Determining the Value of an S Corp

May 06, 2019

Beyond Income Tax

Over the last several weeks, we have explored various aspects of the choice of entity dilemma that confronts the owners of many closely held businesses, and we have considered how the Tax Cuts and Jobs Act[i] may influence their decision.

In the process, you may have realized that one form of business entity, in particular, has come under greater scrutiny and reconsideration than any other as a result of the Act – the S corporation.[ii] The reason for this is fairly obvious: the reduction in the Federal income tax rate for C corporations from a maximum rate of 35-percent to a flat rate of 21-percent, in contrast to the 37-percent maximum rate applicable to the individual shareholders of an S corporation.[iii]

Although most of our attention has been focused on the direct income tax consequences of an entity’s[iv] status as an S corporation, it is important that one also be mindful of the estate and gift tax consequences of such status as manifested in the valuation of a share of stock in an S corporation.[v]

Tax Affecting

Over the years, many appraisers have sought to “tax affect” the earnings of an S corporation for the purpose of determining the value of a share of stock of the corporation. The practice of “tax-affecting” may be applied under various hypotheses, transfer scenarios, and valuation methodologies.

In brief, tax affecting seeks to account for the fact that the income and gain of an S corporation are generally not subject to Federal income tax at the level of the S corporation. It does this by reducing an S Corporation earnings stream to reflect an “imputed” (hypothetical) C corporation income tax liability.

Thus, if a gift transfer of S corporation stock were to be valued using a so-called “market” approach that relies upon comparing the S corporation’s financials to those of comparable C corporations in the same industry (“guideline” companies) that are publicly traded, and that pay a corporate-level Federal income tax, an appraiser would consider reducing (i.e., tax affecting) the S corporation’s earnings so as not to inflate the relative value of the S corporation.[vi]

A variation on this approach would account for the fact that the shareholders of an S corporation are subject to income tax with respect to the corporation’s profits on a current basis, without regard to whether such profits have been distributed by the corporation. In order to enable these shareholders to satisfy the resulting tax liability, the S corporation must make a “tax distribution” to its shareholders, thereby reducing the amount of cash available to the corporation for reinvestment in its business or distribute to its shareholders as a return on their investment. If this fact were ignored, the thinking goes, the relative value of the S corporation would be inflated, as in the case where a discounted future cash flow valuation methodology were employed.[vii]

The IRS’s Position

The question to which tax affecting is directed can be stated as follows: would a hypothetical willing buyer of shares of stock in an S corporation tax affect the earnings of the S corporation in valuing the shares being acquired?

As one might expect, the IRS has opposed tax affecting, stating that an S corporation has a zero tax rate and, thus, no further adjustments are required, least of all to account for shareholder-specific tax attributes.

What’s more, the IRS has also argued that S corporations are tax-advantaged – they generally do not pay an entity-level income tax – and, so, they should be valued using a premium that recognizes this economic benefit.[viii]

Although most courts seem to have sided with the IRS in concluding that tax affecting would not be appropriate,[ix] a recent decision by a Federal district court seems to have accepted tax affecting under the facts before it, while at the same time rejecting the IRS’s arguments for an S corporation premium.

Gift, Audit, Payment, Refund Claim

Taxpayers were shareholders in Corp, a family-owned S corporation. Approximately 90-percent of Corp’s common stock was owned by Family; the remaining 10-percent was owned by certain employees and directors of Corp who had purchased their shares.

The purchase price for shares sold by Corp to its employees and directors was equal to 120-percent of the book value of each share. No similar formula was established for shares that were transferred among members of Family.

Certain restrictions limited the ability to sell both Family shares and non-Family shares of Corp stock, including a right-of-first-refusal in the corporation’s by-laws that required a non-Family shareholder to give Corp written notice of their intent to sell their shares, and to offer to such shares to Corp before selling to others.

The Corp by-laws also required that Family only gift, bequeath, or sell their shares to other members of Family. According to Family, this restriction ensured that they retained control of Corp, minimized the risk of disruption to Corp’s affairs by a dissident shareholder, ensured confidentiality of Corp’s affairs, and ensured that all sales of Corp minority stock were to qualified subchapter S shareholders.

As part of their estate planning, Taxpayers annually gifted minority shares of Corp stock to their children, including during the years in issue. Taxpayers filed gift tax returns (on IRS Form 709) for those years to report their gifts and to identify the fair market value (“FMV”) for the gifted shares. Taxpayers paid gift taxes with respect to the gifted shares.

