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Tax Court OKs Tax-Affecting of Pass-Through Income

Photo courtesy of New York Public Library

The Tax Court recently issued a ruling that addresses the tax-affecting of pass-through entity earnings in valuing a portion of the entity. The case, Estate of Aaron Jones v. Commissioner, involved valuing interests in pass-through entities engaged in the lumber industry for the purpose of determining gift tax.

In valuing the taxpayer’s interest in the companies, the taxpayer’s valuation expert tax-affected projected earnings by 38 percent, because the valuation in question was as of 2009. He then applied a 22 percent premium for holding pass-through entity tax status because of the benefit of avoiding the dividend tax.

The IRS argued that there should be no tax imputed because (a) there is no tax at the entity level, (b) there is no evidence that the entity would become a taxable C corporation, and (c) tax-affecting abandons the arm’s-length formulation of fair market value, “in the absence of a showing that two unrelated parties dealing at arm’s length would tax-affect” the interest’s earnings “because it inappropriately favors a hypothetical buyer over the hypothetical seller.”

The estate’s expert argued that a tax rate of zero would overstate the value of the interest, because the partners are taxed at their ordinary rates on partnership income whether or not the company distributes any cash, and a hypothetical buyer would take this into consideration. He also argued that the hypothetical buyer and seller would take into account the benefit of avoiding dividend taxes.

Interestingly, the court noted that while the IRS “objects vociferously” to the estate expert’s tax-affecting of income, the IRS’ experts were silent on the matter. “They do not offer any defense of respondent’s proposed zero tax rate. Thus, we do not have a fight between valuation experts but a fight between lawyers.”

An emerging path

Taxpayers – and the valuation community – have been fighting the IRS over this issue for years, starting with Gross v. Commissioner in 1999 (TCM 1999-254), 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 in 2011 (TCM 2011-148).

Jones is the second notable decision this year in which a court has supported the use of tax-affecting in valuing pass-through entities in cases where additional adjustments were made to address the economic benefits of such entities. The other case, Kress v. United States, was decided in March by the District Court for the Eastern District of Wisconsin (16-C-795). There, as in Jones, the court’s decision relied heavily on the taxpayer’s expert.

In Jones, the court went back to the Gross case, quoting from Gross that “the principal benefit that shareholders expect from an S corporation election is a reduction in the total tax burden imposed on the enterprise. The owners expect to save money, and we see no reason why that savings ought to be ignored as a matter of course in valuing the S corporation.”

The court also referenced Gallagher and Estate of Giustina v Commissioner (TCM 2011-141), stating that all three cases did not question the efficacy of taking into account the pass-through tax status, but rather how to do so.

The court credited the estate’s expert for recognizing both the immediate tax burden posed by a pass-through entity’s income, and the benefit of avoiding the dividend tax. The “tax-affecting may not be exact, but it is more complete and more convincing than respondent’s zero tax rate.”

The case is Estate of Aaron Jones v. Commissioner, TCM 2019-101, Docket No. 27952-13, filed August 19, 2019. See pages 36-42 for pertinent details.

The decision is available here:

Tariffs Take Toll on M&A Activity

Photo by Xi Wang on Unsplash

Business brokers say the U.S.’s ongoing tariff battles are taking a bite out of business transactions.

Concerns over the impact of tariffs have compelled some small-business owners to lower their asking prices, while others have chosen not to put their businesses on the market at all, according to the second-quarter edition of Market Pulse, the quarterly survey of business brokers conducted by the International Business Brokers Association and M&A Source.

During the second quarter, 32 percent of lower middle market advisors and 22 percent of “Main Street” advisors reported that one or more of their sellers had been affected by tariff issues, according to Market Pulse. Main Street businesses are defined as those with values of $2 million or less, and lower middle-market ones as those worth $2 million to $50 million.

The brokers reported that some of the affected buyers had reduced their asking prices because of tariff-related concerns, while others decided not to sell as a result of recent changes in trade policy with China, Mexico and Canada, according to the report. Brokers say the timing couldn’t be worse for business owners looking to cash out during what has been a strong seller’s market.

“What’s tragic is that M&A conditions are otherwise extremely strong for sellers right now. However, there is a substantial minority of small business owners affected by tariff issues who can’t take full advantage of this market to exit their business,” Laura Maver Ward, managing partner of Kingsbridge Capital Partners, told Market Pulse. “Many business owners would rather lower their purchase price – reducing their retirement resources and their reward for years of hard work – rather than take a chance on missing their window to sell their company.”

