The Impact of a Buyer’s Tax Perspective on S Corporation Valuations and Potential IRS Challenges

With the number of pass-through businesses growing 45% from 1986 to 2008, appraisals of S corporations has become one of the more highly discussed and debated topics in valuation.

Internal Revenue Service (IRS) Job Aid entitled Valuation of Non-Controlling Interests in Business Entities Election to be Treated as S Corporations for Federal Tax Purposes (Job Aid) presents IRS views of how to value subchapter S corporations. The Job Aid also presents challenges to valuation professionals when valuing pass-through entities. IRS concludes that no entity level tax should be applied in the valuation analysis of a non-controlling interest in an electing S corporation, absent a compelling demonstration that independent third parties dealing at arms-length would do so as part of a purchase price negotiation. An appraiser is therefore tasked with matching valuation approaches and the appropriate inputs with the economics of an interest in a subchapter S corporation paying particular attention to the pass-through attributes of the subject interest. Reconciliation of these disparate economics may be addressed with adjustments to the cost of capital/cash flows, the inclusion of an S Corp premium and/or discounts related to control and marketability.

As most of the publically available information is based on C corporations, challenges arise when attempting to impute an S corporation value based on market data from C corporation. Since C corporations face two levels of tax as compared with the single level of taxation on an S corporation, with all else being equal, economically an interest in an S corporation is more valuable than that same interest in a C corporation. However, unlike a C corporation, an S corporation has several limitations including that it is a domestic entity, has 100 or fewer interest holders who are individuals, estates and certain trusts and certain pension plans and charitable organizations and has one class of stock. These factors imply that there can be additional risk in S corporations that may warrant increased minority and marketability discounts as compared to a C corporation.

Cost of capital inputs rely on market data from publically traded corporations. These rates of return are based on a C corporation tax structure. As a result, a mismatch may exist if S corporation cash flows are discounted with C corporation rates of return. Various S corporations models can address this issue by adjusting for the differences between C corporation returns and the cash flows available to a shareholder in an S corporation by calculating an S corporation premium to apply to after-tax cash flows. The Delaware Chancery Court in 2006 devised its own model assuming statutory tax rates for investors. Assuming the cost of capital was derived utilizing effective tax rates for the public companies, an appraiser may adjust the tax rate on corporate income in the S Corporation Economic Adjustment Model (SEAM) to reflect the fact that investors seek to minimize taxes. The use of this model is a common approach in S corporation valuations today. While the Job Aid takes issue with S corporation premium being derived from models utilizing theoretical assumptions that have been untested in the market, it does reference a theoretical model, validated by market data, by Merle M. Erickson and Shiing-wu Wang, which found that a controlling interest in an S corporation has a premium in the range of 10-20% over a similar interest in a C corporation. This range of premium is consistent with the typical range determined when using the SEAM.     


There are several factors that could impact the adjustment to the cost of capital (the S corporation premium as discussed above) or affect discounts related to marketability or control. Given the parameters of an S corporation, the universe of potential buyers may be limited and the ability to raise capital could be impeded. The valuation specialist must address questions related to the interests of the hypothetical buyer and the hypothetical seller as well as assessing how the hypothetical sale would occur. The overall attractiveness of the subject interest from the perspective of a hypothetical, likely buyer can be affected based on the existing and prospective direction of the company with respect to the policies in the shareholder agreements for items such as distributions, transfers or rights of first refusal. All of these factors should be considered when determining if adjustments should be made to the cost of capital and if any discounts are applicable.  


In addition, when valuing an S corporation the appraiser needs to consider whether a likely buyer would be a C corporation, which would be taxed at the entity level. The facts and circumstances of the subject interest may determine that a C corporation or other non-qualified buyer could be the highest bidder. The Job Aid acknowledges that although it is believed it to be unusual, a non-qualified buyer may purchase a minority interest in an S corporation in circumstances such as a creeping acquisition by a strategic buyer. This is an area in which the valuation specialist must exercise particular caution and look to Tax Court rulings for precedent.


Despite academic evidence to the contrary, the Job Aid seeks to disallow most after-tax analysis in the valuation of S corporations. However, a careful reading of the Job Aid and a clear understanding of the facts and circumstances still permit the recognition of a buyer’s tax perspective when performing an S corporation valuation. That said, it is critical that appraisers understand how the after-tax models take into account factors such as cost of capital and S corporation premium and how their results could be challenged by IRS.