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Case Shows Power of Buy-Sell Agreements

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A recent court decision demonstrated the power of buy-sell agreements. Photo by Matthew Henry on Burst

A buy-sell provision can help ensure an orderly transaction when one shareholder wishes to leave a business. It can dictate the manner in which an owner’s interest changes hands, as well as the price.

The enforcement of one such provision was the point of contention when the shareholders of a family-owned automotive repair business in Nassau County recently faced off in court.

Tabs Motors of Valley Stream Corp. was owned by four siblings, each of whom held 50 shares of common stock. The siblings signed the shareholders agreement in December 2013, after allowing more than a year for consideration of its terms. The agreement featured a buy-sell provision that, among other things, would be triggered upon the filing of a motion to dissolve the company. 

Buy-sell agreements

Buy-sell provisions spell out the terms under which an owner’s share of a business may be reassigned when they leave the company. They often provide for some combination of redemption, in which the company is required to repurchase the interest, and cross-purchase, in which the remaining owners are permitted to buy it. Such provisions are often intended to prevent ownership from falling into the hands of outside parties. If designed properly, they can reduce the likelihood of controversy when a shareholder decides to leave the company.

Tabs Motors’ shareholders agreement (as cited in the decision) includes a buy-sell provision stating that “if any shareholder files a petition to dissolve the Corporation; … the Corporation firstly, and then the other Shareholders shall have the option to purchase all, but not part of the shares owned by such Shareholder.”

On October 29, 2019, two of the shareholders of Tabs Motors, Michael Louros and the Estate of Connie Collins, filed a petition for dissolution of the corporation. The filing triggered the buy-sell provision in the shareholders agreement. The corporation held a shareholder meeting on December 16, 2019, at which the two nonpetitioning shareholders voted to have the corporation exercise its option to purchase the shares held by the petitioners. The shareholders agreement excluded the petitioning shareholders from voting.

The closing was set for February 11, 2020. The purchase price was set by the shareholders agreement at $5,250 per share, nearly twice the value determined by an appraisal of the company in 2011, two years before the execution of the shareholders agreement.

In response to the petition for dissolution, Tabs Motors filed a counterclaim seeking to enforce the sale of the petitioners’ shares. Supreme Court Justice Robert Reed granted summary judgment in favor of Tabs Motors, ordering the sale of the interests. 

Justice Reed rejected the petitioners’ contention that the shareholders agreement was unconscionable, noting that it applied equally to any shareholder who petitioned for dissolution and that the parties had more than a year to review the agreement and receive counsel prior to signing. He rejected the claim that the valuation provided in the shareholders agreement was stale, pointing out that it was double the 2011 valuation and that it had been affirmed in 2018 in the probate of Connie Collins’ estate.

Finally, Justice Reed rejected the petitioners’ assertion that the other owners had breached their fiduciary duties, noting that even if the claims were legitimate, “they would not invalidate the buy-sell provision. The buy-sell provision is still enforceable.”

Parting thoughts

The ruling in Estate of Connie Collins v. Tabs Motors demonstrates the durability of buy-sell provisions written into owners agreements. That’s why it is vital to give due consideration to the wording of such agreements. For instance, language that calls for an appraisal in the event of a controversy can help ensure equitable treatment of all interests. For more information on buy-sell agreements or other valuation matters, please contact the trusted professionals at Advent.

The case is The Estate of Collins v. Tabs Motors of Valley Stream Corp. You can read the decision here. Read additional Advent blog posts on buy-sell agreements here and here.

Advent Named to Top 10 Emerging Firms List

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Advent Valuation Advisors has been named one of the Top 10 Emerging Valuation Services Companies for 2022 by CFO Tech Outlook magazine. The honorees were unveiled in the March edition of the magazine, which was dedicated to business valuation. The article is available here.

Valuations of Distressed Companies Require Special Treatment

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Valuing a financially troubled company requires special treatment. Photo by Andrea Piacquadio from Pexels

Over the last two years, market conditions — from cost increases and forced shutdowns to shortages of labor and supplies — have taken their toll on many businesses. While owners of distressed businesses may hope to turn things around, some will unfortunately shutter. Valuation is a prophecy of the future, not the past. So, valuing a financially troubled company requires special treatment.

