Valuing A Minority Interest in Pass-Through Entities

Over the past few decades, S corporations, limited liability companies (LLCs) and other pass-through entities have grown significantly in popularity. Why? A major reason is their favorable treatment under the Internal Revenue Code.

But it's important to select wisely, because entity choice can affect the amount of taxes your business will pay and how much cash flow it will generate. In some cases, entity choice can even affect the value of a business interest. So, special considerations may apply when valuing pass-through entities, especially for ownership interests that can't control the business's entity choice. An IRS job aid on valuing minority interests in S corporations compiles resources on this issue that may also be useful in valuations prepared for nontax purposes.

Background on Pass-Through Entities

nitially, many small businesses start as sole proprietorships that are reported on the taxpayer's personal tax returns, using Schedule C for a nonrental business, Schedule E for a rental operation or Schedule F for a farm or ranch. As startups mature, they may incur debt, hire employees, enter into contractual agreements, and buy expensive equipment and property. At this point, the owner(s) may decide to set up a separate legal entity. Many choose to incorporate to limit their personal liability for business obligations.

However, there's a downside to incorporating: double taxation. A C corporation owes corporate-level federal (and possibly state) income tax on its taxable income. Then, after-tax amounts that are distributed to shareholders may constitute dividends that are taxed again at the shareholder level.

To avoid double taxation, some businesses elect to operate as pass-through entities. Examples include:

  • S corporations,
  • Limited liability companies (LLCs),
  • Limited partnerships, and
  • General partnerships.

With these alternative structures, owners pass the business's income, gains, losses, deductions and credits through to their personal tax returns and pay tax at their individual rates. Distributions are generally nontaxable, as long as they don't exceed the owners' tax basis in the business. (Tax basis is essentially a function of an owner's capital contributions and his or her share of the corporation's earnings over time.)

Most Popular Entity

A recent report by the Joint Committee for Taxation (JCT), Overview of the Federal Tax System as in Effect for 2016, noted that there were 24 million sole proprietorships (including single member LLCs, but excluding farms) in the United States in 2013. By comparison, there were 1.7 million C corporations, 4.3 million S corporations and 3.5 million partnerships (including multi-member LLCs that elect to be taxed as partnerships).

The JCT has issued its report every five years since 1978. Over the past 35 years, the use of pass-through entities, including S corporations, partnerships and multi-member LLCs, has grown substantially — from roughly 1.7 million to 7.8 million. However, fewer entities are choosing to operate as C corporations. Their numbers declined from 1.9 million in 1978 to 1.7 million in 2013.

These trends might be more striking if it weren't for the fact that the IRS restricts the types of businesses that can elect Subchapter S status. To be eligible, a business must:

  • Be a domestic entity,
  • Have 100 or fewer interest holders who are 1) individuals (excluding nonresident aliens), 2) estates, 3) certain trusts, or 4) certain pension plans and charitable organizations, and
  • Have only one class of stock.

Differences in voting rights or straight debt don't qualify as another class of stock.

Tax-Affecting Debate

Professional valuators debate whether S corporation earnings should be tax affected as if the business operates as a C corporation. Tax affecting artificially lowers an S corporation's cash flows and, therefore, its value.

For many years, tax-affecting S corporation earnings was commonplace, because valuation experts argued that choosing one type of entity over another wasn't a value-creating decision. Moreover, S status may be lost if the business no longer meets the IRS's eligibility requirements.

That mindset has shifted. In 1999, the Tax Court ruled in Gross v. Commissioner that, because of their tax advantages, S corporations were worth more than otherwise identical C corporations. Several other cases followed suit, and many valuators decided that the correct tax treatment depends on whether the subject business interest has the ability to control entity choice and distributions.

IRS Guidance

In 2014, the IRS published guidance on tax affecting pass-through entities in Valuation of non-controlling interests in business entities electing to be treated as S corporations for federal tax purposes. That job aid helps IRS analysts evaluate appraisals of minority interests in S corporations. But it can also be useful when valuing these interests for nontax purposes.