The Market Pulse report echoes findings of a survey conducted early this year by the National Federation of Independent Business. In that survey, 37 percent of small business owners reported negative impacts of U.S. trade policy changes with Mexico, Canada and China. 

Manufacturers hit hard

Several brokers cited in the Market Pulse report said that manufacturing clients have been among those hardest hit by tariffs. While the pace of manufacturing deals has been hampered, activity in the construction/engineering sector has heated up, driven in part by private-equity interest, according to the report.

Market Pulse reported that overall market sentiment fell during the second quarter across all five value ranges tracked in the survey, when compared to confidence levels a year before. That said, 66 percent or more of advisors still see a seller’s markets in each of the three value ranges between $1 million and $50 million. Sentiment in the two value ranges below $1 million are at or below 50 percent.

“It’s still a strong marketplace with more buyers than sellers, and companies, for the most part, are doing well,” Randy Bring of Transworld Business Advisors told Market Pulse. “But tariff issues are popping up, and talk of a recession in the next 12 to 18 months is scaring some buyers away.”

Market Pulse is compiled by the Pepper­dine Private Capital Markets Project at Pepperdine Graziadio Business School. To learn more, go to Pepperdine’s Market Pulse page:

bschool.pepperdine.edu/institutes-centers/centers/applied-research/research/pcmsurvey/market-pulse-reports-overlay.htm

Bumpy Ride for Business Values

Continued Volatility Seen in Latest Edition of Value Index

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Price volatility continued in the small-business transaction market during the second quarter of 2019, according to the latest edition of DealStats Value Index.

The median EBITDA multiple – the ratio of selling price to earnings before interest, taxes, depreciation and amortization – jumped to 4.2 for transactions completed in the second quarter, up from a median of 3.4 during the first three months of the year. That increase continued a trend of large quarterly swings that began during the second quarter of 2017.

DealStats is a database of private-company transactions maintained by Business Valuation Resources. The database is used by business appraisers when applying the market approach to valuation. Multiples such as sale price-to-EBITDA can be derived from transactions involving similar businesses and used to estimate the value of a company, subject to adjustments for unique characteristics of the company being valued.

Companies that sold during the second quarter were generally less profitable than those sold in the first quarter, according to Value Index. EBITDA represented 11 percent of revenue for second-quarter transactions, down from 15 percent for the first quarter of the year.

In short, transactions reported to DealStats for the second quarter featured companies that were less profitable (as measured by EBITDA) than those sold in the previous quarter, but they sold at higher multiples to the reduced earnings.

Not all sectors are created equal

What’s driving the increase in volatility? DealStats doesn’t offer any theories. One contributing factor could be a shift in the types of businesses sold from one quarter to the next. For instance, much has been written in recent years about consolidation in healthcare. Businesses in healthcare and social assistance sold at a median of 6.3 times EBITDA during the second quarter, among the highest multiples tracked by DealStats. Retailers, in contrast, sold for a median multiple of 3.8. A spate of medical practice mergers could drive up the overall multiple for a quarter. A run of retail acquisitions could drive it down.

The industries boasting the highest median EBITDA multiples during the second quarter were information at 11.1, and mining, quarrying and oil and gas extraction services at 8.3. The lowest EBITDA multiples were reported for transactions in accommodation and food services at 2.6, and other services at 3.0.

Size premium

The smallest of small businesses tend to enjoy the largest profit margins, but they garner the lowest multiples of that profit when they sell. The Value Index tracks this dynamic by dividing transactions into four groups based on net sales (less than $1 million, $1 million-$5 million, $5 million-$10 million and greater than $10 million).

Of those groups, businesses with less than $1 million in net sales have produced the highest net profit margins in each year since 2010, while businesses with sales of more than $10 million have generated the lowest margins in each year except 2011. This isn’t surprising, since the smallest businesses typically have limited overhead, and many are sole proprietorships with little payroll expense.

When small businesses are sold, however, the largest among them generate the highest price multiples. In 2018, the median ratio of selling price to EBITDA for businesses with sales greater than $10 million was a shade over 12, according to the Value Index. For those with sales of less than $1 million, the median was less than 4.

As we’ve noted before, larger businesses typically face less risk because they have more diversified products, vendors and customers. There’s an inverse relationship between risk and value. Larger businesses are rewarded with higher multiples in part because they are less risky.