Diagnosing the Situation

Valuing a distressed business is similar in many ways to valuing a healthy one: The valuation professional evaluates financial information and examines the business and its industry to assess the company’s ability to generate earnings. But troubled companies don’t behave in quite the same way as healthy companies, so valuators must approach them a little differently.

One of a valuator’s biggest challenges in valuing a struggling company is normalizing its operating results. Most valuations, even of healthy companies, involve some normalization. The valuator adjusts the company’s operating results to exclude unusual items — such as nonrecurring income or expenses. This allows the valuator to project earnings under “normal” conditions.

Determining the causes of a company’s poor performance is critical. If the company got into trouble because of poor management or excessive debt, it could have a great deal of value to a buyer with a stronger management team or greater access to capital. But if the company is struggling because of reduced demand for its products or services or because its technology has become obsolete, it may be difficult — if not impossible — to restore it to profitability.

Prescribing a Valuation Method

For healthy companies, past performance is often a reliable predictor of future success. But for troubled companies, valuations must be essentially forward-looking. The key is to identify what caused the company’s financial distress, determine whether the problem can be fixed and develop a picture of the company’s future earnings after management has turned operations around.

For this reason, valuation pros usually use income-based methods, such as discounted cash flow analysis, to value troubled companies.

Market-based methods — where valuators apply price-to-earnings multiples or other measures derived from transactions involving comparable companies — are difficult if not impossible to use. Most market data is drawn from transactions involving healthy companies, which can’t be applied to troubled companies without complex (and potentially problematic) adjustments.

The cost approach also may be particularly relevant when valuing a distressed business. While healthy companies are almost always valued as going concerns, a distressed company may be worth more in liquidation. Therefore, the valuator needs to determine its liquidation value for comparison.

Proper Treatment

Distressed companies operate under extraordinary circumstances, so different rules apply. Advent’s business valuation experts have experience working with struggling companies and can help determine what’s appropriate for your case. Contact us for more information.

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Opinions Split on Discounts for Controlling Interests

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Courts and experts often disagree on the applicability of marketability discounts for controlling interests. Photo by Artem Beliaikin from Pexels

In a business valuation context, the term “marketability” refers to the ability to quickly convert property to cash at minimal cost. While publicly traded stocks are readily marketable, interests in private companies typically require substantial time, cost and effort to sell. To the extent that public stock data is used to value private businesses, a discount may be warranted to reflect the lack of marketability. However, an important distinction must be made when applying these discounts to controlling interests.

Minority vs. Controlling Interests

Marketability discounts are well established when valuing minority interests in closely held businesses. Several empirical studies support and quantify these discounts. Restricted stock and pre-IPO studies, for example, demonstrate the spread between prices paid for freely traded shares and identical shares that are less marketable because they’re restricted or not yet publicly traded. Discounts typically average between 30 percent and 45 percent.

Using marketability discounts for controlling interests is controversial, although courts have sometimes accepted them. Most experts agree that the size of marketability discounts shrinks as the level of control increases. But while many argue that some amount of discount is available at all levels of control – even 100 percent – others say it is inappropriate to apply a marketability discount to a controlling interest.

Illiquidity

Marketability discounts applied to controlling interests are sometimes referred to as “illiquidity” discounts to help differentiate them from discounts taken on minority interests. With a controlling interest, it takes time and expense to complete a sale. The discount reflects the uncertainty and risk associated with the timing of the sale and the ultimate price.

The rationale underlying taking a marketability discount on a controlling interest is that fair market value is a cash equivalent concept. In contrast, a future sale of a controlling interest is speculative and expensive. The deal also may include noncash terms, such as employment contracts, restricted stock or installment payments.

For example, in a divorce case, it may seem inequitable for one spouse to receive $1 million of an illiquid business, while the other spouse receives $1 million of cash and real estate, which are considerably more liquid.

When quantifying illiquidity discounts, valuation experts consider the time, costs and risks of selling a business (or a controlling interest within it). Alternatively, they may estimate the costs of going public. No official empirical data exists to support marketability discounts on controlling interests. But all else being equal, most experts agree the discount for a controlling interest should generally be lower than for a minority interest in the same company.

