Challenges to Valuing an S Corporation in the Gross Environment: The Continuum Model as a Solution
By: G. Dennis Bingham, William C. Herber, Robert J. Strachota and Scot A. Torkelson
This article is the first in a two-part series describing a proposed solution to the problem of valuing the minority interests held in an S Corporation. Part I is the actual development of our Continuum Model to help solve this complex valuation issue. Part II (which will appear in the next issue of Valuation Viewpoint) discusses how to deal with differences in the taxes due at the time of sale between a C and an S Corporation when valuing a minority interest.
The conclusion in Gross v Commissioneri resulted in an S Corporation minority value which was 60%+ greater than the value of an otherwise identical C Corporation. The Gross case and its companion cases, Heckii and Adamsiii, have created quite a stir in the valuation community. Much has been written, but little has been resolved.
In this article, we will look at the very complex and highly disputed matter of developing an appropriate methodology to value an S Corporation minority interest, while acknowledging that S Corporations receive benefits, which C Corporations do not enjoy, and that these benefits may result in a market value premium. Determining the extent, if any, of the potential premium is the disputed issue with a secondary emphasis on the capital gains issue, at the time of sale.
What the Gross decision says is that we need to value the S Corporation benefits that the seller has to sell and that the buyer may purchase. The willing buyer-willing seller concept is well established and directs us to determine what is the S Corporation benefit, and then to value this benefit over and above the appraised value of a minority stock interest as a C Corporation. The continuum model identifies and values the benefits directly.
In valuing the S Corporation premium, we believe that sound economic theory supports the use of industry dividends rather than historical dividends because: the past may not be indicative of the future; over the long-term, companies do not have the ability to pay out greater dividends than the industry if they want to remain competitive and maintain current profit margins; and paying out dividends greater than the industry, over the long-term, will cause a decrease in retained earnings and an impairment of the subject's debt to equity ratio in comparison to the industry average.
It should also be emphasized that our method is appropriate only when valuing a minority interest. This is because the economic benefits are being measured by comparing the S Corporation minority interest shareholders with C Corporation minority interest shareholders.
We believe that any premium associated with a capital gains tax on retained earnings is generally not supported by applicable law or sound economic theory; however, when such a premium is applicable, it is highly case specific. Because the continuum model applies only to a willing buyer of a minority interest, any future sale of the 100% interest would occur only as a possible future event, if at all. Therefore, the capital gains tax benefit associated with S Corporations would be small, as well as very difficult to calculate with any precision as a willing buyer would not know the time frame, pricing or terms of such future sale.
Introduction-Methodology Proposal
We would propose that the best place to start is to value a minority interest in an S Corporation as an otherwise identical C Corporation. The reason for such a starting point is that there is an historic precedent for this proposed method-that of the valuation of minority interests, which emerged over the past ten years. Disputes between taxpayers and the IRS resulted in a methodology which values the company as a 100% controlling interest by means of various approaches to value which all parties understand and can agree to, and then ascertaining what the appropriate minority and/or marketability discounts would be to reflect the partial interest being appraised. We are proposing the same generalized concept for the valuation of S Corporations.
The recommended steps to determine the fair market value of an S Corporation are as follows:
- Establish value of otherwise identical C Corporation (per share)
- +/- Adjustment for S Corporation premium/discount
- = Value of S Corporation (per share)
Considerations for Determining an S Corporation Premium
The calculation of an S Corporation premium is a product of comparing what shareholders of an S Corporation are entitled to receive relative to what shareholders of an otherwise identical C Corporation are entitled to receive.
S Corporations can make discretionary dividend distributions (beyond those necessary to pay shareholder level taxes) tax-free at the corporate level. In contrast, C Corporation discretionary dividends are made after corporate level taxes, and are then taxed a second time at the shareholder level. However, income retained by the C Corporation is subject to no second tax. This is an important distinction because the rhetoric related to the issue of C vs. S Corporation values revolves around C Corporations being taxed twice and S Corporations being taxed once. But that is not entirely true. The earnings of both a C Corporation and an S Corporation are subject to one level of tax that the Tax Code says has to be paid when it is earned (with C Corporations taxed at the corporate level and S Corporations taxed at the shareholder level). However, any dividends paid out and distributed to the shareholders by C Corporations are taxed a second time (at the shareholder's personal tax rate). Earnings retained by the C Corporation are subject to no further tax. They are taxed only once-the same as S Corporations.
Thus, in most businesses, the variable level of taxation discussed above creates a continuum of S Corporation benefits and a resulting continuum of S Corporation value premiums. Only in the instance where there is a 100% dividend distribution by the C Corporation is there a true 'double taxation,' as only in this instance are there no retained earnings. Distributions of 100% of earnings occur only rarely in the real world of small businesses; but it happened to be precisely the case in Gross vs. Commissioner, which set the S Corporation premium dispute in motion.
