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The PTE Conundrum: Valuing Pass-Through

Entities

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4. The PTE Conundrum:

Valuing Pass-Through Entities

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LearningObjectives:

SegmentOverview:

Field of Study:

RecommendedAccreditation:

RequiredReading(Self-Study):

Running Time:

VideoTranscript:

Course Level:

CoursePrerequisites:

Advance Preparation:

Expiration Date:

Taxes

August 31, 2017

Work experience in tax planning or tax compliance, or an introductory course in taxation

None

1 hour group live2 hours self-study

Update

“Income Approach and Value to the Holder”By Eric J. BarrExcerpt from Chapter 5 of “Valuing Pass-Through Entities,” JohnWiley & Sons (Oct. 2014)For additional information or to order copies of the book, go to:http://www.wiley.com/WileyCDA/WileyTitle/productCd-1118848667.html

See page 4–11.

See page 4–18.

33 minutes

Pass-through entities (PTEs) have been an enigma to accounting,tax and valuation professionals for many years. In this segment,Marks Paneth partner Eric Barr explains these phenomena and howan accountant should tax-effect the earnings of a partnership, a Ccorporation, a limited liability company, and a sole proprietorshipwhen valuing such business ownership interest. He also sheds lighton the PTE Conundrum, a topic which has been litigated andcontested in different courts.

Upon successful completion of this segment, you should be able to:● Identify the attributes of a pass-through entity;● Recognize why you value a business ownership interest;● Recognize the difference between taxation of a pass-through

entity and a C corporation;● Identify the court cases that provide guidance on business

valuation.

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Outline

A. Pass/Flow-Through Entities1. Special business structure that is used

to reduce the effects of doubletaxation

2. Do not pay income taxes at thecorporate levela. Income treated as the income of

the owners or investors3. U.S. law requires flow-through

entities to file an annual K-1statement

B. Business Appraisal Values1. Business ownership interest one of

the most valuable assets a businessowner has

2. Understanding factors that eitherincrease or decrease value is criticallyimportant for a CPA advisor

3. Value generally defined as the risk-adjusted present value of futureeconomic benefitsa. Most frequently applied definition

would be after-tax cash flowsb. Might be EBITDA, EBIT, gross

margin or some other factor

C. Valuation Applications1. In a transaction involving ownership

interesta. Valuation could be for estate or

gift tax purposes2. May be needed for:

a. Litigationb. Merger or acquisitionc. Employee ownership – either

through an ESOP or for a directtransfer

d. Could be for options or warrantvaluation

e. Equitable distribution in adivorce

I. Value of Business Owner Interest

A. Types of Ownership Interest1. Two different types of ownership

interests2. Ownership or controlling interest

a. Owner has the prerogatives ofcontrol

3. Minority or non-controlling interestsa. Don't have control

B. Valuation Approaches1. Net asset approach

a. Look at fair market value of assetsand the liabilitiesi. The difference is the value

2. Income approach – most commonlyused for small/midsize owner-managed businessa. Look at either historical or future

earningsb. Risk adjust a present value of the

future cash flows3. Market approach

a. See what other types of ownershipinterests have sold for

b. Private company transactionsinvolve controlling interest

c. Public company transactions aretypically a minority interest

C. Impact of Control on Value1. With control one typically has a

greater value than a pro rata share ofthe entire entity

2. Generally a discount from pro ratashare is used for value of minorityinteresta. Referred to as a discount for lack

of control

II. Determining Value

Outline (continued)

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A. Pass-Through Entity Defined

1. Company where there's no incometax paid at the entity level

2. Revenues, expenses, and all othertax attributes pass-through to theowners

3. Contrasts with a C corporation –public companies are typically Ccorporations

a. Tax at the entity level

b. Second tax when dividends arepaid and received by theshareholders

B. Increasing Number of Pass-ThroughEntities

1. More and more pass-through entitiesin the form of LLCs, partnershipsand S corporations than Ccorporations being filed each year

2. For the year-ended 2012, 78% of allentities that file U.S. federal incometax returns are pass-through entities

C. Tax Benefits of Pass-Through Entities

1. Example: investor buys ownershipinterest in a pass-through entity andin a C corporation

a. Both generate $500,000 of pre-tax income at the entity level

2. Pass-through entity would providemore after-tax income

a. No tax at the entity level

3. With a C corporation there's a tax atthe entity level

a. Dividend tax

b. Medicare tax

D. PTE Conundrum

1. Valuation multiples are derived frompublic company valuation multiples

a. Assumption that there are twolevels of income tax

b. Pass-throughs have only onelevel

2. Has to be some adjustment made

E. Model to Value Pass-Through Entities

1. 2007 case Delaware MRI v. Kessler

a. Said that there should be avaluation adjustment and anincome tax adjustment for pass-through entities

2. Use a modified version of DelawareMRI

III. Pass-Through Entities vs. C-Corporations

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A. History of the Income Tax

