The conclusion in Gross v Commissioner resulted in an S Corporation value which was 60%+ greater than an otherwise identical C Corporation. The Gross case and its companion cases, Hech and Adams, have created quite a stir in the valuation community. Much has been written and little has been solved.

Here, we are going to look at the very complex and highly disputed matter of developing an appropriate methodology to value an S Corporation, while acknowledging that S Corporations receive benefits which C Corporations do not enjoy, and these benefits may result in a market value premium. The extent of that premium is what is in dispute.

Introduction - Methodology Proposal

In our proposed methodology for valuing S Corporations, the first step is to find a beginning point. We would propose that the best starting point would be to value 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 has emerged over the past ten years between taxpayers and the IRS. In the valuation of minority interests, the methodology which emerged was to first value the company's 100% interest, and then ascertain what the appropriate minority and marketability discounts would be. Then applying these discounts to the 100% market value would result in the appropriate minority interest market value. We are proposing the same conceptual series of steps for the valuation of S Corporations.

Once such a starting point is established, the various benefits associated with an S election can next be considered to establish a premium for the S Corporation election, resulting in a market value conclusion for the S Corporation.

1. Establish value of C Corporation (per share)
2. + Add: adjustment for S Corporation premium
3. = 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 then are 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 in that much of the rhetoric related to the issue of C vs. S Corporation values are typically attributed to C Corporations being taxed twice and S Corporations being taxed once. But that is not entirely true. The earnings of a C Corporation and an S Corporation are both 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 shareholders 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 business, but it happened to be precisely the case in Gross vs. Commissioner which has set the S Corporation premium dispute in motion.

As we examine what happens to the relative shareholder benefits between a C Corporation and S Corporation, as distributions made to shareholders increase from 0% to 100%, the rising premium is readily apparent (see Table 1 and Table 2).

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. So 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 shareholders are always constant because shareholders are subject to only one level of tax irrespective of what the level of distributions are. Any discretionary distribution after taxes are paid tax free.

C Corporation - The C Corporation has a variable shareholder interest. As we have stated only monies distributed to shareholders are subject to a second level of tax. Thus in viewing Table 1, 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.

Table 1

As an example, if a 40% shareholder distribution is made by the C Corporation, the distribution would be $23.60 (40% of the $59 net income). The net after tax distribution retained by the shareholder would be $12.74 ($23.60 less personal income tax of $10.86). The earnings retained by the C Corporation would total $35.40 (60% of $59 after tax net income). The earnings retained by the C Corporation would be 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 would find a 12.16% S Corporation premium ($54/$48.14) relative to the C Corporation market value.

If a 60% distribution were made, the distribution would be $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 would 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 would find a 26.42% S Corporation premium ($54/$42.72) relative to the C Corporation market value.

As shown in Table 1 and Table 2, assuming various levels of C Corporation distributions from 0% to 100%, it is possible to develop a continuum of premiums from 0% to 69.29% (the maximum benefit derived from an S Corporation election with 100% distributions).

Table 2

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 valuable. The overall S Corporation premium, in this study, was found to be in the range of 12% - 17%. Can we expand this discussion?

A review of the Dow Jones Industrial Average over the past five years and ten years shows that discretionary distributions of C Corporations have ranged (averaged) from 40% to 50% of net income overall. Therefore, the continuum model would predict the overall public market would find an S Corporation premium ranging from 12.2% (the 40% distribution) to18.9% (the 50% distribution). The continuum model therefore ties to the market evidence shown in the Erickson and Wang study (see Table 2 and Table 3).

Table

Considerations and Application to Gross

The continuum model also is consistent with the conclusions of the Gross Case, which today forms the context of any S Corporation valuation. The case of Gross vs. Commissioner involved Pepsi-Cola Bottler 'G&J,' which was distributing 100% of earnings. The tax court concluded that Mr. Mukesh Bajaj (the IRS appraiser) and the taxpayer's appraiser used the same discounted cash flow method and that Mr. Bajaj's decision not to tax affect the company's earnings was not a difference as to 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. 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. And despite the fact that these polar extremes formed the basis of the dispute, the Court, even in the case of Gross, could see the need for a continuum type of analysis which would tie the two polar positions together. The 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 no believe that further evaluation was necessary under the circumstances." (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 Mr. Bajaj appears to be supportive of a continuum model, while yet arguing for the highest premium for the facts as they pertain to G&J, namely 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 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."

