This is the fourth in a series of six monthly technical blogs on issues related to business valuation. Many business valuers believe that all entities whether a C-corp that is taxed or an S-corp that pays no federal income taxes should both be valued as if they pay tax (Grabowski, Mercer, Van Vleet)[i]. These business valuers believe there is no difference in the determination of fair market value. Others believe there is an S-corp adjustment to be made, but it should not be fully taxed (Fannon, Treharne)[ii]. These approaches suggest a premium for an S-corp. In general, the IRS believes that an S-corp should not be tax affected since it does not pay federal income taxes. This article looks at this issue in general. For a more complete analysis of this topic see original commentary dated Valuing Interests in S Corps (2013) or an updated and more comprehensive commentary within Business Valuations and the IRS (2018).

Background

This is a complex issue. The IRS realized this too and formed a team to address how the IRS would consistently approach this issue. As the original champion of this issue at the IRS, upon leaving the IRS, and realizing that the IRS did not intend to release their perspective to the public, I presented the IRS with a Freedom of Information Request for the study. It was updated with the title Valuation of Non-Controlling Interests in Business Entities Electing to be Treated as S Corporations: A Job Aid for IRS Valuation Analysts (October 29, 2014).  This Job Aid was obtained in 2015. The result was a critique of the Job with specific advice in 2015 entitled How the IRS Values Non-Controlling Interests in S-Corps (June 15, 2015).  With three more years of experiences and examples of working various issues with clients with this issue before the IRS Business Valuations and the IRS: Five Books in One was written to help clients work the most common issues with the IRS including S-corp valuations.  This text address not only covers S-corp valuations, but also reasonable compensation, discount for lack of marketability, IRS structure and process, and resolving conflicts with the IRS. It is the most comprehensive and up to date book ever written on the topic with 852 pages, 180 practical pointers and 38 examples.

Court cases

There are a host of court cases on point. This is a listing of some more historical (2000 to 2011) and current court cases (2019- 2022) regarding tax affecting and others on point related to business valuation demonstrating a trend of federal tax court rulings. Numbers have been applied to these cases simply to segregate the most recent relevant court case (#1) to the originating court case directly on point (#14) regarding tax affecting on S-corps

1. Nelson v. Comm December 21, 2021 TC Memo 2020-81,  5^th Circuit November 3, 2021 70% win for the TP on valuation
2. Estate of Michael Jackson May 3, 2021 (Corp)  Win for TP
3. Estate of Warne February 18, 2021 Win for TP
4. Lucero v. U.S. October 27, 2020 Win for TP
5. Pierson M. Greive v. Comm March 2, 2020 Win for TP
6. Estate of Aaron U. Jones August 19, 2019 (Corp) Win for TP (1120S)
7. Kress v. U.S. March 26, 2019 (Corp) Win for TP (1120S)
8. Estate of Gallagher June 28, 2011
9. Guistina TC Memo 2011-141 (Limited Partnership)
10. Dallas T.C. Memo 2006-212 (Corp)
11. Adams T.C. Memo 2002-80 (Corp)
12. Heck T.C. Memo 2002-34  (Corp)
13. Wall TC Memo 2001-75 (Corp)
14. Gross v. Commissioner T.C. Memo 1999-254, aff’d 272 F. 3d 333 (6^th Cir. 2001cert denied, 537 U.S. 827 (2002) (Corp)

The Gross court case(#14) set a precedent for not tax affecting an S-corp. This case was affirmed in the 6^th Circuit and the U.S. Supreme Court refused to hear the case and let the earlier decision stand. Cases #8 to #13 all reaffirmed not tax affecting an S-Corps. Case #7 (Kress) was a win by the taxpayer related to tax affecting. Both the taxpayer and the government experts tax affected on this case. The court made no direct ruling on tax affecting, but accepted valuations by both parties. This is a U.S. District Court Case for Eastern Wisconsin but does not have national implications. Case #6 the taxpayer tax affected and the IRS did not supply a valuation in one instance and in the other instance the court found the taxpayer’s appraisal to be more on point with tax affecting. Most recently the Michael Jackson case (#2) rejected tax affecting. Cases #1, #3, #4, and #5 are all government losses on business valuation cases. The point to be made is that in recent history (2019 to today) in terms of valuation the government has consistently gone to court on cases (#1 to #7) and lost in court on the valuation issues, although being sustained on tax affecting with exceptions of cases #6 and #7 when the issue was in play.

Where does this leave you?

See the IRS Job Aid on S-Corps and the IRS Job Aid on Discounts for Lack of Marketability.  Since an S-corp has some significant additional risks such as no distributions and having to pay taxes on what could have been distributed,  distributions not covering taxes, distributions covering only taxes, distributions not 100% distributed, limited to only one class of stock, limited to the number of shareholders, and other issues the IRS with example 2 on page 19 of the IRS Job Aid on S-Corps makes the case for a higher DLOM for an S-corp. The additional risks may also impact the discount rate applied to the income approach. For these and other reasons, the IRS is out to determine a reasonable determination of fair market value. You may not approach the issue the same way, but you may end up with a number that the IRS deems to be reasonable. To avoid conflict, you may want to consider federal S-corp valuations without tax affecting and instead impacting the discount rate and the DLOM. This is a grossly simplified commentary but points out that two parties can take quite different approaches and end up with values very similar to each other.

I welcome feedback on this commentary. What do you think? My intention is to help you negotiate the complexities of federal fair market value valuations of S-corp entities and avoid conflicts with the IRS.