The IRS challenged the valuation for the shares that Taxpayers reported on their gift tax returns. After examining the returns, the IRS assessed deficiencies, finding that the FMV of the gifted shares equaled the price used for actual share transactions between Corp and its employees. The IRS issued notices of deficiency for the tax years at issue, and Taxpayers paid the asserted deficiencies.

Taxpayers subsequently filed claims for refund for the years in issue, seeking a refund for the additional taxes paid, which Taxpayers claimed had been erroneously assessed by the IRS. After six months elapsed without receiving a response from the IRS regarding Taxpayers’ claims,[x] Taxpayers initiated a lawsuit in Federal district court to recover these gift taxes. [xi] The sole issue presented in the suit was the FMV of the Corp stock gifted by Taxpayers to their children.

The District Court

The Court began by explaining that the Federal gift tax was imposed for “each calendar year on the transfer of property by gift during such calendar year by any individual resident.”[xii] The amount of the gift, it stated, is considered to be the value of the gifted property on the date it was given.[xiii]

The determination of FMV, the Court stated, was a question of fact. The trier of fact “must weigh all relevant evidence of value and draw appropriate inferences.” The FMV of stock, the Court continued, is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”[xiv]

Valuation Factors

When the FMV of stock cannot be determined by examining actual sales of stock within a reasonable time before or after the valuation date, as was the case here, the FMV must generally be determined by analyzing factors that a reasonable buyer and seller would normally consider, including the following:

a) the nature of the business and the history of the corporation,

b) the economic outlook in general, and the condition and outlook of the specific industry in particular,

c) the book value of the stock and the financial condition of the business,

d) the earnings capacity of the corporation,

e) the dividend-paying capacity,

f) whether the business has goodwill or other intangible value,

g) sales of the stock and the size of the block to be valued, and

h) the market price of stocks of corporations engaged in the same or similar line of business having their stocks actively traded, either on an exchange or over the counter.[xv]

Valuation Methods

According to the Court, these factors had to be considered in light of the facts of the particular case. The FMV of non-publicly traded stock, the Court stated, is generally determined by using one or a combination of the following valuation methods: the market approach, the income approach, or the asset-based approach:

  • The market approach values a company’s non-publicly traded stock by comparing it to comparable stock sold in arms’ length transactions in the same time period.
  • The income approach values a company’s non-publicly traded stock by converting anticipated economic benefits into a single amount; valuation methods may “directly capitalize earnings estimates or may forecast future benefits (earnings or cash flow) and discount those future benefits to the present.”
  • The asset-based approach values a company’s non-publicly traded stock by analyzing the company’s assets net of its liabilities.

The Experts

Taxpayers’ experts prepared reports and provided testimony regarding the valuation of a minority share of Corp stock. Their reports used different valuation methods that resulted in different proposed valuations.

Taxpayers maintained that the Court should adopt the FMV of a minority share of Corp as determined by their expert and reported on their original gift tax returns.

The IRS abandoned its initial valuation assessments and requested that the Court adopt its expert’s conclusions of FMV.[xvi]

The Court reminded the parties that it was not bound by the opinion of any expert witness and could accept or reject expert testimony, in whole or in part. The Court then examined the experts’ opinions and methodologies.

IRS’s Expert

The IRS’s expert determined the FMV of the gifted shares by using both the market approach and the income approach, and then ascribing a weight to each. After analyzing the values under the market approach[xvii] and the income approach[xviii] – for which he applied an effective tax rate to Corp, as if it were a C corporation, and then applied a premium to account for Corp’s tax advantages as an S corporation[xix] – he weighted the market approach 60-percent and the income approach 40-percent to determine the final FMV.

Once the IRS’s expert had calculated the preliminary minority share value, he then applied marketability discounts[xx] to reach his conclusions of FMV.

The Court found that the IRS’s expert’s valuation conclusions overstated the value of a minority-held share of Corp stock.

Among other things, the Court noted that the IRS’s expert applied a separate “subchapter S premium” to his valuation. Although both the Taxpayers’ expert and the IRS’s expert applied C corporation level taxes to Corp’s earnings to effectively compare Corp to comparable C corporations, the IRS’s expert then assessed a premium to account for the tax advantages associated with subchapter S status, such as the elimination of a level of taxes, and noted that Corp did not pay C corporation taxes in any of the years in issue, and did not expect to pay such taxes in the future.

