The Institute of Business Appraisers
2003 Annual Business Valuation Conference
Challenges of Valuing
an S Corporation
in the Gross Environment
6/02/03
Dennis Bingham
Robert Strachota
Scot Torkelson
William Herber
1
Here is a Group of Appraisers Trying to Value an
S Corporation
2
Introduction / Background
Shenehon was hired to help resolve a significant additional
tax imposed by the IRS on a manufacturing company that gifted
a 25% minority interest to a GRAT
The original valuation was done by another firm using
traditional methods to value the S Corp
Although we were able to reduce the tax and interest by half at
the agent level based upon our Continuum Model, that reduction
was still not reasonable and the case is now going to Appeals
3
Introduction / Background
The IRS position is very strong in application of what we call
the Gross Formula
The IRS in determining the additional tax and interest
valued the company without tax affecting the earnings - the
Gross Formula
The report in this instance was submitted before the Gross Case
was decided but was under audit when the case was decided
and is now being held to the Gross Formula
4
Introduction / Background
The Shenehon Continuum is a Model which measures the
benefits of the S Corp election over a C Corp election
Our model is a way to measure the premium of the Corporate
S election
It is only applicable when an analysis is first made of the
company as if it were a C Corporation, ie. Taxes at the
corporate level have been deducted (tax affected)
5
What is all the Fuss About??
The Gross Case conclusion results in an
S Corp value which is 69% greater than an
otherwise identical C Corporation
Why?? S Corporations pay only one level of tax at
the personal level. While a C Corporation pays taxes
at the Corporate level and when dividends are paid
at the personal level as well
The issue is two levels of tax vs. one level of tax
6
Chart 2:0
7
Gross Court Quote
“We disagree with the tax court’s characterization of the
respective experts’ approaches to tax affecting as a mere
difference in variables. There was no spectrum of tax
percentages from which the court could have selected.
Rather, the choice was either a corporate tax rate of 40%
or a rate of 0%, the latter meaning no tax affect at all.
But while the tax court’s analysis was rather cursory,
we do not believe that further evaluation was necessary under
the circumstances.” Gross 6th Circuit (emphasis added)
8
9
10
Chart 2:1
Establish
Minority Value
per Share of
Subject
as a C
Corporation
Value per
Share
Adjustments
>
for S Corp
Premium
>
of Subject
as an
S Corporation
11
“‘Why won’t people become S Corporations and increase
market cap by 60%?’ The answer is, well if they could, they
should . . . if organizations choose their organizational form
appropriately, you will not see this large value gap.”
“S Corporations have a tax advantage than C Corporations.
This tax advantage is a function of payout rate; it is a
function of corporate versus personal marginal tax rates.”
Bajaj, transcript
12
The fact is, in general, corporations that are organized as
C Corporations reduce some of the potential value differential
… because, given their investment and distribution policies,
they expect not to make large distributions
… which tend to favor C Corporations …. Bajaj
13
Chart 3:1A
Polar Example: Family Farm
S Corporation
•No Operating Income
•No Distributions
•No Increase in the Market Value of Farm Land
14
Chart 3:1B
Polar Example: Family
Farm
S Corporation
•No Operating Income
•No Distributions
•No Increase in the Market Value of
Farm Land
15
Bajaj:
“There are offsetting disadvantages of being an S Corporation
and I addressed this question, as well in the Gross case and the
example I used was that of Netscape. . . I testified that . . .
it would be silly for Netscape Corporation to be an
S Corporation.”
--------------Why??
Because Netscape Made No Distributions
There would be NO S Corporation Benefit/Premium
16
Chart 3:2A
Polar Example: 100% Distribution
S Corporation
17
Chart 3:2B
Polar Example:
100%Distributing
C Corporation
18
Chart 3:3
19
Step 4
“Shareholders of C Corporations directly or indirectly through
the Corporation or through themselves pay two taxes, one at
the level of Corporation and then at their own level, whereas
holders of S Corporations pay only one layer of tax.
“[The] level of distributions would affect relative values of
S versus C corporation and that is absolutely correct ….
