Challenges to Valuing an S Corporation

Resolving the Issue of S Corporation Benefits and Capital Gains

By: G. Dennis Bingham, William C. Herber, Robert J. Strachota and Scot A. Torkelson

In our last issue, we described a possible solution to the problem of valuing the minority interests held in an S Corporation. Part II discusses how to deal with differences between a C and an S Corporation (when valuing a minority interest), with regard to the taxes due at the time of the sale.

A second issue that must be dealt with when valuing an S Corporation is the potential for different tax levels between C and S Corps at the time of sale. Defining the tax differences between C and S Corporations at the time of the sale of a corporation is very difficult, not only from a quantitative standpoint but from a qualitative one as well. It is readily apparent that taxes paid for a regular C Corporation, at the time of sale or transfer of assets, are different from those paid for an S Corporation at the time of sale or transfer of assets.

As with dividends, the S Corporation's proceeds are only taxed once, while the C Corporation's distribution of proceeds is taxed twice in a 100% interest sale. In an asset sale, the C Corporation's proceeds, in excess of the basis, are taxed at corporate tax rates at the time of sale and when distributed to the minority shareholder at capital gains tax rates. With an S Corporation, there is no tax at the time of sale on the proceeds at the corporate level. The S Corporation also gets a stepped-up basis in the retained earnings and the shareholder is taxed at capital gains tax rates. Assuming the sales price of a company is no greater than the basis of the company sold, the only tax difference between a C and an S Corporation is the capital gains tax. In each of these scenarios, the taxes anticipated are to be paid by the seller and are based upon the seller's basis.

In an article submitted in Insights, Winter 2003, Mr. Daniel Van Vleet proposes a methodology for valuing minority interests in S Corporation securities. The indicated value derived, using this methodology, is similar to the continuum model except for one variable - capital gains tax liability. Mr. Van Vleet assumes "the capital gains tax is economically recognized when incurred,"i and that it is paid by the buyer to the seller. The continuum model would include a capital gains tax liability only in a limited number of circumstances based upon the following discussion.

We believe that any premium applied to the S Corporation associated with the capital gains tax savings, as proposed in Mr. Van Vleet's model, is really focusing on a benefit realized by the seller only at the time of sale. The law is clear that market value is associated with future benefits and is determined from the buyer's point of view. The question is: How would these taxes impact what a buyer would pay for the stock looking into the future, from the buyer's point of view. In the context of the Gross Decision, the question is: what benefit does the buyer get that the buyer would willingly pay for.

The Second Circuit Court in Eisenberg, set forth its rule regarding this question as follows:

"Fair market value is based on a hypothetical transaction between a willing buyer and a willing seller, and in applying this willing buyer-willing seller rule, 'the potential transaction is to be analyzed from the viewpoint of a hypothetical buyer whose only goal is to maximize his advantage&. [C]ourts may not permit the positing of transactions which are unlikely and plainly contrary to the economic interest of a hypothetical buyer&.' Our concern in this case is&what a hypothetical buyer would take into account in computing fair market value of the stock. We believe it is common business practice and not mere speculation to conclude a hypothetical willing buyer, having reasonable knowledge of the relevant facts, would take some account of the tax consequences of contingent built-in capital gains on the sole assets of the Corporation at issue in making a sound valuation of the property."ii

The rules are put even more forcefully by the Fifth Circuit Court in Dunn v Commissioner.iii The following quotes are taken from Dunn (emphasis is added):

"We are satisfied that the hypothetical willing buyer of the Decedent's block of Dunn Equipment stock would demand a reduction in price for the built-in gains tax liability of the Corporation's assets at essentially 100 cents on the dollar, regardless of his subject desires or intentions regarding use or disposition of the assets. Here, that reduction would be 34%. This is true "in spades" when, for purposes of computing the asset-based value of the Corporation, we assume (as we must) that the willing buyer is purchasing the stock to get the assets, whether in or out of corporate solution. We hold as a matter of law that the built-in gains tax liability of this particular business's assets must be considered as a dollar-for-dollar reduction when calculating the asset-based value of the Corporation, just as, conversely, built-in gains tax liability would have no place in the calculation of the Corporation's earnings based value." (Footnote 24 elaborates on this point by citing Pratt for the proposition that the tax consequences of ownership and/or transfer of stock usually are quite different from those of ownership and/or transfer of direct investment in underlying assets.)

"This truism is confirmed by its obverse in today's dual, polar-opposite approaches (cash flow; assets). The fundamental assumption in the income or cash-flow approach is that the assets are retained by the Corporation, i.e., not globally disposed of in liquidation or otherwise. So, just as the starting point for the asset-based approach in this case is the assumption that the assets are sold, the starting point for the earnings-based approach is that the Corporation's assets are retained-are not sold, (other than as trade-ins for new replacement assets in the ordinary course of business)-and will be used as an integral part of its ongoing business operations. This duly accounts for the value of assets-unsold-in the active operations of the Corporation as one inextricably intertwined element of the production of income."

