Understanding & Valuing S-Corporations

Transcription

1 Edward Pratesi, CPA/ABV, ASA, CM&AA, CVA Brentmore Valuation Advisors, LLC Bryan Browning, CFA, ASA Valuation Research Corporation Understanding & Valuing S-Corporations An Overview of the History and Valuation Methods for S-Corporations About Our Presenters Ed Pratesi, CPA/ABV/CFF, ASA, CM&AA, CVA Managing Director Brentmore Valuation Advisors, LLC o o o Summit Transition Strategies, LLC Managing Director West Hartford, CT & New York City Member of Business Enterprise Institute s Network of Exit Planning Professionals TM 2

2 About Our Presenters Bryan Browning, CFA, ASA Managing Director Valuation Research Corporation o o 29+ years with VRC Focus on valuation and value-related services for private and public companies Intellectual property Capital stock Fairness, solvency and capital adequacy opinions Litigation support 3 Discussion Outline o History of S-Corporation Valuations o IRS Job Aid o Considerations in Valuing S-Corporations o S-Corporation Valuation Models o An Alternative Valuation Approach o Prediction for the Future of S Corporation Valuation 4

3 History of S-Corporation Valuations o Pre-2001 :: General S-Corporation valuation practices o :: Tax court case decisions o 2001 to present :: Valuation professionals response 5 Pre-2001 General S-Corp Valuation Practices o Treated like a C-Corporation Tax effect S-Corp earnings with C-Corp tax rate Use guideline company comparables for public comparables o Rationale Assumed a most likely C-Corporation buyer Considered to be a best practice Deemed consistent with IRS Valuation Guidelines Thought that professional investors also tax effected earning 6

4 :: Tax Court Case Decisions o 2001 :: Gross v. Commissioner o 2001 :: Wall v. Commissioner o 2002 :: Heck v. Commissioner o 2002 :: Adams v. Commissioner o 2006 :: Dallas v. Commissioner Present :: Valuation Professionals Response o New models created o Empirical research conducted o New best practices developing 8

5 Job Aid for IRS Valuation Analysts With respect to the attribute of pass-through taxation, absent a compelling reason, no entity level tax should be applied in determining the cash flow of an electing S-Corporation. 9 Job Aid for IRS Valuation Analysts 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. 10

6 Considerations in Valuing S-Corporations Universe of buyers under a HB/HS Scenario The holding period of the Transferred Interest The economic interests of the HS Amount of historical and expected distributions Terms of the Shareholder Agreement 11 Considerations in Valuing S-Corporations Ability to raise equity Sub S restrictions Ability to borrow Cost of capital data from public companies Investor level taxation 12

7 S-Corporation Valuation Models 1. Treharne 2. Mercer 3. Grabowski 4. Van Vleet 13 S-Corporation Valuation Models :: Treharne Model o Begins with value as a C-Corporation 1 o Considers distributions to noncontrolling shareholders o Considers differences in tax rates o Considers basis build-up 14

8 S-Corporation Valuation Models :: Mercer Model o Initially considers C- and S-Corporations values as equal 2 o Distributions do not impact value o Uses QMDM (DCF) to quantify premium or discount for S-Corporation o Important variables Holding period Expected distributions Risk of loss of tax benefits 15 S-Corporation Valuation Models :: Grabowski Model 3 o Provides four methods o Key assumptions Expected distributions Holding period Likely buyers 16

9 S-Corporation Valuation Models :: Van Vleet Model 4 o S-Corporation Economic Adjusted Model (SEAM) o Compares value of fully-taxed C-Corporation to that of S- Corporation with one level of tax o Six significant assumptions 17 Are Taxes Important to Investors? o The Job Aid seems to suggest that taxes do not matter o That the Service will not accept a tax affected valuation o Do we have a method of considering taxes that does not impact cash flows? 18

10 S-Corporation Model Results Public C-Corp S-Corp Premium Income before Corp Tax $100 $100 Corp Income Tax Rate 40% 0% Available Earnings $60 $100 No Tax Affecting Model 67% Taxes at Personal Level 20% 40% Available After Personal Taxes $48 $60 Premium per S Corp Models 25% The question is then do taxes have an impact on value? 19 Two Questions o Are S-Corporations worth more than C-Corporations? o Is the total tax burden of an S-Corporation less than a public C- Corporation? 20

11 Cost of Capital o How is the Cost of Capital derived for purposes of a private company valuation? o Typically using the Duff & Phelps market returns as published in their Valuation Handbook Guide to Cost of Capital o Consists of two returns: Income (dividends) Capital Gains 21 Cost of Capital o Does then the Cost of Capital derived from Duff & Phelps for example, match the S-Corporation we are valuing? 22

12 Cost of Capital! o Public companies pay income taxes and its investors pay tax on any income or capital gains o Investors in S-Corporations pay individual level tax on income allocated but no other personal level tax except on sale 23 Pricing Differences in the Market! o The market prices of securities reflect future taxes that must be paid by investors. o It is easily seen in the lower returns paid by taxable versus tax-exempt municipal bonds personal taxes are considered in any investment decision when comparing the alternatives! 24

13 An Alternative Model! o Instead of adjusting the cash flows in the various valuation models analysts should consider an adjustment to the Cost of Capital used to value S-Corporations 25 Prediction! We believe that taxes do matter both at the entity level and the personal level as all investment decisions are based on what remains after taxes. We believe further that a valuation case will be brought up at some point where the appraiser will use tax affecting, will provide a cogent explanation of why taxes matter and refer to the research into investor motivations and decision making. 26

14 Prediction! We also believe that this future case will have the appraiser tax affecting S Corp earnings at corporate tax rates to recognize that a tax will be paid by either the entity or the individual. However since pass-thru entity holders enjoy of not paying dividend or cap gains taxes on distributions an adjustment will be made to the Cost of Capital to recognize this premium over C Corps. The expected premium is between 5% and 10% over C Corp value. More research to follow! 27 Thanks to the Researchers and Valuation Model Builders! Finally we wanted to thank Nancy Fannon & Keith Sellers for their work on valuing S Corporations and Pass-thru entities. In addition we thank all of the S Corp valuation model builders Chris Treharne, Chris Mercer, Roger Grabowski and Daniel Van Vleet. Their works have laid the ground work for continued progress in this task. 28

15 BrentmoreAdvisors.com Thank You! Ed Pratesi, CPA/ABV, ASA, CM&AA, CVA Managing Director, Brentmore Valuation Advisors, LLC North Main Street, 3 rd Floor West Hartford CT Madison Avenue, Suite 200 New York NY ValuationResearch.com VRG.net Bryan Browning, CFA, ASA Managing Director, Valuation Research Corporation [email protected] East Kilbourn Avenue Milwaukee WI 53202