The relative advantage of an S versus C Corporation is very
much a function of level of payouts. Other things being equal,
in general, the higher the payout ratio the more advantageous
it would be to be an S Corporation.”
Bajaj
20
Chat 4:1A
21
Chart 4:1B-1
Comparison of C Corp vs. S Corp Distributions
S Corp Benefit Premium (S-C/C)
69.5%
22
Chart 4:1B-2
Comparison of C Corp vs. S Corp Distributions
S Corp Benefit Premium (S-C/C)
18.9%
23
Model of S Corp Benefit Premium Calculation
With Equivalent S Corp % Dividend Distributions
C Corp Shareholder benefit
Income
Tax on income
Net Income
100.00
(41.00)
59.00
100.00
(41.00)
59.00
100.00
(41.00)
59.00
100.00%
59.00
(27.14)
31.86
50.00%
29.50
(13.57)
15.93
0.00%
0.00
0.00
0.00
0.00
29.50
59.00
31.86
45.43
59.00
S Corp Shareholder benefit
Income
Retained By Corporation
Dividend (Pretax income less amount retained in Corp)
100.00
0.00
100.00
100.00
(29.50)
70.50
100.00
(59.00)
41.00
Tax on income
(46.00)
(46.00)
(46.00)
54.00
0.00
54.00
24.50
29.50
54.00
(5.00)
59.00
54.00
100.00%
70.50%
41.00%
69.49%
18.86%
0.00%
C Corp Dividend % of Net Income
Dividend
Tax
Retained by Shareholder
Retained By Corporation (Net Income less Dividend)
Total C Corp Shareholder Benefit
Retained by Shareholder
Retained by Corporation (Income less dividend)
Total S Corp Shareholder Benefit
S Corp Dividend % of Income
S Corp Premium
24
4:1D Graph
Calculation of S Corp Benefit
80%
S Corp Benefit
70%
60%
50%
40%
30%
20%
10%
0%
C Corp
0%
S Corp
41.0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
46.9% 52.8% 58.7% 64.6% 70.5% 76.4% 82.3% 88.2% 94.1% 100.0%
Market Distribution Percentages
25
Chart 4:2
Key of the Respective S Corp Benefits Relative
to C Corp vs. S Corp Equivalent Distributions
C Corp Dividend % of Net Income
100.00%
90.00%
80.00%
70.00%
60.00%
S Corp Dividend % of Pre tax Income
100.00%
94.10%
88.20%
82.30%
76.40%
69.49%
56.19%
44.82%
34.99%
26.42%
S Corp Premium
C Corp Dividend % of Net Income
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
S Corp Dividend % of Pre tax Income
70.50%
64.60%
58.70%
52.80%
46.90%
41.00%
S Corp Premium
18.86%
12.16%
6.18%
0.80%
0.00%
0.00%
26
Chart 5:1
In 1992, Gross was Distributing 100% of its Net Income
to Shareholders
Year
1988
1989
1990
1991
1992
Average
Total
Income
17,731,135
19,479,830
23,946,605
24,338,440
27,585,873
Total
Distributions
17,778,483
19,458,148
24,032,657
24,126,041
28,188,889
% of
Total Distributions
to Total Income
100.27%
99.89%
100.36%
99.13%
102.19%
100.37%
27
Chart 5:2B
Ye ar
Coca Cola Bottling
Discretionary
D iv ide nds
88 - 90
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
100.0%
100.0%
100.0%
52.0%
66.0%
60.0%
57.0%
55.0%
56.0%
100.0%
100.0%
5 Year Avg - 88-92
100.0%
5 Year Avg - 93-97
58.0%
28
Chart 5:3
Gross Case as of Valuation Date 1992 and 1998
29
Chart 5:4
S Corp
Premium 0.0% 0.0%
.8%
6.2% 12.2% 18.9% 26.4% 35.0% 44.8% 56.2% 69.5%
30
Chart 6:1A
Type of
Industry
E Commerce
Restaurant
Manufacturing
Cosmetics/Household
Railroad
Publishing/Chemical
Coal/Tobacco
Natural Gas
Petroleum
Canadian Energy (Hydro)
Gross
C Corp Market S Corp Equiv.