1. Lincoln signed the Act of 1862

a. First law authorizing a U.S.income tax on individuals

b. Income tax eliminated after theCivil War

c. Sixteenth Amendment made theincome tax permanent

2. Since 1990 federal statutoryindividual income tax rates inmaximum income brackets have been30-40%

3. Pattern has emerged

a. Congress passes tax laws

b. Taxpayers interpret these laws

c. IRS challenges taxpayerinterpretations

d. Taxpayers and the IRS deciphercourt decisions

e. Congress again passes new laws

B. Income Tax a Primary Value Driver

1. After-tax returns to the owner isreally what's critical

a. Primary value driver for mostbusiness owners

2. Important to consider that incometaxes are paid once with pass-throughentities

a. Twice with C corporations

C. Impact on Returns and Valuations

1. Major tax law changes impact after-tax returns to owners and the valueof a business entity

2. Before 2003 dividend income wastaxed no differently than ordinaryincome

a. Was subject to maximumindividual income tax rates northof 35%

3. With George Bush tax cuts themaximum rate was 15 percent

IV. Income Tax Implications

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A. Tax Court Perspective1. Critical to understand the court's

thinking in all relevant cases2. Thinking and conceptual foundation

used by the court will always applyB. Gross v. Commissioner

1. Involved a valuation date in the mid-90s before the Bush tax cuts

2. Tax cost of owning a C corporationwas immense

3. In 2003 the tax on dividend incomewent from mid-30s down to 15%a. Relative advantage of being a

pass-through to a C corporationcut almost in half

C. Delaware MRI v. Kessler1. Delaware MRI came up with a

methodologya. Effectively reverse engineered the

income tax rate based on the factspresented

2. Modified Delaware MRI modela. Proposed as the appropriate way

to go about valuing pass-throughentitiesi. Considers the possibility that

there may be an entity-leveltax

ii. Considers the possibility thatincome might be retained inthe business

3. Concepts contained in the modifiedDelaware MRI model also apply tothe market approach

D. Fractional Ownership Interest1. May be equal to the value of the

entire entity multiplied by the subjectpercentage interesta. Depends on facts and

circumstances2. If you're dealing with a control

interest then it may work out thatway

3. If you're dealing with a non-controlling interesta. May have a situation where

minority interest has a value that'sgreater than a pro rata share

b. May also have situations whereit's worth less than a pro ratashare

V. Tax Court Decisions

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A. Valuation Expertise1. If a CPA doesn't have the valuation

talent in-housea. Should bring in a business

appraiser valuation consultantb. Could protect the relationship

with the client and complete theservice offering

2. Will be many companies for sale inthe not-too-distant futurea. Business ownership interest

usually the largest single assetthat the business owner has“…it's critical to understand whatthat ownership interest is worth,what actions enhance value, andhow to package that company ina way that down the road it ismore marketable and has morevalue.”

- Eric BarrB. Documentation Analysis

1. Important to understand thehistorical results of companyoperations a. Before one can estimate future

cash flows 2. In many owner-managed businesses

a. Reported numbers don't trulyreflect economic returns of thebusiness

3. Business appraiser has to be able tolook at the numbersa. Pull out non-economic itemsb. Pull out non-recurring itemsc. Come up with an accurate,

reliable, understandable anddefendable valuation conclusion

C. Prepare to Be Challenged by IRS1. Risk that IRS will examine valuation

in connection with:a. Gifting of an ownership interestb. Estate tax returnc. Employee transactiond. Related party transaction

2. Accountant of record for a companywho prepares financial statements ortax returnsa. Is not the accountant who should

be preparing the valuationb. Creates an independence issue

D. Differing Valuation Perspective“Value, like beauty, is in the eyes of thebeholder.”

- Eric Barr1. Value to the holder of an ownership

interest might be vastly differentfrom the value to the buyera. Buyer may bring into play certain

synergies 2. Valuation is evolving

a. Important to really understandcase law and the standards

VI. Accountants’ Perspective

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● As the Discussion Leader, you shouldintroduce this video segment with wordssimilar to the following:

“In this segment, Eric Barr explains theenigma of pass-through entities (PTEs)and also sheds light on the PTEConundrum, a topic which has beenlitigated and contested in differentcourts.”

● Show Segment 4. The transcript of thisvideo starts on page 4–18 of this guide.

● After playing the video, use thequestions provided or ones you havedeveloped to generate discussion. Theanswers to our discussion questions areon page 4–8. Additional objectivequestions are on page 4–9 and 4–10.

● After the discussion, complete theevaluation form on page A–1.

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4. The PTE Conundrum: Valuing Pass-Through Entities

1. What is a pass-through entity?

2. Under what circumstances would a CPAneed to value a client’s businessownership interest? What is yourexperience with valuing businessownership interests?

3. What are the different approaches tovaluation? Which approaches do youhave experience with?

4. How does a pass-through entity differfrom a C corporation?

5. What is the pass-through entityconundrum? What adjustments does theModified Delaware MRI model putforth?

6. What are Mr. Barr’s observations withregards to changes in the tax laws andrates and their impact on valuations? Doyou agree with him? If so, why? If not,why not?

7. What are some of the key issues toconsider when performing a valuation?What are Mr. Barr’s observations withregards to performing a valuation?

Discussion Questions

You may want to assign these discussion questions to individual participants before viewingthe video segment.