When we examine what happens to the relative shareholder economic benefits between a C Corporation and S Corporation, as distributions increase from 0% to 100%, the rising discount/premium is readily apparent (see Tables 1 and 2).
C Corporation
The C Corporation has a variable shareholder benefit depending on the level of distribution. As stated, only cash distributed to shareholders is subject to a second level of tax. We see, in viewing Table 1, that all operating income of a C Corporation is subject to a 41% estimated corporate tax ($100 less $41), for a net after corporate tax income of $59.00. Then, depending on distributions, there may be a differential from an otherwise identical S Corporation with the exact same level of retained earnings relative to distributions. Note that the same level of earnings is retained whether the Corporation is C or S. Because we are valuing an S Corporation relative to an otherwise identical C Corporation, retained earnings must be kept equivalent so that, on an operational basis, the two entities remain identical.
S Corporation
The S Corporation operating income is subject only to the personal tax rate (estimated at 46% in this article). Thus, irrespective of the dividend distribution vs. earnings retained by the S Corporation, the net shareholder's benefit would always be the same. In this instance: $100 of operating income paying $46 personal tax, nets $54 total shareholder benefit irrespective of what is paid as dividend or retained by the S Corporation. Remember, the shareholder benefit to the S Corporation shareholder is always constant because shareholders are subject to only one level of tax irrespective of the level of distribution. Any discretionary distribution after taxes is paid tax-free.
As an example, if a 40% shareholder distribution is made by the C Corporation, the distribution is $23.60 (40% of the $59 net income). The net after tax distribution retained by the shareholder is $12.74 ($23.60 less personal income tax of $10.86). The earnings retained by the C Corporation total $35.40 (60% of $59 after tax net income), and are subject to no further tax. The total C Corporation shareholder benefit is $48.14 (composed of the net $12.74 shareholder distribution and $35.40 retained earnings). Therefore, where there is a 40% C Corporation distribution, one finds a +12.16% S Corporation premium ($54/$48.14 minus 1) relative to the C Corporation market value.
If a 60% distribution were made, the distribution is $35.40 with a 46% personal tax of $16.28, and a net after tax distribution retained by the shareholder of $19.12. The earnings retained by the C Corporation total $23.60 (40% of $59 after tax net income). The total C Corporation shareholder benefit is $42.72 (composed of the net $19.12 shareholder distribution and $23.60 retained earnings), compared to the otherwise identical S Corporation total shareholder benefit of $54 (always $54). Therefore, where there is a 60% C Corporation distribution one finds a 26.42% S Corporation premium ($54/$42.72 minus 1) relative to the C Corporation market value.
As shown in Tables 1 and 2, assuming various levels of C Corporation distributions from 0% to 100%, it is possible to develop a continuum of discount/premiums from -8.5% to 69.29% (the maximum benefit derived from an S Corporation election with 100% distribution).
Market Comparison
The continuum model has also been paired with market evidence. Merle Erickson and Shing Wu Wang studied 77 samples of acquisitions of S Corporations versus C Corporations and determined that S Corporations were more valuableiv. The overall S Corporation premium, in this study, was found to be in the range of 12% to 17%.
A review of the Dow Jones Industrial Average over the past five/ten years shows that discretionary distributions of C Corporations averaged from 40% to 50% of net income overall. The proposed continuum model predicts that the overall public market would find an S Corporation premium ranging from 12.2% (the 40% distribution) to 18.9% (the 50% distribution)-Table 3. The continuum model therefore appears to tie to the market evidence shown in the Erickson and Wang study. We would note however that this study is examining S Corporations at the entity level, whereas our analysis is at the shareholder level.
The continuum model is also consistent with the conclusions of the Gross decision, which today forms the background of any S Corporation valuation, especially in the area of Estate and Gift Tax. The case of Gross vs. Commissioner involved Pepsi-Cola Bottler 'G&J,' which was distributing 100% of its earnings. The Tax Court concluded that Dr. Mukesh Bajaj (the IRS appraiser) and the taxpayer's appraiser used the same discounted cash flow method and that Dr. Bajaj's decision not to tax affect the company's earnings was not a difference of methodology but was, at least with respect to the discounted cash flow approach, exclusively the result of differences between the experts as to the values of certain variables. In this case, the question is whether to tax-affect the earnings of the S Corporation or not. The result was a greater than 60% premium to value for the S Corporation relative to an otherwise identical C Corporation. In this instance, the dispute was between 'tax-affecting' or 'not tax-affecting' the earnings. Despite the fact that these polar extremes formed the basis of the dispute, the Court, even in the case of the Gross decision, could see the need for a continuum type of analysis, which would tie the two polar positions together.