Click below to read Advent’s recent article about size premiums in business valuation:

To learn more about Advent Valuation Advisors, email info@adventvaluecom.

Adjusting Public Company Multiples When Valuing Private Companies

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One way that business valuation professionals can calculate the value of a business is by comparing it to publicly traded companies whose value has been established by the market. But how realistic is it to compare an independent five-store hardware chain – if such a thing exists these days – to Home Depot and Lowe’s?

In an article first published in the August/September edition of Financial Valuation and Litigation Expert, William Quackenbush, director of Advent Valuation Advisors, explains the process of adjusting a guideline public company’s market multiples when valuing a closely held business. Click the link below to read “Quantitatively Adjusting Guideline Public Company Multiples.”

Divorce Decision Reversed After Judge Double Dips

Divorce cases involving family businesses can pose unique challenges. Photo by Kelly Sikkema on Unsplash

A Connecticut appellate court recently delivered a resounding rebuke to a trial judge for “double-dipping” in a divorce case.

The court hearing the appeal in Oudheusden v. Oudheusden determined that the trial judge acted unfairly in dividing the couple’s assets and setting alimony, despite warnings from the lawyers for both sides regarding the risk of double-dipping.

According to the appellate decision, Mr. Oudheusden built two businesses during the couple’s decades-long marriage, and they represented his only sources of income. The trial judge awarded Mrs. Oudheusden $452,000, representing half the fair market value of the two businesses, as well as lifetime alimony of $18,000 per month.

In its decision, the appellate court stressed that the lump sum award and the stream of alimony payments were drawn from the same source.

“We agree with the defendant that, under the circumstances of this case, the court effectively deprived the defendant of his ability to pay the $18,000 monthly alimony award to the plaintiff by also distributing to the plaintiff 50 percent of the value of his businesses from which he derives his income,” the decision reads. “The general principle is that a court may not take an income producing asset into account in its property division and also award alimony based on that same income.”

Second bite of the apple

In divorce cases where the assets include a business, the value of the business and its profitability are key considerations in dividing the estate. In Oudheusden v. Oudheusden, the judge sided with the wife’s valuation expert in determining that the businesses were worth a total of $904,000, and that the husband’s annual gross income from them was $550,000.

Under the income approach to valuing a closely held business, the valuation is derived by calculating the present value of future benefits (often cash flow or some variant thereof) that the business is expected to generate. First, the business’s operating results are adjusted, or normalized, for nonrecurring or unrealistic items. In many small, closely held businesses, it is not unusual for the amount of compensation the business pays to its owner-operator to be motivated by tax considerations. In such a case, a business appraiser should normalize the owner’s compensation to reflect a fair market salary for the owner’s job duties. This formalizes the distinction between the reasonable compensation for the owner’s efforts and the business’s return on investment after deducting that compensation.

Next, a multiple of the normalized earnings is calculated based on the perceived risk to the company’s future performance and the expected growth rate of its earnings. The result of that calculation represents the present value of the future benefits to be generated by the business.

When a couple gets divorced, a judge who awards the nonowner spouse half the value of the family business has in essence given that spouse half of the future benefits to be generated by the business, discounted into today’s dollars. Awarding alimony based on a percentage of the same future benefits to be generated by the business would be taking a second bite from the apple, since that stream of benefits has already been divided.

Mrs. Oudheusden’s attorney explained the concept nicely in his closing statement, when he warned the judge of the perils of double-counting a single stream of income:

“Whatever value the court attributes to the business, the court has to, and should back out a reasonable salary for the officer and owner of the company. Because if the court is going to set a support order based on his income, it would not be fair and equitable to also ask that he pay an equitable distribution based on that as well,” he said. “That would be double-dipping.”

Decision reversed

After the trial court issued its decision, Mr. Oudheusden filed a post-judgment motion for clarification, asking if the judge considered $550,000 to be his income from his businesses, or his earning capacity if employed elsewhere. The judge responded that the figure was not a measurement of earning capacity, but rather of income from the two businesses.

The appeals court found that the trial judge “failed to take into account that the defendant’s annual gross income was included in the fair market value of his businesses.”

The appeals court also took issue with the trial court’s award of non-modifiable, lifetime alimony, because it barred Mr. Oudheusden from seeking a modification if he became ill or decided to retire, or if his businesses saw a reduction in their earning capacity. But that is a topic for another day.

The appeals court reversed the trial judge’s financial orders in their entirety and returned the case for a new trial on those issues.