Instructions for Segment

Group Live Option

For additional information concerning CPE requirements, see page vi of this guide.

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4–8Suggested Answers to Discussion Questions

4. The PTE Conundrum: Valuing Pass-Through Entities

1. What is a pass-through entity?● Pass-through entity

❖ Special business structure used toreduce effects of double taxation

❖ Does not pay income tax atcorporate level

❖ Income treated as income ofowners/investors

2. Under what circumstances would a CPAneed to value a client’s businessownership interest? What is yourexperience with valuing businessownership interests?● Business ownership interest: Why

value it?❖ Estate or gift tax purposes❖ Litigation❖ Merger or acquisition❖ Employee ownership❖ Options or warrants❖ Divorce

● Based on participant experience

3. What are the different approaches tovaluation? Which approaches do youhave experience with?● Different valuation approaches

❖ Net asset: Look at FMV of assetsand liabilities

❖ Income: Look at historical orfuture earnings with PVadjustment

❖ Market: Look at other sales● Based on participant experience

4. How does a pass-through entity differfrom a C corporation?● Pass-through entities

❖ No tax paid at entity level❖ Revenues, expenses and all other

tax attributes pass through toowners

● C corporations❖ Tax at the entity level❖ Second tax when dividends are

paid

● Taxation of pass-through entity vs. Ccorporations❖ Pass-through entity: One level❖ C corporation: Two levels

5. What is the pass-through entityconundrum? What adjustments does theModified Delaware MRI model putforth?● The pass-through entity conundrum

❖ How do you deal with the factthat multiples are based on twolevels of tax but PTE only hasone?

● Modified Delaware MRI model:Adjustments for possibility❖ Of an entity level tax❖ Income might be retained in the

business

6. What are Mr. Barr’s observations withregards to changes in the tax laws andrates and their impact on valuations? Doyou agree with him? If so, why? If not,why not?● Barr’s observations on changes in

tax laws and rates❖ When tax rates change, after-tax

returns change❖ Major tax law changes impact

after-tax returns❖ Changes in tax rates in 2003

impacted valuation adjustments● Based on participant opinion

7. What are some of the key issues toconsider when performing a valuation?What are Mr. Barr’s observations withregards to performing a valuation?● Valuation issues: Consider

❖ Non-economic items❖ Non-recurring items❖ Recurring cash flow

● Barr’s observations❖ “Value is in the eyes of the

beholder”❖ IRS is looking closely at estate

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1. All of the following are attributes of apass-through entity except:

a) it pays income tax at the corporatelevel.

b) it does not reduce the effects ofdouble taxation.

c) it does not file any forms orstatements.

d) its income is treated as that of itsowners or investors.

2. A CPA may prepare a valuation forwhich of the following instances?

a) estate and gift tax purposes

b) mergers and acquisitions

c) divorce proceedings

d) all of the above

3. The _______ approach to valuation istypically used when valuing _______companies.

a) net asset; small or mid-size

b) market; public

c) income; public

d) market; real estate holding

4. Value is impacted by control through theuse of:

a) a discount only.

b) a premium only.

c) either a premium or discount.

d) Control has no effect on value.

5. The pass through entity conundrumrefers to:

a) how pass through entities face doubletaxation.

b) discounts applied for non controllinginterests.

c) the fact that PTE valuations arebased on C corporation multiples.

d) the fact that non controlling ownershave no influence on businessmatters.

6. The Bush tax laws of 2003:

a) increased the advantages of CCorporation ownership.

b) developed a model for valuing passthrough entities.

c) imposed an entity level tax on passthrough entities.

d) increased the tax on dividend incomefrom C Corporations.

7. When valuing a business, an accountantshould:

a) review only the financial statementsto understand the economic returns.

b) try to estimate future cash flows.

c) consider all non recurring andrecurring events in the valuation.

d) not pay attention to historical resultsas those are in the past.

8. The only thing that matters whenvaluing an ownership interest based on avalue to the buyer assumption is:

a) the value of ownership interest in thebuyer’s hands.

b) the cost capital of the seller.

c) the income tax rate of the seller.

d) the pre tax cash flows of the seller.

You may want to use these objective questions to test knowledge and/or to generate furtherdiscussion; these questions are only for group live purposes. Most of these questions are basedon the video segment, a few may be based on the required reading for self-study that starts onpage 4–11.

4. The PTE Conundrum: Valuing Pass-Through Entities

Objective Questions4–94–9

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9. In the case of the Delaware Open MRI v.Kessler:

a) the analysts for both sides used thesame income tax rate in valuing thebusiness but used different valuationmethods.

b) the court concluded that an S-Corporation cannot affect materialinterest.

c) the court determined that a 0% taxaffecting adjustment was improper.

d) the court’s analysis did not considerthe pass through entity premiumresulting from the double taxation ofC Corporations.

