in business valuation. Here’s a look at some of the issues and considerations involved.

Before Tax or After Tax?

The terms “before-tax” and “after-tax” can easily cause confusion. Most valuation assignments call for “fair market value,” which is essentially the estimated value the “universe of hypothetical buyers and sellers” would agree to for a subject company.

When deciding on the appropriate price to pay, the “universe of investors” considers only the entity-level taxes the company would likely encounter. Personal- or other investor-level tax implications are ignored, because these taxes depend on the individual buyer.

Fair market value is not purely before- or after-tax. Instead, it is typically after entity-level taxes, but before individual investor-level taxes. For instance, the values quoted for public companies’ stock on the New York Stock Exchange reflect the overall market’s consideration of entity-level tax—but not individual investors’ tax consequences or benefits. When valuing private companies, business appraisers traditionally apply after- (entity-level) tax pricing multiples and discount/capitalization rates to after- (entity-level) tax income streams.

What About S Corporation Earnings?

Traditionally, valuation practitioners have treated Subchapter S corporations as if they were C corporations and subtracted income taxes (based on C corporation rates) from the company’s income stream. Among the reasons for this conventional wisdom are:

Not all hypothetical buyers could legally retain S corporation status, and
A company’s selection of entity type is not in itself a value-creating decision.
In several recent Tax Court cases, the courts ruled that S corporation earnings should be tax-affected, but at a rate of zero, the deemed corporate-level tax rate. These Tax Court decisions are highly controversial and contested by most valuation professionals.

Not only is it contrary to conventional wisdom for S corporations to trade at premiums over otherwise identical C corporations, but it is also unsupported by real-life market data. Nonetheless, attorneys should be aware of these Tax Court rulings and be prepared to address the issue if the IRS raises it.

What About Built-In Capital Gains Tax?

When valuing a company, a valuation expert considers more tax issues than just its income taxes. Over the last decade, the Tax Courts have recognized that entity-level, built-in gains tax liabilities are unavoidable for C corporations and are an important consideration for investors. Thus, they have begun to allow C corporations to take discounts from net asset value for their built-in capital gains tax liabilities—even if liquidation is not imminent.

In some cases, the discount is incorporated into the entity’s marketability discount. In others, a separate discount—usually less than the entire capital gains tax obligation—is permitted.

What About Real Estate?

Unlike business valuation methodology, real estate appraisal methods do not usually subtract income taxes form the property’s earnings. Therefore, some valuation professionals mistakenly believe that real estate appraisals provide pretax values that require adjustment before comparing to (or incorporating into) business valuations.

Subtracting entity-level tax for a parcel of real estate is unnecessary for a variety of reasons. For instance, most real estate investments are flow-through entities without entity-level income tax consequences. Additionally, when valuing real estate, appraisers effectively match pretax income streams (typically net operating income) to pretax market multiples.

Local Case Study

In a recent case involving a local physician practice, the valuation expert witnesses for both sides determined the tax affects of the business interests in a similar way, thus avoiding any controversy.

This is just a brief look at a very complex subject. Please call Mike Costello with your questions about taxes and business value. We can help you navigate the tax jungle and avoid being blindsided by the IRS or the opposition during trial.

(D. Michael Costello is a Certified Public Accountant, business appraiser and consultant with more than 15 years of training and experience in business valuations and appraisals, business acquisitions and divestitures, and related fields.

He has written several articles for the Tennessee CPA and the AICPA’s Management Consultant newsletter.

He was the Managing Director and President of Costello, Strain & Company, PC, a CPA firm he established in May 1984. The firm was merged with Joseph Decosimo and Company, LLP, CPA’s in September 2003. Joseph Decosimo and Company, LLP was founded in 1972 and today is one of the top 100 CPA firms in the nation.)