Distribution
Distribution
Percentage
Percentage
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
41.0%
46.9%
52.8%
58.7%
64.6%
70.5%
76.4%
82.3%
88.2%
94.1%
100.0%
S Corp
Benefit
0.0%
0.0%
0.8%
6.2%
12.2%
18.9%
26.4%
35.0%
44.8%
56.2%
69.5%
31
Chart 6:1B
Type of
Industry
E Commerce
Restaurant
Manufacturing
Cosmetics/Household
Railroad
Publishing/Chemical
Coal/Tobacco
Natural Gas
Petroleum
Canadian Energy (Hydro)
Gross
C Corp Market S Corp Equiv.
Distribution
Distribution
Percentage
Percentage
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
41.0%
46.9%
52.8%
58.7%
64.6%
70.5%
76.4%
82.3%
88.2%
94.1%
100.0%
S Corp
Benefit
0.0%
0.0%
0.8%
6.2%
12.2%
18.9%
26.4%
35.0%
44.8%
56.2%
69.5%
32
Chart 6:2
Calculations of Dividend Distributions as a % of Net Income
Metal Fabrication Industry
Metal Fabrication
P ublic C Corpora tions
S Corp
Equiv.
1995
1996
1997
1998
Avg.
Amcast Industrial Corp.
Fastenal
26.0%
3.0%
30.0%
2.0%
32.0%
2.0%
36.0%
1.0%
31.0%
2.0%
Illinois Toolworks
Kennmetal
19.0%
23.0%
18.0%
23.0%
18.0%
24.0%
19.0%
26.0%
18.5%
24.0%
The Timken
25.0%
22.0%
23.0%
34.0%
26.0%
59.3%
42.2%
51.9%
55.2%
56.3%
Median
23.0%
22.0%
23.0%
26.0%
24.0%
55.2%
21.0%
53.4%
Value Line Average
33
Chart 653A
Industry Average Comparison
Metal Fabrication (Value Line)
C Corp vs. S Corp from Industry Average Data
S Corp Premium (S-C/C)
1.3%
34
Chart 6:5B
Industry Average Comparison
Comparable Analysis
C Corp vs. S Corp from Industry Average Data
S Corp Premium (S-C/C)
2.9%
35
Chart 6:5C
Calculation of S Corp Benefit
80%
S Corp Benefit
70%
60%
50%
40%
30%
20%
Market Data
10%
0%
C Corp
0%
S Corp
41.0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
46.9% 52.8% 58.7% 64.6% 70.5% 76.4% 82.3% 88.2% 94.1% 100.0%
Market Distribution Percentages
36
Quantifying the Tax Difference Between an
S Corp and a C Corp
Lets Set the Stage
Facts
•There are Tax Benefits to an S Corp relative to a C Corp
at the time of a 100% Interest Sale
•This again due to the issue of single vs. Double Taxation
•When valuing a Minority Interest in a Company a Sale
of the 100% Interest is NOT Triggered
Questions
•Whose Point of View? Buyer or Seller?
•What Level of Value? Entity Level or Shareholder?
•How do you Value the Tax Benefit?
37
Defining the Issues of Tax Differences
Between C and S Corps
• Capital Gains Taxes at the time of sale are different
between a C Corp and S Corp
• As with dividends, S Corp proceeds are taxed once while C
Corp are taxed twice:
– C Corps are taxed once at corporate rates at the time of the sale and
again when distributed to the shareholder at capital gains rates
– S Corps are not taxed at the time of sale at the corporate level. The
S shareholders get a stepped up basis in the retained earnings
(AAA) and the shareholder is taxed at capital gains rates.