10. The courts in the Delaware Open MRIand Bernier case_______maximumstatutory federal tax rates ______as tothe actual individual income tax ratespaid by the S corporations shareholders.

a) did not utilize; and were silent

b) utilized; and addressed

c) did not utilize; and formed newopinions (or addressed)

d) utilized; but were silent

Objective Questions (continued)

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Self-Study Option

Required Reading (Self-Study)

1. Viewing the video (approximately 30–35 minutes). The transcript of thisvideo starts on page 4–18 of this guide.

2. Completing the Required Reading (approximately 25–30 minutes). TheRequired Reading for this segment starts below.

3. Completing the online steps (approximately 35–45 minutes). Pleasesee pages iii to v at the beginning ofthis guide for instructions oncompleting these steps.

When taking a CPA Report segment on a self-study basis, an individual earns CPE credit bydoing the following:

Instructions for Segment

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INCOME APPROACH AND VALUE TO THE HOLDER

By Eric J. BarrExcerpt from Chapter 5 of “Valuing Pass-Through Entities,” John Wiley & Sons (Oct. 2014)For additional information or to ordercopies of the book, go to:http://www.wiley.com/WileyCDA/WileyTitle/productCd-1118848667.html

Internal Revenue Service Revenue Ruling59–60 directs business appraisers toconsider the following factors when valuingthe stock of closely held corporations:

a. The nature of the business and thehistory of the enterprise from itsinception.

b. The economic outlook in general andthe condition and outlook of the specificindustry in particular.

c. The book value of the stock and thefinancial condition of the business.

d. The earning capacity of the company.

e. The dividend-paying capacity.

f. Whether or not the enterprise hasgoodwill or other intangible value.

g. Sales of the stock and the size of theblock of stock to be valued.

h. The market price of stocks ofcorporations engaged in the same orsimilar line of business having theirstocks actively traded in a free and openmarket, either on an exchange or over-the-counter.1

Factors to consider when applying theincome approach are presented in RevenueRuling 59–60, § 4.02, which states that“[p]rimary consideration should be given tothe dividend-paying capacity of thecompany rather than to dividends actuallypaid in the past.”2 The Revenue Rulingcontinues thus:

In the final analysis, goodwill isbased upon earning capacity. Thepresence of goodwill and its value,therefore, rests upon the excess ofnet earnings over and above a fairreturn on the net tangible assets.While the element of goodwill may

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be based primarily on earnings, suchfactors as the prestige and renown ofthe business, the ownership of a tradeor brand name, and a record ofsuccessful operation over aprolonged period in a particularlocality, also may furnish support forthe inclusion of intangible value.3

Value to the Holder versusValue to the Buyer When applying the income approach, it isimportant to recognize that the conclusionof value may be different depending on thepurpose or standard of value applied inconnection with the appraisal. In addition,the degree of control of the subject may alsohave an impact on value because absent theability to assert influence or control, theowner of a business ownership interest mayhave limited ability to affect the future cashflows. When valuing a noncontrollinginterest, the pretax cash flows may not bemuch different in the hands of thehypothetical (or specific) seller than in thehands of the hypothetical (or specific)buyer. This is true whether or not thesubject interest is a minority ownershipinterest in a C corporation or a PTE.

On the other hand, if the subject interest canexercise influence or the prerogatives ofcontrol, then the present value of futurepretax cash flows generated for the benefitof the subject interest may be very differentin the hands of a seller or a buyer. A selleror a buyer may offer the business different(1) synergies, (2) depth of expertise, (3)sources of capital, (4) cost of capital, and soforth.

The holder of an ownership interest in abusiness may enjoy a very differenteffective income tax rate than thehypothetical buyer. For example, the holdermay be a qualifying owner of a businessoperating as an S corporation, whereas thehypothetical buyer may be a C corporation(which would automatically terminate the Scorporation election). The holder may havea different overall effective income tax ratethan the buyer due to other sources ofincome, expenses, and deductions.

Finally, the holder may have a different costof capital than the buyer. If the buyer hasgreater (1) sources of working capital and/or(2) access to debt and/or equity capital thanthe holder, then the buyer’s potentiallylower cost of capital may yield a greatervalue than the company’s value in the handsof the holder. Thus, when valuing anownership interest based on a value to theholder assumption, it is not the selling pricethat could be realized from the sale to ahypothetical buyer that is relevant (unlessthere is an intention to sell, near term);rather, it is the value of the ownershipinterest in the hands of the owner thatmatters.

When valuing an ownership interest basedon a value to the buyer (investment value)assumption, it is not the pretax cash flows,income tax rate, or cost of capital of theseller that matters; it is the value of theownership interest in the hands of the buyerthat matters. When preparing a businessappraisal under the value to the holderassumption, it is important to properlymatch (1) pretax normalized cash flows, (2)the applicable income tax rate, and (3) theapplicable cost of capital to the appropriatebuyer/seller valuation assumption.

Jurisdictional Issues Value to the holder assumptions vary bystate. In some jurisdictions, the value to theholder is equivalent to fair value and shouldbe employed in matrimonial dissolutions,dissenting shareholder/partner/memberdisputes, and other circumstances. In otherjurisdictions, fair value can be interpretedvery differently from value to the holder,that is, pro rata share of fair market value orwhatever the court thinks is fair andequitable under the circumstances. It isadvisable to confirm the jurisdictionalinterpretation of fair value and the value tothe holder assumption with counsel beforeemploying it on a valuation engagement.