Case in Point

To see how this can play out in court, let’s look at a recent divorce case where the husband’s expert applied a marketability discount on a controlling interest in the husband’s dental practice. (Kakollu v. Vadlamudi, No. 21A-DC-96, Ind. App., July 26, 2021.)

The wife’s valuation expert valued the entire practice at $3 million. The husband’s expert arrived at a value of $1.56 million after taking a 45 percent marketability discount. The lower court rejected the expert’s discount because he admitted that:

  • A discount greater than 35 percent would likely draw IRS attention, if it was taken in a valuation prepared for federal tax purposes,
  • Controlling interests may be easier to sell than minority interests,
  • Dental practices are easily tradeable as they have a ready market of purchasers (new dentists) graduating each year, and
  • The husband had no intention to sell his practice.

Because the marketability discount was the primary reason for the difference between the experts’ values, the trial court accepted the analysis prepared by the wife’s expert. The Indiana Court of Appeals upheld the decision, concluding that there was no requirement for the trial court to apply a marketability discount when determining the value of a business. You can read the decision here: https://adventvalue.com/wp-content/uploads/2022/03/Srinivasulu-Kakollu-v.-Sraina-Sowmya-Vadlamudi.pdf

Contact Us

The application and magnitude of marketability discounts are matters of professional judgment and can vary significantly from one valuation assignment to the next. The professionals at Advent Valuation Advisors can help you support or challenge the use of a marketability discount for a specific case.

What is ‘Known or Knowable’ on Value Date?

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With limited exceptions, events that occur after the valuation date generally are not considered in determining the value of a business interest. Photo by Wyron A on Unsplash.

The value of a business interest is valid as of a specific date. The effective date is a critical cutoff point because events that occur after that date generally are not taken into account when estimating value.

However, there are two key exceptions.

1. When an Event Is Foreseeable

Subsequent events that were reasonably foreseeable on the effective date are usually factored into a valuation. That’s because, under the definition of fair market value, hypothetical willing buyers and sellers are presumed to have reasonable knowledge of relevant facts affecting the value of a business interest. Examples of potentially relevant subsequent events are:

  • An offer to purchase the business,
  • A bankruptcy filing,
  • The emergence of new technology or government regulations,
  • A natural or human-made disaster,
  • A pending legal investigation or lawsuit, and
  • The loss of a key person or major contract.

But not all of these examples would be reasonably foreseeable. For example, you probably can’t predict when your company will be affected by a tornado or a data breach.

This issue has come to the forefront during the COVID-19 pandemic. To determine what was known or knowable about this ongoing crisis on a valuation’s effective date, experts must put themselves in the shoes of hypothetical buyers and sellers on that date and consider how they would have perceived the situation.

Many businesses have been adversely affected by the pandemic; others have taken advantage of opportunities that emerged from the the crisis. The effects also may vary depending on the company’s geographic location or industry, so valuators must evaluate the situation closely to determine what’s appropriate for the specific subject company.

In addition to facts that are publicly available, “reasonable knowledge” includes facts that a buyer would uncover over the course of private negotiations over the property’s purchase price. During normal due diligence procedures, a hypothetical buyer is expected to ask the hypothetical seller for information that’s not publicly available.

2. When a Transaction Provides an Indication of Value

A subsequent event that’s unforeseeable as of the effective date may still be considered if it provides an indication of value. However, it generally must be within a reasonable period and occur at arm’s length.

For example, in a landmark case — Estate of Jung v. Commissioner (101 T.C. 312, 1993) — the U.S. Tax Court ruled that actual sales prices received for property after the effective date may be considered when valuing a business interest, “so long as the sale occurred within a reasonable time … and no intervening events drastically changed the value of the property.” This ruling differentiates subsequent events that affect fair market value from those that provide an indication of fair market value.

Full Disclosure

When you hire a business valuation expert, it’s important to share all information that could potentially be relevant to the value of the business. This includes information about subsequent events that affect value or provide an indication of value. Once the valuation expert is aware of this information, he or she can determine whether an event is appropriate to consider when valuing the business interest.