"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." (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 &.". (emphasis added)

Use of Market Evidence for Distributions

In applying the continuum model more broadly, we believe 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 payout a very high level of distributions (84%) having low retention needs, and therefore the benefit S Corporation election would be relative 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 there to be a very low premium or even no benefit 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 comparable public companies relative to the subject company being appraised.

Table 4

In 1992, the industry average for dividend distributions as a percentage of net income for bottlers was 100%. Therefore, using industry averages, the continuum model would find a maximum S Corporation premium of 69.5% relative to the C Corporation value. The facts of the Gross Case support the maximum benefit of the S Corporation election. This maximum benefit is also supported in the continuum model.

Issue of S Corporation Benefits Associated with the Issue of Capital Gains

In a forthcoming article, Mr. Daniel Van Vleet proposes a methodology for valuing S Corporation securities. The indicated value derived, using this methodology, is identical 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." The continuum model would include a capital gains tax liability only in a limited number of circumstances.

We believe reducing the C Corporation shareholder benefit, as proposed in Mr. Van Vleet's model, by the amount of capital gains tax is really focusing on a benefit realized at the time of sale by the seller. In addition, we believe the law is clear that the benefit is determined from the buyer's point of view. In the traditional sense, the question is how would these taxes impact what a buyer would pay for the stock. In the Gross context, the question is what benefit would the buyer be getting that the buyer would willingly pay for.

The Second Circuit in Eisenberg set forth its rule 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&. 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."

The rules are even put more forcefully by the Fifth Circuit court in Dunn v Commissioner. 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 whether to reduce for capital gains tax, the Service is to look from the buyer's point of view to determine what a buyer would be willing to pay a seller for the stock. This is because the courts are saying that a seller can only seek payment and a buyer would only pay 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 the buyer may receive. Reducing the C Corporation value for the capital gain in the model would have the buyer being willing to pay the seller for the benefit the seller would receive, not the buyer, and Eisenberg and Dunn says that is not done. Further, Dunn clearly says the law requires that capital gains tax is taken into account only in the asset approach, not the income approach and presumably 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. 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 gain tax liability is not correct because of any basis step-up an S shareholder receives from retained earnings. The issue of basis increased by retained earnings is already taken into account in the continuum model by always valuing the benefit of the S Corporation shareholder benefit thus giving full consideration of the benefit in the cash flows.

Finally, the law requires the Service to use the willing seller-willing buyer standard to value what the seller has to sell, which, with respect to this issue, is the possibility that the retained earnings may come out of the company sometime in the future with no tax if it is an S Corporation. This is all the seller has to sell to the buyer and this is what the buyer would be purchasing. How much can a seller demand for this benefit and how much would a buyer pay for this benefit if an S election is in place?

Generally, we maintain that the value is much of anything, because it is uncertain that any benefit will ever be realized by the buyer for several reasons. It is not a certainty that the retained earnings will come out and this is the only way a buyer will realize a benefit under the S Corporation benefit analysis of Gross. There usually are no plans to liquidate the company or sell the company. The retained earnings clearly are not coming out as part of the hypothetical sale that is deemed to occur as of the date of the gift. A company 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.

However, we believe it is appropriate to investigate the possibility of a transaction occurring that would trigger the capital gain 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.

Summary

What Gross 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 directs us to determine what is the S Corporation benefit that needs to be valued and then to value these benefits based on what a willing seller has to sell and would accept and what a willing buyer may be willing to purchase and pay the seller over and above the appraised value of the stock as a C Corporation. The continuum model identifies and values these benefits.

In valuing the S Corporation premium we believe 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 stable industries 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.

Lastly, we believe reducing the C Corporation benefit for a tax on retained earnings is generally not supported by applicable law or sound economic theory; however, when applicable is highly case specific.