Delaware Open MRIRadiology Associates, P.A.v. Howard B. Kessler 4

It is essential to understand relevant caselaw when applying the value to the holder

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assumption because the courts are ultimatelythe final arbiters of competing valuationtheory. When considering the issue of tax-affecting PTEs under the value to the holderassumption, reference is made to the 2006decision Delaware Open MRI RadiologyAssociates, P.A. v. Howard B. Kessler.5

The parties involved in Delaware Open MRIwere radiologists who formed an Scorporation to capture additional revenuesby owning MRI centers. Due to a split in theunderlying radiology practice, majority andminority stockholder groups were formed.The majority stockholder group(respondents) forced a squeeze-out merger,and the minority stockholder group(petitioners) filed suit in 2004, claiming thatthey did not receive fair value for theirshares in the S corporation that owned theMRI centers.6

In Delaware Open MRI, the Court ofChancery of Delaware considered thetestimony of two valuation analysts. Bothanalysts relied on the discounted cash flowmethod due to the recent and expectedgrowth of the subject business. However,respondent’s valuation analyst imposed a 40percent corporation income tax rate, and thepetitioner’s valuation analyst imposed a 0percent corporation income tax rate.7 Thepositions taken by each valuation analyst arepresented in Table 5.1, which is derivedfrom a chart in the case opinion itself.8

The valuation conclusion derived byapplying a 40 percent tax rate results inearnings subject to capitalization of 60percent; the valuation conclusion derived byapplying a 0 percent tax rate results inearnings subject to capitalization of 100percent. The difference between the two tax-affecting adjustments is very substantial—and illustrates the PTE conundrum. Here,one valuation analyst concluded thatbecause an income tax will be paid at the

owner level via distributions tostockholders, a 40 percent tax-affectingadjustment is required. In substance, thisanalyst treated the earnings of the Scorporation as if it were the earnings of a Ccorporation. The other valuation analystconcluded that because no tax is incurred atthe entity level of an S corporation, no tax-affecting adjustment is appropriate.

The following are the facts andcircumstances specific to this case, thecourt’s application of the fair value standardof value, the theories and reasoningadvanced by the court, and the court’sconclusions with respect to how best toaddress the PTE conundrum in this instance.

The court concluded the following:

1. Petitioners should be awarded their prorata share of the subject company’sappraisal value on the valuation date.This value was referred to as fair valueand is more of a jurisprudential conceptthan an interpretation of the Delawareappraisal statute.9

2. “[I]t would be highly misleading” to (1)determine the value of a market-basedacquisition of an S corporation bycomparison to C corporations and (2)“then assume that the S corporationwould be sold at a higher price becauseof its [PTE] tax status.”10 The court was

“not trying to quantify the value atwhich Delaware Radiology would sellto a C corporation”; it tried “to quantifythe value of Delaware Radiology as agoing concern with an S corporationstructure and award the [petitioners]their pro rata share of that value.”11 Thisconclusion was based on Delaware law,which states that a “petitioner is‘entitled to be paid for that which hasbeen taken from him.’”12

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Table 5.1: Delaware MRI—Business Appraiser’s Tax-Affecting Assumptions

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g 3. Petitioners were “involuntarily deprivedof the benefits of continuing asstockholders in a profitable Scorporation—benefits that [included] thefavorable tax treatment that [potentially]accompanies S corporation status.”13

For the reasons described in Chapter 3and as acknowledged by the court, thestockholders of the S corporation paidlower income taxes than they wouldhave if the company operated as a Ccorporation.

The court adhered to the reasoning ofprior decisions that recognized that an Scorporation structure can produce amaterial increase in economic [interest].That reasoning [supports] not only[court decisions] [in] the Adams, Heck,and Gross cases in the U.S. Tax Court,14

but an appraisal decision of [the sameDelaware Court of Chancery], whichcoincidentally also involved a radiology[practice]. The opinion In re RadiologyAssociates noted that “under an earningsvaluation analysis, what is important toan investor is what the investorultimately can keep in his pocket.”15

4. No evidence was presented to the courtindicating that the business wouldconvert to C corporation status in theforeseeable future.16

5. The business was “highly profitable”and “distribute[d] income well in excessof the stockholder level taxes itsstockholders [would] pay” on theincome of Delaware Open MRI taxed ontheir personal income tax returns.17

The court concluded that the secondappraiser’s 0 percent tax-affectingadjustment was improper, stating thus:

Assessing corporate taxes to ashareholder at a personal level does notaffect the primary tax benefit associatedwith an S corporation, which is theavoidance of a dividend tax in additionto a tax on corporate earnings. Thisbenefit can be captured fully whileemploying an economically rationalapproach to valuing an S corporationthat is net of personal taxes. To ignorepersonal taxes would overestimate thevalue of an S corporation and would

lead to a value that no rational investorwould be willing to pay to acquirecontrol. This is a simple premise—noone should be willing to pay more thanthe value of what will actually end up inher pocket.18

The court’s analysis fully recognized thePTE premium resulting from the doubletaxation of C corporation earnings due to thedividend tax on distributions. The court thenanalyzed how best to quantify the PTEpremium.