If you require assistance with a business valuation-related matter, please contact Advent for trusted guidance.

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Divorce Case Spotlights Complexities of Double-Dipping Analysis

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Courts sometimes have difficulty determining an appropriate allocation of assets in a divorce.

The division of assets in a divorce is vital to the financial futures of the spouses. A fair division of assets is required under New York state equitable distribution law. For many couples, a professional practice (think doctor, lawyer or accountant) or a business is a key asset in their divorce. While not a New York case, Oudheusden v. Oudheusden was an interesting read for those of us seeking to better understand this topic. 

In this Connecticut case, the husband defendant, whose marriage had been dissolved, appealed to the Appellate Court a judgment of the trial court. The trial court had awarded his wife $18,000 per month in permanent alimony that could not be modified or changed in duration or amount. The trial court found the husband’s gross annual income of $550,000 was completely derived from his two closely held businesses, which were valued at $904,000.

As part of its financial orders, the court awarded 50 percent of the fair market value of the two businesses to each party, ordering the defendant to pay the plaintiff $452,000. The court awarded 100 percent ownership of both businesses to the husband. 

Income vs. Profit

On appeal to the Connecticut Appellate Court, the husband claimed that the trial court impermissibly double-counted his income by considering it both for the purpose of valuing his businesses and in making its maintenance award.

The Appellate Court reversed in part the trial court’s judgment and remanded the case for a new hearing on all financial issues. The Appellate Court concluded that the trial court had abused its discretion in failing to issue equitable orders and to consider, with respect to its maintenance award, the possibility that the husband, who was 58 years old at the time of the dissolution and had a history of alcohol abuse, could become ill or might want to retire, or that his businesses could fail to prosper through no fault of his own.

The Appellate Court further determined that the trial court had engaged in double-counting. The plaintiff wife then appealed to the Connecticut Supreme Court. 

Double Reversal

The judgment of the Appellate Court was affirmed by the Supreme Court with respect to its determination regarding the trial court’s financial orders but reversed with respect to its determination that the trial court improperly double-counted the value of the defendant’s businesses for purposes of the property division and alimony awards. The case was remanded to the Appellate Court with direction to remand the case to the trial court for a new hearing on all financial issues.

The case is Oudheusden v. Oudheusden, (SC 20330, Connecticut Supreme Court, Apr. 27, 2021). Read the decision here. For additional blog posts on divorce-related topics, click here, here or here.

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If you require assistance with the valuation of a business or determination of reasonable compensation in a matrimonial matter, please contact Advent for trusted guidance.  

Lost Profits: Calculating the Damage

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When a business has been damaged by another party, an expert may be needed to estimate the damages. Photo by Dovis from Pexels

Financial experts are often hired to measure economic damages in contract breach, patent infringement and other tort claims. Here’s an overview of how experts quantify damages, along with some common pitfalls to avoid.

Estimating Lost Profits

Where would the plaintiff be today “but for” the defendant’s alleged wrongdoing? There are three ways experts address that question:

1. Before-and-after method. Here, the expert assumes that, if it hadn’t been for the breach or other tortious act, the company’s operating trends would have continued in pace with past performance. In other words, damages equal the difference between expected and actual performance. A similar approach quantifies damages as the difference between the company’s value before and after the alleged tort occurred.

2. Yardstick method. Using this technique, the expert benchmarks a damaged company’s performance to external sources, such as publicly traded comparables or industry guidelines. The presumption is that the company’s performance would have mimicked that of its competitors if not for the tortious act.

3. Sales projection method. Projections or forecasts of the company’s expected cash flow serve as the basis for damages under this method. Damages involving niche players and start-ups often call for the sales projection method, because they have limited operating history and few meaningful comparables.

Experts will consider the specific circumstances of the case to determine the appropriate method (or methods) for the situation.

Discounting Damages

After experts have estimated lost profits, they discount their estimates to present value. Some jurisdictions have prescribed discount rates, but, in many instances, experts subjectively build up the discount rate based on their professional opinions about risk. Small differences in the discount rate can generate large differences in valuators’ final conclusions. As a result, the discount rate is often a contentious issue.