38
An Example of Tax Differences Between
S Corps and C Corps - Stock Sale
Sale Price
$1MM
$1MM
C-Corp
S-Corp
Assets
Cash
FF&E
Accumulated Depreciation
Total Assets
$250,000.00
$250,000.00
$1,250,000.00 $1,250,000.00
($500,000.00) ($500,000.00)
$1,000,000.00 $1,000,000.00
Equity
Stock & Paid in Capital
Retained Earnings/AAA
Total Equity
$200,000.00
$800,000.00
$1,000,000.00
Stock Sale
Adjusted Basis in Stock
Gain on Sale of Stock
Federal Tax on Seller All Capital Gain
Net Cash to Seller
Sale Price
$2MM
$2MM
C-Corp
S-Corp
$200,000.00
$800,000.00
$1,000,000.00
$1,000,000.00 $1,000,000.00 $2,000,000.00 $2,000,000.00
($200,000.00) ($1,000,000.00) ($200,000.00) ($1,000,000.00)
$800,000.00
$0.00 $1,800,000.00 $1,000,000.00
$160,000.00
$840,000.00
$0.00
$360,000.00
$1,000,000.00 $1,440,000.00
20% Increase
$200,000.00
$1,800,000.00
24% Increase
39
An Example of Tax Differences Between
S Corps and C Corps - Asset Sale
Sale Price
$1MM
$1MM
C-Corp
S-Corp
Assets
Cash
FF&E
Accumulated Depreciation
Total Assets
$250,000.00
$250,000.00
$1,250,000.00 $1,250,000.00
($500,000.00) ($500,000.00)
$1,000,000.00 $1,000,000.00
Equity
Stock & Paid in Capital
Retained Earnings/AAA
Total Equity
$200,000.00
$800,000.00
$1,000,000.00
$200,000.00
$800,000.00
$1,000,000.00
$1,000,000.00
____________
$1,000,000.00
$1,000,000.00
___________
$1,000,000.00
Asset Sale
Corporate Federal Tax
Liquidation Proceeds
Federal Tax on Seller
Adjusted Basis
Taxable Gain Distributed/
Allocated
Individual Tax Effect - All
Capital Gain
Net Cash to Seller
($200,000.00) ($1,000,000.00)
Sale Price
$2MM
$2MM
C-Corp
S-Corp
$2,000,000.00 $2,000,000.00
($328,250.00)
$0.00
$1,671,750.00 $2,000,000.00
($200,000.00) ($1,000,000.00)
$800,000.00
$0.00 $1,471,750.00
$160,000.00
$840,000.00
$0.00
$294,350.00
$1,000,000.00 $1,377,400.00
20% Increase
$1,000,000.00
$200,000.00
$1,800,000.00
30% Increase
40
Based on the Theoretical Example
Theoretically, at the time of sale an S
Corp owner/seller will receive at least
20% more in net proceeds than the
same C Corp owner/seller
41
Tax Differences are Not as Simple or Clear-Cut in the
Real World
Buyers are willing to mitigate to some degree taxes paid by
the seller if it does not affect what they are willing to pay for
the assets
Examples:
• Non-compete agreements
• Consulting agreements
• Personal goodwill vs. corporate goodwill
• Asset sale vs. stock sale
• Negotiation of sales price
Conclusion: Taxes Can be Mitigated at the Time of Sale
42
Minority Interest Capital Gain Tax Issues
Between C and S Corps
• Minority Interest Sales in an Operating Company do not trigger the sale
of a Company nor payment of trapped in capital gains
– If the company is never sold, the tax will never be incurred
– If you assume a holding period for when the company is sold, at the
very least this benefit will only be received sometime in the future
• This is the reverse of the trapped in capital gain argument made for
holding company’s in asset valuations
• In most instances, the tax benefit of an S Corp over a C Corp would be
small and very difficult to calculate
43
The Law is Clear That You Should
Look at the Buyer’s Perspective
Eisenburg, “the potential buyer whose
only goal is to maximize his advantage …
Courts may not permit the posting of
transactions which are unlikely and
plainly contrary to the interest of a
hypothetical buyer.”