"In our recent response to a similarly misguided application of the built-in gains tax factor by the Tax Court, we rejected its treatment as based on "internally inconsistent assumptions." In that case we reversed and remanded with instructions for the Tax Court to reconsider its valuation of the subject Corporation's timber property values by using a more straightforward capital gains tax reduction. Similarly, because valuing Dunn Equipment's underlying Corporate assets is not the equivalent of valuing the Company's capital stock on the basis of its assets, but is merely one preliminary exercise in that process, the threshold assumption in conducting the asset-based valuation approach as to this company must be that the underlying assets would indeed be sold. And to whom? To a fully informed, non-compelled, willing buyer. That is always the starting point for a fair market value determination of assets qua assets. That determination becomes the basis for the company's asset-based value, which must include consideration of the tax implications of those assets as owned by that company."

Eisenberg and Dunn stand for the proposition that, in determining adjustments for the capital gains tax, an appraiser must look at the transaction from the buyer's point of view to determine what a willing buyer would pay a willing seller for the stock. The courts are saying that a seller only seeks payment and that a buyer only pays for the future benefit that the buyer may receive. In looking at the S benefit, a buyer would only pay a seller for the benefit that the buyer may receive.

Applying a premium to the S Corporation value for the possible capital gains tax savings in the model-and on a dollar for dollar basis-would have the buyer paying the seller for the benefit that the seller receives, not the buyer. Eisenberg and Dunn say that this is not done; and Dunn clearly says the law requires that capital gains tax is taken into account only in the asset approach, not the income approach (nor presumably in the market approach), neither of which assumes individual ownership of the assets. It is also important to note that the capital gains tax discussed in all of these cases is the tax payable by the corporation, not the shareholder. Remember we are valuing a minority interest, not the 100% sale of the company. With respect to retained earnings, a C Corporation pays no capital gains tax on retained earnings because the C Corporation already has basis in these amounts.

Likewise, analyzing the potential capital gains tax liability is not correct because of any basis step-up a S shareholder receives from retained earnings. The issue of basis increased by retained earnings is already taken into account in the continuum model by virtue of valuing the benefit of the S Corporation to the shareholder, thus giving full consideration of the benefit in the cash flow to the minority shareholder.

Finally, we maintain that any purported capital gains tax to the buyer is a potential tax (or savings) payable in the future. The primary question is: how to value this future tax cost, if at all, and any resulting benefit to S Corporation shareholders of a buildup in basis not subject to such a future tax. Any difference between S and C Corporation capital gains tax liability must take into consideration such qualitative factors as whether the market value sale triggers release of any trapped in gains. Minority interest stock sales almost never trigger such tax costs, and in this instance we are valuing only minority interests in S Corporations. For the buyer of a minority interest in stock then, one must look to the benefits anticipated by the buyer. Because there usually are no plans to liquidate an operating company or for the buyer to immediately resell the company, any capital gains tax due (or build up in basis benefit) remains in the indeterminate future.

Clearly, the retained earnings are not coming out as part of the hypothetical minority interest sale that is deemed to occur in a minority interest stock valuation. Even when considering the asset sale of a company, it could be sold to a public company in a tax-free reorganization and the tax benefit of getting the retained earnings out in the future may be postponed indefinitely. Further, sellers of C Corporations rarely pay the entire capital gains tax as there are many ways to mitigate the cost at this point as well-such as reinvesting the proceeds into another company within a proscribed time frame.

However, we believe it is appropriate to investigate the possibility of a transaction occurring that would trigger the capital gains tax liability. While the facts and circumstances of each case will vary, the following questions should be considered:

• Have there been any sales of the subject's assets, 10% or more, in the last five years?
  
• Is management currently considering the sale or liquidation of the subject?
  
• Is there anything in the Articles of Incorporation, Bylaws, Shareholders Agreement, or other legal documents, which could force the sale of the subject or a substantial portion of its assets?
  
• Is the industry currently experiencing consolidation? If yes, is the subject a viable takeover candidate?
  
• Can the ownership interest being valued force the sale of the subject?

If the answer to any of these questions is yes, then it may be appropriate to include consideration of a "potential" capital gains trigger. A discussion of an appropriate adjustment to assign the capital gains factor is beyond the scope of this article. In any event, capital gains savings by S Corporations are clearly not a dollar for dollar benefit to shareholders, in our opinion.

Conclusion
The continuum model as a solution to determining the benefits of an S election to a minority shareholder has significant merit. The appraiser should keep in mind the key points of this article:

• The Continuum Method is applicable to a minority interest only.
  
• The double taxation argument only applies when there is a 100% dividend distribution by the C Corporation.
  
• The Continuum Model is consistent with market evidence.
  
• The Court, in Gross, recognized the need for a continuum type of analysis to tie the two polar positions together.
  
• When valuing a minority interest in an S Corporation, the appraiser should look at guideline companies' retained earnings vs. distributed income (or the overall industry).
  
• The buyer only pays a seller for the portions of the S benefit that the buyer may receive.

Nonetheless, The Continuum Model is only a starting point and does not take into consideration a myriad of other qualitative factors differentiating C from S Corporations requiring additional consideration.

Endnotes
i Daniel R. Van Vleet, The Valuation of S Corporation Stock: The Equity Adjustment Multiple, Insights, Winter 2003.
ii Eisenberg V. Commissioner, 155 F.3d 50, 57 (2nd Cir. 1998).
iii Dunn v. Commissioner, T.C. Memo 2000-12 (January 12, 2000).

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