Ultimately, the court concluded that a 29.4percent effective corporation tax rate wasappropriate in the circumstances.19 Thecourt assumed the following in connectionwith its calculations, based on the testimonyof the two valuation analysts:20

1. A perpetual effective combined federaland state C corporation income tax rateof 40 percent

2. One hundred percent of availableearnings to be perpetually distributed incash in the year earned

3. A perpetual effective combined federaland state individual income tax rate of40 percent on ordinary income

4. A perpetual effective combined federaland state individual tax on qualifyingdividend income of 15 percent

The court’s calculations are presented inTable 5.2, which are derived from a table inthe case opinion.21

The court accepted the inputs provided bythe two valuation analysts to calculate theamount that was ultimately available to thestockholders after corporation and individualincome taxes. The court accepted valuationanalyst #1’s assumptions that (1) the Ccorporation would continue to pay federaland state income taxes at a combinedeffective tax rate of 40 percent, and (2) thestockholder of a C corporation wouldcontinue to pay a tax on dividends receivedat the federal tax rate of 15 percent. Thecourt also accepted valuation analyst #2’sassumptions that (1) the S corporationshareholders would pay federal and stateindividual income taxes at a combined

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g effective tax rate of 40 percent, and (2) $60is the amount available after corporation andindividual income taxes assuming Scorporation status. “In its decision, the courtmathematically determined [the] 29.4percent effective corporation tax rate (aplug) in order to produce the desiredavailable after-tax amount” ($60).22

Table 5.2 shows that the amount available tothe stockholders after individual incometaxes as an S corporation, $60, exceeds theamount that is available to the stockholdersassuming a 40 percent effective corporationincome tax rate (federal and state) and a 15percent qualified dividend tax rate, $51. The$9 benefit of being taxed as an S corporationover the amount that the stockholders wouldreceive as a C corporation is of real value tothe S corporation stockholders—it is not ahypothetical benefit.

The court in Delaware Open MRI valued thesubject interest under the value to the holderassumption by using after-tax companyearnings of $71 and dividing it by acapitalization rate. The capitalization rateused by the court was derived using thebuild-up method from after-tax publiccompany data. Hence, the court consistently

matched hypothetical after-tax C corporationearnings of the S corporation (beforeindividual income taxes) with acapitalization rate derived from after-tax netearnings of public C corporations (beforeindividual income taxes) in deriving itsconclusion of value.23

Bernier v. Bernier In its 2012 decision, the Appeals Court ofMassachusetts, in Bernier v. Bernier,24 alsoapplied the methodology utilized inDelaware Open MRI. Bernier was amatrimonial dissolution matter that involvedthe valuation of two supermarkets that wereoperated as S corporations. The lower courtstated that “where valuation of assets occursin the context of divorce, and where one ofthe parties will maintain, and the other beentirely divested of, ownership of a marital

asset after divorce, the judge must takeparticular care to treat the parties not asarm’s-length hypothetical buyers and sellersin a theoretical open market, but asfiduciaries entitled to equitable distributionof their marital assets.” The court appliedthe concept of “value to the holder” in this

Table 5.2: Delaware MRI Experts’ Conclusions

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g Massachusetts matrimonial matter, similar toDelaware Open MRI.25

In Bernier, after applying applicable year’s(2000) tax rates and utilizing the DelawareOpen MRI methodology, the mathematicallyderived effective corporation tax rate waszero percent. The court concluded that “azero percent tax affecting rate does notnecessarily lead to an inequitable result.There is a distinction to be drawn betweenfailing to tax affect at all the earning of thesupermarkets because an S corporation doesnot pay federal taxes at the entity level andutilizing a zero percent tax affecting ratearrived at through application of allapplicable rates, as ordered.”26

Limitations of DelawareOpen MRI and Bernier

The courts’ reported decisions in DelawareOpen MRI and Bernier did not addresschanges that would need to be made to themodel presented in Table 5.2 in the eventthat facts and circumstances under the“value to the holder” assumptions weredifferent. For example:

● Both decisions utilized maximumstatutory federal tax rates (2004 forDelaware Open MRI and 2000 forBernier) as presented in experts’ reports.Both decisions were completely silent asto the actual individual income taxespaid by S corporation shareholders onPTE earnings.

● States have different corporation andindividual tax rates; therefore, oneeffective individual or corporationincome tax rate cannot apply to eachand every state.

● Certain states or localities (New YorkCity, for example) do not recognize Scorporation status.

● Certain states or localities imposeunincorporated business taxes onpartnership or limited liability companyincome (e.g., New York City).

● Not all companies and individuals earnlevels of taxable income that place them

in the highest federal statutory incometax rate.

