R.D. Clark & Sons – Tax-Affecting Debate Continues
For decades, business valuation experts and the IRS have been at odds regarding the practice of “tax affecting” the earnings of pass-through entities. Though the U.S. Tax Court has consistently rejected this practice, the court has recently softened its stance and other courts have been less rigid on the matter. A recent Connecticut appellate court decision highlights both sides of the debate — and the importance of considering the facts of the specific case.
Generally, so-called “pass-through” entities pay no entity-level federal taxes on their income. Instead, a pass-through entity’s income and deductions flow through to the interest holders, who are responsible for the entity’s federal income tax liability. Examples of pass-through entities include partnerships, limited liability companies (LLCs), S corporations, and sole proprietorships.
Some business valuation experts argue that every business pays some form of federal taxes, and hypothetical investors factor taxes into their investment decisions. Plus, not every hypothetical buyer would be eligible to elect pass-through status. When tax affecting, valuation experts apply corporate tax rates to the earnings of pass-through entities to level the playing field and account for the impact of taxes on business value.
The IRS, however, contends that tax affecting ignores the tax benefits of operating as a pass-through entity and, therefore, underestimates the value of a business interest. For more than 20 years, this position has generally prevailed in the U.S. Tax Court — but now the tides appear to be shifting.
In other courts, tax affecting has received a mixed reception. Courts are generally reluctant to offer bright-line rules on the applicability of tax affecting, instead tailoring their rulings to the case facts.
Buyout Gone Bad
The Appellate Court of Connecticut’s decision in R.D. Clark & Sons is a recent example of a case where tax affecting was rejected when valuing an S corporation. In Clark, three siblings owned one-third interests in a family business. The owners acted as the company’s officers and directors, until one was terminated. He subsequently resigned as an officer and director.
Two years later, the company sued the departing owner and his new company, alleging unlawful use of proprietary information to compete with the family business. The departing owner countersued on grounds of shareholder oppression and sought to have the family business dissolved.
Pursuant to Connecticut law, the company elected to buy back the departing owner’s shares. When the parties couldn’t agree on the fair value of those shares, the court was asked to intervene.
Trial Court Valuation
Both sides hired business valuation experts who applied the income approach and tax affected the pass-through entity’s earnings. The company’s expert applied a 25% entity-level income tax rate, and the departing owner’s expert applied a 12.6% rate. The trial court generally agreed with the approach used by the company’s expert, but the court conducted its own valuation — without any tax-affecting adjustment.
On appeal, the company argued that not tax affecting its earnings “results in an artificially inflated value of the corporation because it fails to take into account that shareholders will not receive the full benefit of the corporation’s earnings because they must pay income tax on same.” The appellate court observed that Connecticut law doesn’t address the issue and that the propriety of tax affecting “remains the subject of considerable debate.”
Ultimately, the appellate court concluded that the trial court hadn’t abused its discretion by rejecting tax affecting because there was “considerable support for its approach,” including various Tax Court decisions. In addition, the appellate court found that “the present case was ill-suited to tax affecting earnings in light of [the company’s] practice of extending loans to shareholders to cover their tax liabilities and then retiring those loans through the payment of bonuses, and it was entirely foreseeable that such a practice would continue.”
The court in Clark discerned no bright-line rule on tax affecting. But one point seems crystal clear in this decision: Valuation experts must consider the appropriateness of tax affecting within the context of the case and be prepared to explain the reasoning underlying their tax-affecting approaches.
Has the Tax Court Opened the Door to Tax Affecting?
Dating back to its 1999 decision in Gross v. Commissioner, the U.S. Tax Court has consistently rejected tax affecting when valuing pass-through entities. However, in 2019, the court in Estate of Jones seemed open to the practice.
In Estate of Jones, the court accepted the estate expert’s use of tax affecting when valuing two related pass-through entities — an S corporation and an LLC — that made up a family-owned timber enterprise. The expert discounted earnings using a 38% assumed rate for combined federal and state taxes. Significantly, in reaching his value conclusion, the expert also added a premium to reflect the benefits associated with avoiding double taxation.
The court distinguished its previous tax-affecting rulings as involving different facts. It found that by considering both tax costs and benefits, the estate’s expert had “more accurately taken into account the tax consequences of [the company’s pass-through] status” than the IRS’s expert had.