On March 25, 2019, a U.S. District Court in the Eastern District of Wisconsin issued a decision in Kress v. United States. You may ask yourself why this particular decision is important. To answer that question, I have to give some background on the IRS’s stance on the issues surrounding the valuation of S Corporations.
The IRS’s stance stem from the seminal case on the subject matter, Gross v. Commissioner (T.C. Memo. 1999-254, Docket Nos.’s 4460-64, 4469-97). It is in this case, and others following it using Gross v. Commissioner as precedent, where the IRS took the stance that you should not “Tax affect” an S Corporation’s earnings in determining discounted cash-flow. “Tax affecting” is a process where the cash flow is adjusted to account for the taxes that are payable by an owner on the taxable income of the company. In Gross, the court states that “We believe that the principal benefit that shareholders expect from an S corporation election is a reduction in the total tax burden imposed on the enterprise (emphasis added). The owners expect to save money, and we see no reason why that savings ought to be ignored as a matter of course in valuing the S corporation.” Using this line of thought, and some IRS friendly facts and circumstances surrounding the case, the IRS prevailed and the precedent of not tax affecting earning was established.
I do not agree with the precedent set by the Gross decision. I believe that any “hypothetical” willing buyer or seller, under the Fair Market Value standard of value, will consider the cash outlay for income taxes when determining the value of a Company. I also believe that there is a need to match the pre-tax or post-tax level of both the cash flows and the discount rate (this was mentioned by the court in Gross). Discount rates developed under the Duff & Phelps Build-Up Method (and other methods) develop a “post-tax discount rate.” Returns that are obtained from the public markets, such as Duff & Phelps, are after taxes. Public market returns include the negative effects of shareholder taxes on value. A December 2005 study by Dhaliwal, Krull, Li, and Moser, “Dividend Taxes and the Implied Cost of Equity Capital” found that shareholder level taxes are capitalized into public stock prices. This is also evidenced in pricing in the public bond market. Two otherwise equal bonds, except that one has a tax preference status for the deferral of taxes, are priced differently in the market to account for the difference in shareholder level taxes. The market is clear in that shareholder-level taxes matter to an investor. I believe that most valuators hold a similar belief, but we all face the precedent set by Gross.
Kress v. the United States
Now, along comes Kress v. United States. This decision is important in that it addresses several valuation related issues, including the one that caught my attention. In Kress, both the expert for the IRS and the expert for the taxpayer applied a tax rate when valuing a minority ownership interest in an S Corporation. This is different than the decision in Gross. Does this signal that the IRS is realizing that the valuation community was correct in the assumption that taxes matter when valuing an S Corporation? Time will tell if a decision in a U.S. District Court in Wisconsin will be adopted by other courts across the county. What I do know is that at least in Kress, I think the IRS finally got it right and allowed tax affecting in the valuation of an S Corporation.
Should you have questions regarding discount rates or business valuation in general, please contact me, T. Eric Blocher CPA, ASA, CVA, Principal & Director of Business Valuation Services with McKonly & Asbury at firstname.lastname@example.org.