Valuation experts have debated the proper way to value S corporations and other tax pass-through entities for decades. The Tax Cuts and Jobs Act enacted at the end of 2017 will further fuel the debate.
The Impact of Taxes on the Discounted Cash Flow Method
By way of background, most experts use the discounted cash flow method to value corporate entities. With that method, the expert projects a company’s future cash flows, then applies a discount rate in order to calculate the present value of those projected cash flows.
Whether the company is a C corporation or an S corporation can impact the cash flow projections. A C corporation pays corporate taxes on its income. If the company pays dividends, the individual C corporation shareholders separately pay personal taxes on that dividend income. They do not, however, pay taxes on the company’s earnings if no dividends are paid. By contrast, an S corporation does not pay income taxes at the corporate level. Instead, individual shareholders pay taxes on their pro rata shares of the company’s income (i.e., the taxes “pass through” to the shareholders), regardless of whether they receive cash distributions.
A company’s status as a C corporation or an S corporation can also affect the discount rate. Most of the data that experts use to determine the appropriate discount rate comes from published rates of return for publicly-traded C corporations. Because S corporations are all privately owned, published information about expected rates of return for S corporations is more limited.
Expert Approaches to Valuing S Corporations
Starting in the mid-1980’s, valuation experts took one of three approaches to valuing S corporations and other tax pass-through entities. At one extreme, experts treated an S corporation just like a C corporation and applied a hypothetical corporate tax to the S corporation’s projected income. Courts uniformly rejected that approach because it failed to account for the added value of an S corporation’s tax pass-through income compared to the potentially “double-taxed” C corporation earnings. At the other end of the spectrum, experts ignored taxes completely, at both the corporate and shareholder level, and simply calculated the present value of the S corporation’s untaxed cash flows. See, e.g., Hamelink v. Hamelink, 2013 WL 6839700 (Minn. Ct. App. Feb. 26, 2014). Critics of that approach opined that it overvalued the S corporation by failing to account for shareholder-level taxes and exaggerating the benefit of owning an S corporation. Critics were also uncomfortable applying after-corporate-tax rates of return for C corporations in order to discount untaxed S corporation cash flows.
In response to problems they saw in both of the above approaches, some experts developed hybrid approaches to valuing S corporations. See, e.g., Delaware Open MRI Radiology Associates, P.A. v. Kessler, 898 A.2d 290 (Del. Ch. Ct. 2006). Experts who used hybrid approaches would project the company’s cash flows as if it were taxed like a C corporation, calculate the present value of those cash flows using a discount rate based on expected C corporation returns, and then add a premium at the end to reflect the tax benefits of owning an S corporation over a comparable C corporation. To determine the premium, experts looked to empirical data on sale prices of S corporations compared to equivalent C corporations, or they created models to calculate the premium associated with S corporation tax benefits. The idea was to match after-corporate-tax discount rates to projected after-hypothetical-corporate-tax cash flows, while applying a premium that captured the actual added value of S corporations.
Possible Changes Caused by the New Tax Law
That was the state of the debate through 2017, but the Tax Cuts and Jobs Act changed the calculus. For many companies, the new tax law may have diminished – if not entirely eliminated – the S corporation premium. For example, the new law lowers the top federal marginal corporate tax rate that C corporations pay from 35.0% to 21.0%. The law also lowers the top federal individual tax rate, but less significantly (from 39.6% to 37.0%). At the same time, the law eliminates or caps certain individual tax deductions. On the balance, these changes are likely to benefit C corporation shareholders more than S corporation shareholders, which closes the gap between C corporation and S corporation values. Read more.