Taxpayers’ Expert

Taxpayers’ expert did not consider Corp’s subchapter S status to be a benefit that added value to a minority shareholder’s stock because a minority shareholder could not change Corp’s tax status.

The Court agreed with Taxpayers’ expert, finding that Corp’s subchapter S status was a neutral factor with respect to the valuation of Corp’s stock. The Court also explained that, notwithstanding the tax advantages associated with subchapter S status, there were also notable disadvantages, including the limited ability to reinvest in the corporation and the limited access to capital markets. Therefore, it was unclear, the Court stated, if a minority shareholder enjoyed those benefits.

Taxpayers’ expert employed the market approach, although he also incorporated concepts of the income approach into his overall analysis. He testified that the market approach was the better methodology here because there were a sufficient number of comparable companies for the years in issue. Taxpayers’ expert selected comparable guideline companies to determine the base value a minority share of Corp stock might be worth if it were sold at a mature public market. Accounting for Corp’s industry, its conservative management style, its entire book value, and other considerations, he compared Corp to companies on a “holistic” basis.

After selecting the guideline companies, he derived multiples via the ratio of market value of invested capital to EBITDA, to account for Corp’s subchapter S status, as well as multiples derived from earnings, dividends, sales, assets, and book value. He also evaluated price-to-earnings, price-to-EBITDA, and price-to-sales multiples. He then compared Corp’s multiples to each guideline company’s multiples to reach a base value for the stock.

To his base values, Taxpayers’ expert applied a discount for lack of marketability to reflect the illiquidity of the minority shares of Corp stock.[xxi]


After reviewing the reports and testimony of these experts,[xxii] the Court found that the valuation methodology of the Taxpayers’ expert was the most sound, and agreed with this expert’s determination of the FMV of Corp’s common minority stock.


The Court was frugal in its discussion of tax affecting; it accepted the concept, noting that it had been employed by both the IRS and Taxpayers in valuing Corp’s stock. Indeed, it was noteworthy that even the IRS’s expert used tax affecting in his valuation report; although the Court was not bound by either expert’s opinion, it accepted their use of tax affecting in arriving at FMV.

Likewise, the Court did not dedicate much time to dismissing the IRS’s argument that Corp’s FMV should have been increased to account for the tax benefits Corp enjoyed as an S corporation. The Court simply stated that S corporations also faced many disadvantages because of their tax status,[xxiii] and found that Corp’s subchapter S status was a neutral factor with respect to the valuation of Corp’s stock.

Notwithstanding the brevity of its analysis, the Court’s decision is nonetheless important for those S corporation shareholders who are planning to transfer shares as part of their estate plan. These taxpayers, and their valuation professionals, should take some comfort in the fact that the Court accepted tax affecting – though the impact of the concept should be less significant in light of the much reduced corporate income tax rate – and also rejected the IRS’s argument for an S corporation tax premium.

That being said, it is worth remembering that there is no substitute for a timely, well-reasoned, and empirically-supported appraisal by a qualified and seasoned professional. Yes, it will cost the taxpayer some money today, but it will save the taxpayer a lot more money (including taxes, interest, penalties and attorney fees) later on.

[i] P.L. 115-97; the “Act.”

[ii] See, e.g., https://www.taxlawforchb.com/2019/04/post-2017-is-it-time-to-kick-your-corporations-s/

[iii] Perhaps 40.8-percent if the shareholder does not materially participate in the business of the S corporation.

[iv] Which may include an LLC; an LLC, that is otherwise disregarded or treated as a partnership for tax purposes, may elect to be treated as an S corporation. Reg. Sec. 301.7701-3.

[v] The increased exemption amount for Federal estate and gift tax purposes may have provided a greater cushion for valuation missteps; however, it has also encouraged greater gifting, with many individual taxpayers seeking to utilize their entire exemption so as to shift as much appreciation away from their estate, and to minimize the value of their gross estate. IRC Sec. 2010.

[vi] Apples and oranges.

[vii] Basically, the present value of a projected net positive income stream.

[viii] No double taxation of its profits: once at the corporate-level and again when distributed to the shareholders. https://www.irs.gov/pub/irs-utl/S%20Corporation%20Valuation%20Job%20Aid%20for%20IRS%20Valuation%20Professionals.pdf

[ix] See, e.g., Gross v. Comm’r, T.C. Memo 1999-254, aff’d 272 F.3d 333 (6th Cir. 2001).

