To Tax Affect or Not to Tax Affect? Federal Case Reviews the Tax-Affecting Debate for Pass-Through Entities
In Kress v. United States, the U.S. District Court for the Eastern District of Wisconsin accepted the practice of tax affecting the earnings of so-called “pass-through” entities. These include sole proprietorships, partnerships, limited liability companies, and S corporations. The term “tax affecting” refers to reducing the earnings of a pass-through business for an assumed corporate tax rate. The court also rejected the application of a premium to reflect the tax advantages of owning a minority interest in a pass-through business.
In Kress, the court seems to say that there’s no difference in value between minority interests in otherwise identical S and C corporations. This is significant because the IRS has taken the position for decades that the earnings of pass-through entities shouldn’t be tax affected because these entities pay no entity-level taxes. Many courts, including the U.S. Tax Court, have embraced this position.
When interpreting this opinion, it’s important to note that it doesn’t have the same weight as a U.S. Tax Court decision or IRS memorandum. So, it has limited precedential value beyond the Eastern District of Wisconsin.
In Kress, the plaintiffs — shareholders of Green Bay Packaging, Inc. (GBP), a family-owned S corporation — gifted stock to their children and grandchildren. The court was asked to determine the stock’s fair market value on a minority, nonmarketable basis for federal gift tax purposes.
The plaintiffs’ primary valuation expert valued the stock using the market approach. Their second expert used a combination of the income and market approaches, weighting the income approach at 86% and the market approach at 14%. The government’s expert applied similar methodology, weighting the income approach at 40% and the market approach at 60%.
The plaintiffs’ primary expert and the government’s expert both applied corporate-level taxes to the company’s earnings “to effectively compare GBP to other C corporations.” The plaintiffs’ second expert used pretax multiples, essentially avoiding the issue but ascribing no valuation advantage to the company’s S corporation status.
It’s noteworthy that the government’s expert tax affected GBP’s earnings, given the IRS’s long-standing position. His valuation did, however, add a premium to account for the tax advantages associated with S corporation status. He reasoned that GBP hadn’t paid corporate taxes in any of the valuation years and didn’t anticipate paying them in the future.
A “Neutral” Factor
The court chose the value set forth by the plaintiffs’ primary expert, which was tax affected and did not include a premium for S corporation status. The court found S status to be a “neutral consideration with respect to the valuation of its stock.” It noted disadvantages associated with subchapter S status, “including the limited ability to reinvest in the company and the limited access to credit markets.”
Though not included in the court opinion, many valuation experts believe that S corporation status provides no real valuation advantage. Despite the lack of corporate-level taxes, shareholders of pass-through entities pay income taxes on their shares of the corporation’s earnings at their individual rates, and S corporations typically distribute sufficient earnings to cover those taxes.
Plus, for tax years beginning after December 31, 2017, corporate tax rates have been permanently reduced under the Tax Cuts and Jobs Act (TCJA). So, avoidance of double taxation of C corporation profits (once at the corporate level and again when they’re distributed to shareholders) is less of an advantage for S corporations under the TCJA than under prior law.
Federal District Court Tackles Family Transfer Restrictions
Family transfer restrictions may affect the fair market value of minority interests for gift and estate tax purposes. The U.S. District Court for the Eastern District of Wisconsin addressed this issue head-on in Kress v. United States.
In this case, the bylaws of Green Bay Packaging (GBP) prohibited family members from transferring shares of stock, except through gifts, bequests, or sales of shares to other family members. The plaintiffs’ primary expert considered this restriction in determining his discount for lack of marketability (DLOM) for gifts of stock to family members. However, the government asserted that doing so ran afoul of Internal Revenue Code Section 2703.
Under Sec. 2703, stock must be valued without regard to such a restriction unless it’s:
- A bona fide business arrangement,
- Not a device to transfer property to members of the decedent’s family for less than adequate consideration, and
- Comparable to similar, arm’s-length arrangements.
Though GBP’s transfer restriction met the first requirement, the court found the second requirement inapplicable. It concluded that reference to the decedent’s family “unambiguously limits its application to transfers at death,” despite regulations to the contrary.
In addition, the court ruled that the plaintiffs had failed to satisfy the third requirement because they hadn’t produced any evidence that unrelated parties dealing at arm’s length would agree to such an arrangement. As a result, it concluded that the expert’s consideration of the restriction was improper in estimating the DLOM.
For years, the valuation community has been at odds over whether it’s appropriate to tax affect earnings when valuing minority interests in pass-through entities. It will likely remain a controversial subject. However, Kress provides some ammunition for tax-affecting proponents.