Mitigating Factors

Another key step is to address mitigating factors. In other words, what could the damaged party have done to minimize its loss?

For example:

• A manufacturer that suffers a business interruption should minimize the impact by resuming operations at a temporary location or outsourcing production to another company, if possible.

• A wrongfully terminated employee needs to make a reasonable effort to find another job.

• An antitrust plaintiff prevented from entering a particular market should explore opportunities to invest in alternative markets.

• A plaintiff in a breach-of-contract case should make a reasonable effort to replace the business lost as a result of the defendant’s wrongdoing.

Most jurisdictions hold plaintiffs at least partially responsible for mitigating their own damages. Similar to discount rates, this subjective adjustment often triggers widely divergent opinions among the parties involved.

Avoiding Potential Pitfalls

Some key factors need to be considered to avoid over- or underestimating a plaintiff’s loss. For example, the taxation of damages can have a significant impact on an expert’s conclusion. If the plaintiff must pay taxes, an after-tax assessment wouldn’t be equitable. Also realize that some parts of a damages award, such as return of capital, may be nontaxable and require an after-tax estimate.

Taxes also need to be handled properly when lost profits are discounted to present value. In other words, if damages need to be calculated on a pretax basis, the expert should use pretax discount rates. Mismatching after-tax discount rates to pretax cash flows would overstate damages, all else being equal.

In addition, it’s important to not assume that damages will occur into perpetuity. Economic damages generally occur over a finite period. They have a beginning and an end. Eventually most plaintiffs can overcome the effects of the defendant’s alleged wrongdoing.

For More Information

When calculating economic damages, there isn’t a one-size-fits-all approach. What’s right depends on the facts of your particular case. Contact the experts at Advent Valuation Advisors to develop an estimate that avoids potential pitfalls and can withstand scrutiny in court.

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What to do if a Spouse Cheats … on Taxes

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A married person filing jointly may be held responsible if a spouse cheats on their tax return. Photo by Burak Kostak from Pexels

When you got married, you knew it was for “better or worse.” But you might not know about laws that hold you responsible if your spouse cheats on a tax return.

Married couples filing jointly should be aware that:

  • You are both responsible for tax, interest and penalties — even after a divorce or the death of a spouse.
  • The IRS may hold you responsible for all the tax due even if there is a divorce decree stating that your ex-spouse is accountable for previous joint returns.
  • You can be liable for tax even if none of the income on a tax return is attributed to you.

To illustrate how the law works, let’s say you have a wage-earning job and your spouse is self-employed. You file joint tax returns. Next year, you get divorced and a year later, the IRS audits your tax return. Your ex-spouse is nowhere to be found, and auditors determine that he or she didn’t report all the income from the business.

What Could Happen?

You are generally liable for paying the tax due, plus interest and any penalties. Your wages can be seized by the IRS even if you paid every penny owed on your share of the family income.

Fortunately, there may be a way to get off the hook. In some situations, the tax law provides “innocent spouse” relief if you can prove:

  • There is a substantial understatement of tax attributable to the grossly erroneous items of your spouse or ex-spouse.
  • The hidden income belonged to your ex-spouse and you didn’t benefit from it.
  • You didn’t know or have reason to know about the understatement.
  • It would be inequitable to hold you liable.

In January 2012, the IRS released proposed streamlined procedures that make it easier to obtain equitable relief. The new guidelines also include an exception to the requirement that items must be attributable to the ex-spouse when that spouse’s fraud is the cause of the understatement or deficiency.

Be aware that the IRS is required to notify an ex-spouse that relief has been requested so that he or she can elect to participate. There are no exceptions, even for victims of domestic violence.

“Innocent” versus “Injured” Spouse

If your current or former spouse has gotten you into tax trouble, you may be able to get help from the IRS.
It all depends on whether the tax agency considers you “injured” or “innocent.” You probably think you qualify as both, but they are two different legal terms:

An injured spouse files a joint return and loses all or part of a refund because of a spouse’s debts.

An innocent spouse claims no liability for items on a joint tax return that belong to a spouse or ex-spouse. Let’s say you and your current spouse file a joint tax return and are expecting a large refund. But you receive a notice from the IRS stating that your refund is being seized to pay a debt owed only by your spouse. For example, back taxes from before you married, past due child support, a delinquent student loan or other federal debt.