[x] IRC Sec. 6532 and Sec. 7422.

[xi] The Court began its discussion by explaining that, in a suit seeking a tax refund, the taxpayers generally bear the burden of proving by a preponderance of the evidence that they are entitled to a refund of tax and what amount they should recover. The Court pointed out that while the IRS’ determination of the tax owed is presumed correct, the taxpayer may overcome this presumption, and shift the burden to the IRS, by introducing “credible evidence” or “substantial evidence” establishing that the IRS’ determination was incorrect. IRC Sec. 7491(a)(1).

However, the Court also noted that the shifting of the burden was only significant in the event of an evidentiary tie.

[xii] IRC Sec. 2501(a)(1).

[xiii] IRC Sec. 2512(a).

[xiv] Reg. Sec. 20.2031-1(b); Reg. Sec. 25.2512-1.

The hypothetical willing buyer and seller are presumed to be dedicated to achieving the maximum economic advantage.

[xv] Rev. Rul. 59-60, 1959-1 C.B. 237 (1959).

[xvi] Which would still have entitled Taxpayers to a refund.

[xvii] Under the market approach, the IRS’s expert identified several companies that were in the same business as Corp. He eliminated several companies based on dissimilar characteristics. He then completed a financial ratio analysis by comparing Corp to the guideline companies, and found two comparable companies. From there, he derived a set of multiples by looking at enterprise value to EBITDA, and price to earnings, and applied the multiples to the relevant Corp financial data.

[xviii] Under the income approach, the IRS’s expert completed a capitalized cash flow analysis. He determined a normalized net sales level and deducted the cost of goods sold and administrative expenses from the normalized net sales level to determine the income from operations.

[xix] Recognizing the value of the S-corporation structure, Corp never seriously consider terminating its S-corporation election during the years in issue. In fact, Corp’s management had previously reported to its shareholders that they expected to save over $200 million in taxes by virtue of the classification as an S-corporation during the period immediately preceding the years in issue.

[xx] He determined the discount by considering restricted stock studies, the costs of going public, and the overall academic research on the topic.

[xxi] In applying the discounts, Taxpayers’ expert considered restricted stock studies, which evaluate identical stock and determine the discount for an individual buying a share that she could not sell for some period of time. He also consulted pre-IPO studies because those studies compare the price of stock that is sold in advance of an initial public offering to the price of the stock at the time of the initial public offering. In reaching these discounts, he considered the financial position of Corp, the payment of dividends, the company’s management, the possibility of any future public offering, and Corp’s status as an S-corporation but did not quantify the impact any of these factors had on his conclusions.

[xxii] In response to the IRS’ criticism that Taxpayers’ expert did not employ a separate income approach, Taxpayers retained a second expert to prepare a report regarding the valuation of the minority-share of Corp stock using a combination of the market approach and the income approach. This expert weighted the market approach 14-percent and the income approach 86-percent. As to the market approach, she searched for comparable companies and compared those companies to Corp in terms of growth, profitability, and geographic distribution. She noted a perfectly comparable company does not exist because all potentially comparable companies were larger and more geographically diverse than Corp. She selected price-to-pre-tax-income as her multiple and used pre-tax income to capture the minority interest of the stock at issue, and to reflect Corp’s subchapter S status.

Under the income approach, Taxpayers’ second expert used the capitalized economic income method and the discount dividend method. She accounted for Corp’s subchapter S status under both methods. Under the capitalized economic income method, she adjusted the discount rate in the base cost to reflect an equivalent after-corporate and after-personal tax return. Under the discount dividend method, she used a tax rate based on three- and five-year averages and on the prior year effective date.

Her market approach and income approach yielded an “as-if-freely-traded” minority equitable interest. She averaged the values she calculated under the market approach and the income method approach to obtain an aggregate, as-if-freely-traded minority common equity value. She divided this amount by the total number of outstanding Corp shares to calculate the per-share value and applied a discount for lack of marketability each year. In determining the discount for lack of marketability, she considered company and industry characteristics, including the applicable stock restrictions and Corp’s S-corporation status. She concluded neither the stock restrictions nor the S-corporation status affected the marketability discount.

[xxiii] More specifically, because of the requirements it had to satisfy in order to maintain that tax status; for example, a single class of stock.