The Sixth Circuit Court stated,
"We disagree with the Tax Court's characterization of the respective experts' approaches to tax affecting as a mere difference in variables. There was no spectrum of tax percentages from which the court could have selected. Rather, the choice was either a Corporate tax rate of 40% or a rate of 0%, the latter meaning no tax affect at all. But while the Tax Court's analysis was rather cursory, we do not believe that further evaluation was necessary under the circumstances."v (emphasis added)
In the case of G&J, which was distributing 100% of its earnings and achieving the maximum benefits as an S Corporation, the Tax Court was persuaded that there should be no tax affect.
A review of subsequent statements by Dr. Bajaj appears to support a continuum model, while yet arguing for the highest premium with regard to G&J, i.e., that 100% distributions were made to shareholders.
"'Why won't people become S Corporation and increase market cap by 60%?' The answer is, well if they could, they should, and if you have the ability to fire managers when not doing so, you should. There are some Corporations that are better off as C Corporations partly because they reduce the tax bite of being a C Corporation by tax planning that you [the questioner] referred to and partly because there are offsetting advantages, and if organizations choose their organizational form appropriately, you will not see this large value gap."vi
"In general, since 1982, when the marginal personal tax rate dropped from 70% to 50%, S Corporations have a tax advantage than C Corporations. This tax advantage is a function of payout rate; it is a function of corporate versus personal marginal tax rates. If we consider the polar case where there is 100% payout, and we assume that both of the companies always have positive pretax income, then S Corporations will always have a tax advantage."vii (emphasis added)
"The fact is, in general, corporations that are organized as C Corporations reduce some of the potential value differential&because, given their investment and distribution policies, they expect not to make large distributions&which tend to favor C Corporations&."viii (emphasis added)
Use of Market Evidence for Distributions Rather than Historic Distributions
In applying the continuum model more broadly, we believe that market evidence (industry data) should be used to determine the level of earnings which must be retained and also the amount which can be distributed.
The importance of market evidence for dividend paying capacity is supported by Revenue Ruling 59-60:
"Primary consideration should be given to the dividend-paying capacity of the company rather than to dividends actually paid in the past. Recognition must be given to the necessity of retaining a reasonable portion of profits in a company to meet competition. Dividend-paying capacity is a factor that must be considered in an appraisal, but dividends actually paid in the past may not have any relation to dividend-paying capacity. Specifically, the dividends paid by a closely held family company may be measured by the income needs of the stockholders or by their desire to avoid taxes on dividend receipts, instead of by the ability of the company to pay dividends&"
By comparing the S Corporation being appraised with its otherwise identical C Corporation counterpart in the public markets (relative to the market levels of retained vs. distributed income), one can assess the S Corporation benefit for the company within its industry and hence the appropriate S Corporation premium. For example, companies in the petroleum industry pay out a very high level of distributions (84%), having low retention needs. Therefore, the benefit of an S Corporation election would be relatively high. In contrast, the relative benefits for a restaurant which distributes low levels of dividends (10%) and must retain a significant portion of its earnings would show that there is, in this instance, a small discount associated with the S Corporation election. Table 4 illustrates the S Corporation benefit using various industry data. An even more detailed determination can be made by identifying the dividend paying capacity of guideline public companies relative to the subject company being appraised.
In 1992, the industry average for dividend distributions, as a percentage of net income, for bottlers was 100%. Using industry averages, the continuum model finds a maximum S Corporation premium of 69.5% relative to the C Corporation value. The facts of the Gross Case also support the maximum benefit of the S Corporation election.
In conclusion, we are of the opinion that industry average dividends should be used to reflect the dividend paying capacity of the company being appraised into the future, due to the fact that over the long-term perspective, companies will tend to follow industry averages. Nonetheless, each appraiser must additionally consider the unique set of facts and circumstances when deciding dividend-paying capacity.
Endnotes
i
Gross v. Commissioner, T.C. Memo 1999-254 (July 29, 1999)
ii
Heck v. Commissioner, T.C. Memo 2002-34 (February 5, 2002)
iii Adams v. Commissioner, T.C. Memo 2002-80 (March 28, 2002)
iv Merle Erickson and Shing Wu Wang,
The Effect of Organizational Form on Acquisition Prices, Journal of Economic Literature, May 7, 2002, pp. 1-44
v
Gross v. Commissioner, T.C. Memo 1999-254 (July 29, 1999)
vi Shannon P. Pratt and Business Valuation Resources,
Tax-Affecting S Corporation Earnings, Audio Confernence Transcript, August 13, 2002, p. 6
vii Ibid., p. 3.
viii Ibid., p. 31.
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