The doctrine against double-dipping is largely settled law in many states, including New York, where a substantial body of case law has refined its application to various scenarios, such as the acquisition by one spouse of a professional license during the marriage. Notable cases include McSparrow v. McSparrow (Court of Appeals, 1995) and Grunfeld v. Grunfeld (Court of Appeals, 2000). That said, attorneys and valuation professionals who work in the matrimonial arena should be aware of the potential for a poorly executed valuation, or a misguided judge, to tilt the scales of justice.

Advent Valuation Advisors has a wealth of experience and a variety of research tools and resources at its disposal to help determine the value of a business and a reasonable salary for its owner-operator. For more information, contact Advent at info@adventvalue.com.

Read the appellate decision in Oudheusden v. Oudheusden here: https://www.jud.ct.gov/external/supapp/Cases/AROap/AP190/190AP283.pdf

Size Premiums: Fact or Fiction?

Photo by Matthew Henry from Burst

Which of these businesses do you think is riskier: A pizzeria on a busy street in some village’s downtown business district, or a company with five pizzerias at similar locations in five villages?

Chances are, the single-location business faces more risk. Think of the effect a broken water main would have on the day’s receipts, or the impact a new competitor might have on foot traffic. Larger businesses tend to have more diversified products, suppliers and customers, all of which mitigate risk.

Why is risk important in business valuation? Because there is an inverse relationship between risk and value. The greater the risk, the lower the value. That’s why business valuation professionals often apply a size premium, also known as a small-company risk premium, to capture the risks and the corresponding additional returns investors expect to earn from the stock of small companies versus larger ones.

How does this principle apply to small-business valuations? In order to shed some light on this question, we analyzed data for small, private-company transactions from 2003 to 2017 provided by Pratt’s Stats Private Deal Update for the second quarter of 2018 (also known as Deal Stats Value Index). Valuation professionals commonly employ these transactions to derive benchmark ratios, or multiples, for use in the market approach to valuation.

One such earnings multiple is MVIC/EBITDA. This is the ratio of the market value of invested capital (think “sale price”) to earnings before interest, taxes, depreciation and amortization, where invested capital equals equity plus debt. A business with $250,000 of EBITDA that sells for $1 million has an MVIC/EBITDA multiple of 4.

Private Deal Update provides median MVIC/EBITDA data by year from 2003 to 2017 for companies in three net sales ranges: up to $1 million, $1 million to $5 million, and greater than $5 million.

The chart clearly shows that companies with the lowest net sales garnered significantly lower EBITDA multiples than did companies in the middle and upper sales ranges. Companies in the highest revenue range tended to sell at the highest multiples, with the distinction more pronounced since the end of the Great Recession. In 2017, the most recent year available, the largest companies sold at a median of 6.7 times EBITDA, compared to 4.5 times EBITDA for the middle range and 3 times EBITDA for the smallest companies.

Consider a scenario in which those MVIC/EBITDA multiples are applied to three fictitious companies, each of which has a 20 percent EBITDA margin:

All three companies exhibit the same degree of profitability as measured by EBITDA margin, but the small company’s implied value is just 60 percent of annual sales, while the large company’s implied value is 134 percent of annual sales.

The data provides a strong endorsement for the application of a size premium in transactions involving small businesses. As is often the case with sweeping pronouncements, however, there are caveats to bear in mind. We’ll leave you with a few:

  • The smallest companies in the dataset – those with up to $1 million in annual sales – tended to be more profitable than larger companies. This might mitigate, to some degree, the effect of their lower multiples.
  • There are many other factors beyond size – and beyond the scope of this article – that can affect a company’s valuation multiples.
  • And finally, the Private Deal Update data includes a melting pot of transactions in a variety of industries, from manufacturing to retail to IT. Each of these industries is made up of numerous subdivisions, each with unique characteristics, financial and otherwise.

Here at Advent, we won’t casually apply a broad analysis, but will drill down into the data to consider these unique characteristics and their impact on risk, and therefore value.

For more information, contact Advent Valuation Advisors at 845-567-0900 or info@adventvalue.com.

What Drives the Value of Unicorns?

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Ever wonder why a startup company that hasn’t turned a profit and may not even have a clear path to generating one can command a billion-dollar valuation?

What drives the value of these unicorns? Why are early investors so eager to pour money into them? Antonella Puca talks about the challenges of unicorn valuation and the importance of intangibles at aicpa.org.