● The amount of earnings retained in abusiness significantly impacts the after-tax returns to the owner. It cannot beassumed that substantially all earningswill always be distributed.27

What is the impact of changing any of theseassumptions? Obviously, a change inincome tax rates (all other things beingunchanged) would change the amount ofafter-tax income that is available to abusiness owner. Therefore, businesses thatoperate in states (or during years) withhigher income tax rates would generatelower after-tax cash flows.28

What is the impact on the value of a PTEwhen a business retains instead ofdistributes its profits? By definition, theowners of a PTE recognize 100 percent ofthe business’s taxable income whether or notthere is a distribution from the business. If abusiness distributes all of its profits, then theowner is paying income taxes on profitsactually received. On the other hand, if abusiness does not distribute any of itsprofits, the owner is still personallyresponsible for paying out-of-pocket theincome taxes related to business earnings.This places the owner of a PTE in a distinctand significant economic disadvantagerelative to an owner of a C corporationwhen earnings are not distributed.29

Many businesses are unable to distribute allof their profits. Cash is often retained in abusiness for capital expenditures, repaymentof interest-bearing debt, expansion plans,working capital needs, and many otherreasons. Income retention is a highlysensitive assumption when estimating after-tax return on investment because anyincome retained by a PTE reduces itsdividend-paying capacity. There often is aninverse relationship between earningsretained in the business and after-tax returnsto the equity owner (however, in someinstances, the income retained in a businesscan greatly accelerate revenue, net incomegrowth, and value). It is important to notethat many of the tax benefits of owning aPTE relative to a C corporation disappearwhen pretax income retention is 60 to 65percent. It logically follows that if a

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g business expects to have income retained ata level that causes the owner to lose thebenefit of a PTE premium relative to actualC corporation rates, the pass-throughelection may be terminated. Howeverlogical it might be in certain circumstancesto terminate the PTE election, in practicethis does not appear to be a commonoccurrence.

Notes1 Rev. Rul. 59–60, 1959-1 C.B. 2031, § 4.01.

2 Id. § 4.02(e).

3 Id. § 4.02(f).

4 Many of the principles and methodologiesdiscussed in this chapter applicable to the analysisof Delaware Open MRI Radiology Associates,P.A. v. Howard B. Kessler, including the MDMM,are derived from and reprinted with permissionfrom Eric J. Barr, “Pass-Through EntityValuations and ‘Value to the Holder’: A NewPerspective,” Value Examiner (Sept./Oct. 2012).

5 898 A.2d 290 (Del. Ch. 2006).

6 Id. at 299.

7 Id. at 326.

8 Id. at 330.

9 Id. at 310.

10 Id. at 327.

11 Id.

12 Id. (quoting Tri-Cont’l Corp. v. Battye, 74A.2d 71, 72 (Del. 1950)). The standard of valuein this case was fair value as defined underDelaware law.

13 Id.

14 In Estate of Adams v. Commissioner, T.C.M.2002-80, 83 T.C.M. (CCH) 1421, T.C. M. (RIA)para. 54,696, 2002 Tax Ct. LEXIS 84 (Mar. 28,2002), Estate of Heck v. Commissioner, T.C.M.2002-34, 83 T.C.M. (CCH) 1181, T.C.M. (RIA)para. 54,639, 2002 Tax Ct. LEXIS 38 (Feb. 5,2002), and Gross v. Commissioner, T.C.M. 1999-254, 78 T.C.M. (CCH) 201, T.C.M. (RIA) para.

99,254, 1999 Tax Ct. LEXIS 290 (July 29, 1999).The U.S. Court of Appeals affirmed the decisionof the Tax Court, 272 F.3d 333 (6th Cir. 2001),each discussed in detail in Chapter 9; the U.S.Tax Court rejected the inclusion of a 40 percenttax-affecting adjustment when valuing a PTE forestate and gift tax reporting purposes under thefair market value standard of value.

15 Delaware Open MRI, 898 A.2d at 327–28(quoting In re Radiology Assocs., 611 A.2d 485,495 (Del. Ch. 1991)) (some citations omitted).

16 Id. at 326.

17 Id.

18 Id. at 328–29 (citations omitted).

19 Id. at 330.

20 Id. at 329.

21 Id. at 330; see also Eric J. Barr, “Pass-ThroughEntity Valuations and ‘Value to the Holder’: ANew Perspective,” Value Examiner (Sept./Oct.2012), at 16, 17.

22 Barr, supra at 17. 23Id.

24 82 Mass. App. Ct. 81 (2012).

25 Barr, supra note at 17 (internal citationomitted). “In Bernier, the court referred to its useof value to the holder as fair market value.” Id. at17, n.2.

26 Id. at 17.

27 Id. at 17–18.

28 Id. at 18.

29 Any future distributions of previously taxedincome will occur tax-free to the owners of aPTE.

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QUINLAN: Pass-through entities have been an enigma to accounting and valuationprofessionals for many years. Valuation itself can be a dauntingundertaking, akin to a paint-by-number picture without the numbers.With a number of different models and approaches, there is no one rightanswer. But what exactly is a pass-through entity?

A pass-through entity is a special business structure that is used to reducethe effects of double taxation. Pass-through entities do not pay incometaxes at the corporate level. The income of such entities are treated as theincome of the owners or investors.

Technically, for tax purposes, flow-through entities are considered “non-entities” because they are not taxed. U.S. law requires flow-throughentities to file an annual K-1 statement.

Like many endeavors, the original purpose for which pass-throughentities were created has long since been forgotten. But understandingthe genesis of pass-through entities provides a rich fabric from which theaccountant can create a more understandable and accurate pass-throughentity valuation.