On the issue of tax affecting, the job aid specifically states:

"Absent a compelling showing that unrelated parties dealing at arm's-length would reduce the projected cash flows by a hypothetical entity level tax, no entity level tax should be applied in determining the cash flows of an electing S Corporation. In the same vein, the personal income taxes paid by the holder of an interest in an electing S Corporation are not relevant in determining the fair market value of that interest."

According to the job aid, if a valuator tax affects a company's earnings, its owner must provide valid reasons why a hypothetical investor would discount the earnings for entity-level taxes. The job aid points out that, while avoiding entity-level taxes is an important benefit to consider when valuing an S corporation, valuators also must consider the downsides to owning a minority interest in an S corporation, such as how much the company distributes to shareholders, and whether there's a differential between tax rates at the corporate level and the investor level.

Several factors to consider when deciding how to handle entity-level taxes include the:

  • Size and composition of the pool of hypothetical buyers, 
  • Economic interests of the hypothetical seller,
  • Actual revenues available to, and actual expenses to be paid by, the entity that has elected to be taxed as an S Corp,
  • Availability at the entity level of equity and debt capital, and
  • Probable holding period of the transferred interest.

Whenever possible, the job aid recommends comparing a pass-through entity to other pass-through entities in the valuation process. But that's often difficult, because much of the data used to value private businesses comes from the public markets, which are made up primarily of C corporations.

Consider Tax Reforms When Valuing Any Business

Reforming business tax laws is a top priority of the newly elected president and congressional Republicans. Within the first 100 day after his inauguration, President Trump plans to introduce various tax reforms to Congress. His proposal released earlier this year includes provisions to:

  • Reduce the top corporate income tax rate from 35% to 15%,
  • Abolish the corporate alternative minimum tax (AMT), 
  • Allow owners of flow-through entities to pay tax on business income at the proposed 15% corporate rate rather than their own individual income tax rate,
  • Eliminate the Section 199 deduction, also commonly referred to as the manufacturers' deduction or the domestic production activities deduction, as well as most other business breaks — but not the research credit,
  • Allow U.S. companies engaged in manufacturing to choose the full expensing of capital investment or the deductibility of interest paid, and
  • Enact a deemed repatriation of currently deferred foreign profits at a 10% tax rate.

It's uncertain which of these proposals will be made into law — or when the changes will go into effect. But, with Republicans retaining control of both chambers of Congress, some sort of overhaul of the U.S. tax code is likely.

Depending on how lawmakers handle tax rates on corporate dividends, the proposed changes could reduce tax advantages that are currently available to S corporations and other pass-through entities. Major business tax reforms could impact all valuations, especially if tax rates drop substantially or the "playing field" is effectively leveled for different types of entities.

When valuing a business, it's important for your expert to consider future tax laws. Investors are interested in historical cash flows only to the extent that cash flows will be similar in the future. In today's uncertain business environment, tax rates could change significantly, although nothing is cast in stone yet.

Bottom Line

Valuation experts take a special approach when valuing S corporations. They decide on a case-by-case basis whether a noncontrolling interest is worth the same as, more, or less than a similar interest in a C corporation. 

LOUIS J. CERCONE, JR., CPA, CFE, CFF, ABV, ASA, CVA
lcercone@briscon.com

Lou is the Managing Director of Brisbane Consulting Group in charge of business valuations, forensic accounting, and litigation support services. He has extensive valuation experience and has served as a financial consultant and expert to attorneys in the economic aspects of matrimonial dissolution. He has been engaged in several forensic accounting cases and has served the judiciary as a court appointed expert and receiver for financially troubled companies. He has testified as an expert witness in State Supreme Court and Federal Court. Lou has also been engaged in the quantification of lost income in determining business interruption claims for insurance adjusters.