44
We hold as a matter of law that the built-in gains tax
liability of this particular business’ assets must be
considered as a dollar-for-dollar reduction when
calculating the asset-based value of the Corporation, just
as, conversely, built-in gains tax liability would have no
place in the calculation of the Corporation’s earnings
based value.
Dunn v. Commissioner
45
Questions You Should Ask Related to
Potential Capital Gain Tax Benefits to
S Corps
• Have there been any sales of the subject’s assets, 10% or more, in the
last five years?
• Is management currently considering the liquidation of the subject?
• Is there anything in the Articles of Incorporation, Shareholder
Agreements, or other legal documents which could force a liquidation?
• Is the industry currently experiencing consolidation?
• Is the subject a viable takeover candidate?
• Can the ownership being valued force the sale of the subject?
46
If the answer is “yes” to any of these
questions, then consideration of a
potential capital gain tax liability may be
necessary.
47
Summary of Tax Benefits of S Corps vs. C
Corps at the Time of Sale
• S Corps have some tax benefits over C Corps, though the
benefit is small
• Minority Interest Sales do NOT Trigger release of Trapped
In Capital Gains
• In the Valuation of an Operating Company the Starting
point is always the assumption that the assets will be
retained and not disposed
• Benefit from capital gain taxes to an S Corp must at the
very least be calculated over an anticipated holding period
48
2 “S” Corporation
Premium Studies
Focus: Controlling Interest & Corporate Structure
• Erickson-Wang
– S Corp premium of 12 to 17%
• Mattson, Shannon & Upton (Pratt’s Stats)
– No S Corp premium
….However
49
Erickson Study Transactions Were
Significantly Larger Than Pratt’s Stats
MVIC
Mean
Median
Revenue
Mean
Median
C Corporation
Erickson-Wang
Pratt's Stats
$ 46,240
$ 21,337
$ 22,600
$ 7,500
$ 62,280
$ 25,605
$ 34,460
$ 9,661
S Corporation
Erickson-Wang
Pratt's Stats
$ 50,310
$ 12,233
$ 29,500
$ 2,700
$ 48,809
$ 16,989
$ 31,640
$ 2,836
($000's)
Source: Business Valuation Update
50
Are Both Studies Measuring The S Corp
Premium But From Different Perspectives?
Test Assumption
• Analyze Publicly Traded Stocks by
Exchange
– Percent of companies paying dividends; and
– Payout percent
51
OTC Median Revenue Is $26 Million:
Less Than Than Erickson,
Greater Than Pratt’s Stats
NYSE
NASDQ
American
Over the Counter
Total
Total
2,234
4,783
671
1,971
($M)
Revenue
Median
1,391
$
76
$
51
$
26
$
9,659
52
26% of All Companies Pay Dividends
However, OTC Percent Is Much Lower
NYSE
NASDQ
American
Over the Counter
Total
Paying
Dividends
59.2%
18.8%
26.8%
5.6%
26.0%
53
Median Payout Percent Is Relative Constant
at 32%
NYSE
NASDQ
American
Over the Counter
Total
Paying
Dividends
59.2%
18.8%
26.8%
5.6%
Payout
Percent
31.9%
31.3%
33.2%
37.6%
26.0%
32.1%
54
Conclusion
• Both studies are measuring S Corp premium
but from a different perspective
Size Matters
The larger the company the more likely
dividends are paid, which increases the
likelihood of an S Corp Premium
55
Summary
There is no Magic Chart you can go to for the Calculation
of S Corp Premiums
Appraisals are Dynamic. We are dealing with different
appraisal dates, industries, company conditions. The
FACTS and circumstances change over time and company
to company
The S Corp premium can be calculated for minority
interests by looking at the dividend paying capacity of a
company, and to a lesser extent the actual history of
dividends
56
Summary
Minority Interest Sales do NOT trigger the release of
trapped in Capital Gains
When Calculating a Premium for S Corps related to the
Capital Gain Tax issue we must remember to conduct the
analysis from the buyers point of view
The Wang Study and the Pratt Study appear to be measuring
different pieces of the spectrum of companies. We do not
find the conclusions of these to studies contradictory with
one another
57