BUSI 534 Week 5 Discussion Board Forum 3 Example

Discussion Board Forum 3: Pass-Through Entities, Estate and Gift Valuation and Family Limited Partnerships

BUSI 534 Business Valuation, Discussion Board Forum 3 Thread and Replies

Thread by [Student Name]

The forum prompt, the two classmates and the worked figures are composites standing in for the course's own prompt; the tax rates in the example are illustrative assumptions, and the cases, rulings, textbook and research cited are real.

Thread

An S corporation that earns $1 million before tax pays no federal income tax itself; its owners pay tax on their shares of the income. When I value it, should I capitalize $1 million or something less? Hitchner (2017) presents the question as the central problem in valuing pass-through entities, and the courts have answered it in different ways.

In Gross v. Commissioner (1999), the Tax Court refused to tax-affect the earnings of an S corporation bottling company, reasoning that the hypothetical buyer would value the absence of entity-level tax, and the Sixth Circuit affirmed. Two decades later, in Estate of Jones v. Commissioner (2019), the court accepted an appraiser's tax-affecting because the appraiser had also credited the benefits of S status rather than treating the company as a C corporation. My position follows Jones: tax-affecting is necessary, but so is crediting the S election.

A worked example shows why. Assume illustrative rates of 21 percent for corporate income tax, 23.8 percent on dividends and a 29.6 percent effective individual rate on S corporation income. If the company were a C corporation, an owner would keep $1,000,000 less 21 percent, or $790,000, and then $790,000 less 23.8 percent on distribution, about $602,000. As an S corporation, the owner keeps $1,000,000 less 29.6 percent, or $704,000. The S election is worth about $102,000 a year, roughly 17 percent more cash to the owner.

Now consider three choices. Capitalizing $1,000,000 untaxed, as Gross allowed, uses a pretax cash flow with a discount rate built from after-tax market returns, which overstates value badly. Tax-affecting at the C corporation rate alone, capitalizing $790,000, ignores the $102,000 advantage. Tax-affecting at an owner-level equivalent captures both the tax and the benefit. Suppose the discount rate, built from after-tax returns on public stocks, implies a capitalization rate of 15 percent. The untaxed approach gives about $6.7 million and the C corporation approach about $5.3 million. The owner-level approach converts the owner's $704,000 into the C corporation earnings that would leave the same cash after dividend tax, $704,000 divided by 0.762, or about $924,000, and so gives about $6.2 million. The spread of $1.4 million on a single company shows why the choice deserves a paragraph of explanation in any report.

The benefit is real in markets. Erickson and Wang (2007) compared taxable acquisitions of S corporations with matched acquisitions of private C corporations and found that S corporations sold for higher multiples, with tax benefits worth roughly 12 to 17 percent of deal value. Buyers pay for the S election, so a fair market value that ignores it misstates what a willing buyer would pay, in either direction.

The method I would use is to tax-affect earnings at a rate that reflects the owner-level burden of the likely pool of buyers and then show the value of the S benefit separately, which makes plain to any reviewer how far the conclusion rests on it. The approach is transparent and consistent with both the standard of value and the evidence, and it lets a reviewer adjust the S benefit if the likely buyer would not preserve the election.

Reply to Tyler

Tyler, your thread gave a clear account of why interests in family limited partnerships receive discounts for lack of control and marketability, and your example of a partnership holding three rental properties showed how a limited partner cannot force a sale or a distribution. I want to add the risk that can make those discounts disappear entirely.

Hitchner (2017) explains that the Internal Revenue Service often challenges family limited partnerships not by disputing the size of the discounts but by arguing that the partnership should be ignored for estate tax purposes. The main tool is Section 2036 of the Internal Revenue Code, which pulls into a decedent's estate any property the decedent transferred while keeping the right to its income or its use. If the court applies Section 2036, the estate is taxed on the full value of the underlying assets, and the discounts never come into play.