You may be able to recover your portion of a joint tax refund that the IRS seized. To qualify, you must have earned your own income and made your own federal tax payments. Ask your tax advisor for more information if you think you qualify.

Advice: Don’t count on innocent spouse relief if you know your spouse is cheating on tax returns. The IRS often denies relief. Consider filing separate tax returns — especially if you’re in the process of a divorce. It may save you a bundle in the future. For more information about your situation, consult with your tax advisor.

If you require the valuation of a business, calculation of reasonable compensation or forensic assistance in a matrimonial matter, please contact Advent Valuation Advisors for trusted guidance. 

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Compensation or Dividend: Know the Difference

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The U.S. Tax Court recently ruled that payments made to a corporate taxpayer’s three shareholders were dividends — not compensation for personal services rendered. The court’s reasoning also may be relevant in shareholder disputes and divorce cases when the parties disagree about whether compensation should be deducted from earnings when valuing a business interest. (Aspro, Inc. v. Commissioner, T.C. Memo 2021-8, Jan. 21, 2021.)

Background

Under current tax law, a corporation may deduct all ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services rendered. In the case of compensation payments, a test of deductibility is whether they’re in fact payments purely for services.

On the other hand, distributions to shareholders disguised as compensation aren’t deductible for federal income tax purposes. Specifically, Internal Revenue Code Section 162 says:

Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible. An ostensible salary paid by a corporation may be a distribution of a dividend on stock. This is likely to occur in the case of a corporation having few shareholders, practically all of whom draw salaries. If in such a case the salaries are in excess of those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings of the officers or employees, it would seem likely that the salaries are not paid wholly for services rendered, but that the excessive payments are a distribution of earnings upon the stock.

Case Facts

The taxpayer operated as an asphalt paving business. Most of its revenue came from contracts with government entities. These public projects are awarded to the low bidder.
Aspro has three owners:

  • Shareholder A is an individual who owned 20% of the company,
  • Shareholder B is a corporation that owned 40% of the company, and
  • Shareholder C is a corporation that owned 40% of the company.

Shareholder A also served as the company’s president and was responsible for its day-to-day management. His responsibilities included bidding on projects. Shareholder A often spoke to the individuals who owned corporate shareholders B and C to get their advice on bidding for projects.

In 2014, Aspro paid management fees to its shareholders for their advisory services on how to bid for projects. Aspro then deducted these management fees for personal services rendered. Neither in 2014 nor in any prior year did Aspro pay dividends to its shareholders. The IRS denied the deduction, claiming the fees were actually dividends.

Tax Court Decision

The Tax Court agreed with the IRS. It didn’t dispute that a portion of payments made to Shareholder A potentially might have been compensation for personal services. However, since the payments weren’t purely compensation, they weren’t deductible for federal income tax purposes.

Factors underlying the court’s decision to classify the payments as dividends, not a form of compensation, include:

Lack of historical dividend payments. Aspro is a corporation with few shareholders that never distributed any dividends during its entire corporate history; it merely paid management fees.

Payments corresponding to ownership percentages. The management fees weren’t exactly pro rata among the three shareholders. However, the two corporate shareholders always got equal amounts, and the percentages of management fees all three shareholders received roughly corresponded to their respective ownership interests.

Payments to shareholders, not individuals. Aspro paid the amounts to corporate shareholders B and C, instead of to the individuals who actually performed the advisory services.

Timing. Aspro paid management fees as lump sums at yearend, rather than paying them throughout the year as the services were performed.

Lessons Learned

The appropriate treatment of payments to shareholders should be decided on a case-by-case basis. The decision has implications beyond federal income taxes. To the extent that a company’s value is based on its earnings or net free cash flow — say, under the income or market approaches — the deductibility of these payments can have a major impact on the value of a business interest.

The federal income tax rules for how to treat these expenses can provide objective guidance when classifying payments for other purposes. In some cases, it may be appropriate to adjust a company’s earnings for deductions that represent dividends, based on the facts of the case.

