Advent Valuation Advisors
On March 25, 2019, the U.S. District Court – Eastern District of Wisconsin issued an important decision supporting the use of tax-affecting in valuing pass-through entities. In Kress v. United States, Chief Judge William C. Griesbach relied heavily on the taxpayer’s expert in valuing non-controlling interests in a Subchapter S operating company called Green Bay Packaging, Inc. (“GBP”).
In the taxpayer’s expert report, GBP was first valued as a C-corporation equivalent, which included tax–affecting. Next, quantitative and qualitative adjustments were made to address economic benefits attributed to the Subchapter S election.
The valuation community and taxpayers have been fighting the IRS over this issue for years, starting with Gross v. Commissioner (TCM 1999-254) in 1999, which rejected the use of tax-affecting when valuing pass-through entities. Courts have generally sided with the IRS in opposing the tax-affecting of pass-through entities in subsequent cases such as Estate of Gallagher v. Commissioner (TCM 2011-148) in 2011.
In Kress v. United States of America (Case No. 16-C-795, U.S. District Court, Eastern District of Wisconsin), plaintiffs James and Julie Ann Kress sued to recover an overpayment of gift taxes. The court accepted the taxpayer’s valuation report, in which GBP was tax-affected as a C corporation, supporting the point that valuation experts have been arguing for several years. While the District Court’s decision in Kress does not carry the precedential weight of a U.S. Tax Court decision, it should be valuable to other courts considering the issue.
In his report, the taxpayer’s appraiser tax-affected the earnings of the S corporation in appraisals filed as of December 31, 2006, 2007 and 2008. The court accepted the fair market value as filed by the taxpayer, with only minor adjustments to the applied discounts for lack of marketability (DLOM).
In their respective reports, the IRS’s appraiser and the taxpayer’s expert each tax-affected GBP’s S corporation earnings as if it were a C corporation. This is significant, because the IRS has held the position in recent years that earnings of pass-through entities (S corporations, LLCs and partnerships) should not be tax-affected, because they do not pay entity-level taxes. Business appraisers have generally endorsed the practice of tax-affecting pass-through entities, arguing that the tax benefit of pass-throughs should be based on the effective difference in the after-tax income of their owners.
In the Kress case, this was not an issue, as both appraisers tax-affected GBP’s earnings. The IRS’s expert also applied a pass-through benefit in its application of the income approach, while the taxpayer’s expert did not.
After acknowledging the efficacy of tax-affecting, the court went even further, stating, “The court finds GBP’s subchapter S status is a neutral consideration with respect to the valuation of its stock. Notwithstanding the tax advantages associated with subchapter S status, there are also noted disadvantages, including the limited ability to reinvest in the company and the limited access to credit markets. It is therefore unclear if a minority shareholder enjoys those benefits.”
In its decision, the court did not accept the S-corporation premium (pass-through benefit) put forth by the IRS’s valuation expert, resulting in a nearly complete victory for the taxpayer. The decision represents an important point of inflection in the controversy over the tax-affecting of pass-through entities and the application of a premium for pass-through entity status.
Over the past 20 years, the application of a premium to pass-through entities based on their pass-through tax status has been a heavily debated topic. In the Kress case, such a premium was not applied by the court. While not all concur, we believe that today, most valuation experts have concluded that pass-through entities may deserve a premium when compared to otherwise identical C corporations.
It is worth noting that the gifts in the Kress case were from 2006, 2007 and 2008, prior to the pass-through tax benefit gaining full traction in the debate within the valuation community. It will be interesting to see if prevailing thought and application change in the future.
Kress will clearly be an important reference for taxpayers in gift- and estate-tax appraisal cases where the IRS argues against tax-affecting of S corporation earnings and for a premium in the valuation of pass-through entities relative to otherwise identical C corporations. The case should be considered as support for tax-affecting the earnings of a company organized as a pass-through entity for income tax purposes.
Lorraine Barton is a partner with Advent Valuation Advisors. She can be reached at firstname.lastname@example.org.