The leading example is Estate of Strangi v. Commissioner (2003). Albert Strangi transferred most of his assets, including his home, to a family limited partnership shortly before his death, but he continued to live in the home and the partnership paid his expenses. The Tax Court found an implied agreement that he would keep the benefit of the assets and included them in his estate under Section 2036. The decision has been followed in many later cases with similar facts.

The lessons for your rental property example are practical. The partnership should have a genuine nontax purpose, such as centralized management of the properties. The parent should not use partnership property personally without paying fair rent, should keep enough assets outside the partnership to live on, and should not treat partnership accounts as personal accounts. Distributions should follow the partnership agreement and be made to all partners in proportion to their interests. Formalities such as separate bank accounts, annual meetings and records matter, because courts look at how the partnership actually operated, not only at its documents.

For an appraiser, the implication is that the discount analysis should be supported by the facts of the partnership's operation. An appraiser cannot decide the Section 2036 question, which is legal, but should describe the partnership's purpose, management and distribution history accurately, since those facts support both the discounts and the partnership's legitimacy. If the facts suggest the parent continued to treat the assets as personal, the appraiser should say so to the client's attorney before the return is filed.

It is also worth noting that the size of the discounts themselves can attract scrutiny when they are much larger than the evidence supports, so a well-documented, moderate discount is often safer than an aggressive one. Did your example's partnership have any operating business purpose beyond holding the properties?

Reply to Monica

Monica, your thread explained that Revenue Ruling 59-60 remains the foundation of fair market value for federal estate and gift tax purposes, even though it was issued in 1959, and I agreed with your point that its age has not reduced its authority. I would add some detail on how its factors work in a modern valuation, since your thread listed them without showing how an appraiser uses them.

The ruling defines fair market value as the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion and both having reasonable knowledge of relevant facts (Rev. Rul. 59-60, 1959). It then lists eight factors to consider: the nature and history of the business, the economic outlook and the condition of the industry, the book value of the stock and the company's financial condition, its earning capacity, its dividend-paying capacity, whether it has goodwill or other intangible value, prior sales of the stock and the size of the block, and the market prices of stocks of similar companies that are publicly traded.

What strikes me is how closely the factors map onto the three approaches we studied in Module/Week 3. Earning capacity and dividend-paying capacity point toward the income approach. Prior sales and the prices of similar public companies point toward the market approach. Book value and financial condition point toward the asset approach. The ruling also stresses that valuation is not an exact science and that sound judgment, rather than a formula, should determine the weight given to each factor. Hitchner (2017) treats the ruling as a checklist that a well-organized report should visibly address, often with a section for each factor.

One part of the ruling is especially relevant to our forum. It emphasizes that the earning capacity and dividend-paying capacity of a closely held company should be judged by what the company could pay, not only what it has paid, since controlling owners often take returns as salary. That idea is closely related to the normalization adjustments Hitchner describes and to the tax-affecting question in my thread, because both involve deciding which earnings a hypothetical buyer would actually receive.

The ruling's treatment of the size of the block also deserves attention, since it recognizes that a controlling block may be worth more per share than a small minority block, the idea behind the control premiums and discounts we read about in chapter 10. And its instruction to consider prior sales of the stock reminds appraisers to ask whether earlier transactions were at arm's length, since sales among family members may not reflect fair market value at all. Did the estate valuation you described in your thread weigh the factors equally, or did one approach dominate?

References

Erickson, M. M., & Wang, S. W. (2007). Tax benefits as a source of merger premiums in acquisitions of private corporations. The Accounting Review, 82(2), 359-387. https://doi.org/10.2308/accr.2007.82.2.359

Estate of Jones v. Commissioner, T.C. Memo. 2019-101 (2019).

Estate of Strangi v. Commissioner, T.C. Memo. 2003-145 (2003), aff'd, 417 F.3d 468 (5th Cir. 2005).

Gross v. Commissioner, T.C. Memo. 1999-254 (1999), aff'd, 272 F.3d 333 (6th Cir. 2001).

Hitchner, J. R. (Ed.). (2017). Financial valuation: Applications and models (4th ed.). Wiley.

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