For more information about the classification of compensation and dividends or other valuation issues, please contact the professionals at Advent Valuation Advisors

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Tax Treatment Complicates S Corp Valuation

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So-called “pass-through” entities — including partnerships, limited liability companies (LLCs) and S corporations — generally aren’t required to pay entity-level taxes. So, when it comes to valuing a small business structured as a pass-through entity for tax purposes, people often wonder: Would investors pay a premium for an interest in this business compared to an interest in an otherwise identical C corporation? And, if so, how much is this favorable tax treatment worth? This is the crux of the tax-affecting debate.

Much of the litigation regarding this issue comes from the IRS and tax courts. But a recent Tennessee Court of Appeals decision discusses this issue in the context of a shareholder buyout. (Raley v. Brinkman, No. 2018-02002, Tenn. App., July 30, 2020)

Pros and Cons of Pass-Throughs

For pass-through entities, all items of income, loss, deduction and credit pass through to the owners’ individual tax returns, and taxes are paid at the personal level. Distributions to owners generally aren’t taxable to the extent that owners have positive tax basis in the entity.

If a pass-through entity distributes just enough of its earnings to cover the owners’ tax liabilities, there may be little potential valuation difference at the investor level between the pass-through entity and a taxable entity, assuming similar tax rates at the entity and the investor levels. If the pass-through entity distributes larger amounts of earnings to the owner, the interest becomes potentially more valuable than an equal interest in a taxable entity, all other things being equal. If the pass-through entity distributes less than the tax liability amount, an interest in the taxable entity could potentially be more valuable in the hands of the owner.

Court Allows Tax Affecting

The tax-affecting issue took center stage in a recent buyout case involving two equal partners in a restaurant that generated roughly $3.4 million in gross annual income in 2016. When the owners disagreed about how to manage their business, a Tennessee trial court ordered a buyout of one owner’s interest at “fair value” under applicable state law.

The business operated as an LLC that elected to be treated as an S corporation for income tax purposes. The trial court allowed the buyout price to include a hypothetical 38% corporate income tax rate to the restaurant’s earnings. But the seller (plaintiff) appealed, arguing that tax affecting wasn’t appropriate for a pass-through business that wasn’t subject to entity-level tax.

The buyer (defendant) contended that tax affecting was appropriate because the income from an S corporation passes through to the owners’ individual tax returns and is taxed at the owners’ personal tax rates. He also argued that valuation experts commonly use after-tax income values to calculate the capitalization rate under the income approach.

The appellate court explained that the problem with using the income approach to value a pass-through entity is that it’s designed to discount cash flows of C corporations, which are taxed at both the entity and the shareholder level. Income from an S corporation is taxed only at the shareholders’ personal level.

Citing the landmark Delaware Open MRI Radiology Associates case, the appellate court concluded that declining to tax affect an S corporation’s earnings would overvalue it, but charging the full corporate rate would undervalue it by failing to recognize the tax advantages of S status. The court also determined that it was appropriate to use an after-tax earnings stream because the expert’s capitalization rate was based on after-tax values.

Finally, the appellate court cited the Estate of Jones. In this U.S. Tax Court case, the court concluded that the cash flows and discount rate should be treated consistently when valuing a pass-through entity.

IRS Job Aid Provides Insight

The debate over tax affecting pass-through entities has persisted for decades. To help clarify matters, the IRS has published a job aid entitled “Valuation of Non-Controlling Interests in Business Entities Electing To Be Treated As S Corporations for Federal Tax Purposes.” This document helps IRS valuation analysts evaluate appraisals of minority interests in S corporations for federal tax purposes.

However, the job aid provides useful guidance on the issue of tax affecting that may be applied more generally to all types of pass-through entities that are appraised for any purposes, not just for tax reasons. Business valuation experts may use this job aid as a reference tool to help support their decisions to apply tax rates to the earnings of pass-through entities when projecting future cash flows.

No Bright-Line Rules

When it comes to tax affecting pass-through entities, there’s no clear-cut guidance that prescribes a specific tax rate — or denies tax affecting altogether. Rather, tax affecting may be permitted on a case-by-case basis, depending on the facts and circumstances.

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