In this segment our own Rebecca Surran looks into pass-through entitiesand how the accountant should tax-affect the earnings of a partnership, CCorporation, limited liability company, or sole proprietorship whenvaluing such business ownership interests. She met with Eric Barr,Partner-in-Charge of Valuation Services at Marks Paneth LLP and authorof the book Valuing Pass-Through Entities. Mr. Barr helps shed light onwhat he calls the PTE conundrum, a topic that has been the subject ofarticles and books and has been contested in numerous litigations and indifferent courts with varying facts and circumstances.

SURRAN: Eric, I want to welcome you to the program this month.

BARR: Thank you, Becky. It’s a pleasure to be here.

SURRAN: Eric, I know that you provide consulting services on all aspects ofvaluation. Can you start by telling us, why is the topic of valuationimportant to CPAs?

BARR: Well, for CPAs to fully service their clients, they have to be aware thatthe business ownership interest is one of the most valuable assets abusiness owner has. It’s important for the CPA advisor to understandthose factors that drive value, that create and enhance value. And sohaving an understanding of the factors that either increase or decreasevalue is critically important for a CPA advisor.

SURRAN: OK. That certainly makes a lot of sense. So how is value defined forbusiness appraisal purposes?

BARR: It’s generally defined as the risk-adjusted present value of futureeconomic benefits. Now, those economic benefits may be defined in avariety of ways.

The most frequently applied definition would be after-tax cash flows. Butdepending on the industry and the circumstances, it might be EBITDA,EBIT, gross margin or some other factor.

Video Transcript

4. The PTE Conundrum: Valuing Pass-Through Entities

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SURRAN: So under what circumstances would a client or a CPA need to know thevalue of their business ownership interest?

BARR: There are a variety of reasons. If someone is thinking about a transactioninvolving their ownership interest, it could be for an estate or gift taxpurposes.

It might be for litigation. It might be for merger or acquisition. It might befor an employee ownership, either through an ESOP or for a directtransfer. It could be for options or warrant valuation. It might be neededbecause the business owner is getting a divorce and as part of the processof determining the amount subject to equitable distribution, they mayneed a valuation. So there’s a host of reasons.

SURRAN: I guess there are a lot of reasons why a valuation might be necessary. Isvalue determined the same way in each circumstance?

BARR: No, it’s not. Generally speaking, you have two different types ofownership interests.

An ownership interest where the owner has the prerogatives of control,and other interests, often referred to as minority or non-controllinginterests. Those two are vastly different.

As a controlling interest holder, you could make decisions regardingwhether a company wants to pay bonuses, not pay bonuses, dividends,expand or contract operations, hiring, a whole host of different factors.With a non-ownership interest, you’re along for the ride. Maybe you havesome influence, but you don’t have control. So they are vastly different.

SURRAN: So we have controlling and non-controlling interests. With respect tovaluation what are some of the different valuation approaches that arecommonly considered by business appraisers?

BARR: There are different standard-setting bodies, and they all focus on threeprimary approaches, very similar to real estate appraisal.

There’s what called a net asset approach, and in the net asset approach,you look at the fair market value of the assets and the liabilities, and thedifference is the value. That’s relevant for certain types of companies likereal estate holding companies or investment companies, companies thatdon’t have a lot of goodwill.

Then there’s the income approach. Under the income approach, you lookat either the historical or future earnings of the company and you riskadjust a present value of the future cash flows. That’s the one approachthat’s most commonly used, particularly for a small or midsize owner-managed business.

The third approach is called a market approach. In the market approach,you look to see what other types of ownership interests have sold for. Youmight look at publicly held companies to see what the stock price is andwhat the valuation metrics are for a guideline public company. Or youmight look at a private company transaction.

The private company transactions involve controlling interest. Publiccompany transactions are typically a minority interest. But they’re freelytradable, so you have differences between the guideline public and theguideline transaction method, but they’re both a market approach that isreferred to and relied upon by business valuation consultants.

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SURRAN: Eric, you seem to keep coming back to the issue of control. How is valueimpacted by control?

BARR: Well, with control, one typically has a greater value than a pro rata shareof the entire entity. With control, you could say that if a business has avalue of say, a million dollars, and one has control, 90 percent, you mightattribute 90 percent of that million dollars to that ownership interest. Butif somebody has the 10 percent ownership interest in that million-dollarbusiness, good luck finding somebody to pay $100,000 for it.

Because there’s generally a discount from the pro rata share to come upwith the value of that minority interest. Those discounts are often referredto discounts for lack of control.

Sometimes those interests are not quite that marketable. Somebody mighthave to hold on to that interest for an extended period of time. In thosesituations, there’s a discount for lack of marketability. You typically don’thave those types of discounts when valuing the control interest.

SURRAN: Eric, so now we’ve discussed the basics related to business valuation,let’s talk about pass-through entities. What exactly is a pass-throughentity?

BARR: It’s funny; I had this conversation with my parents the other day. Myfather’s 88, my mom is 85, and they were very excited that I was writinga book. I presented it to them and showed them the different sections andthe acknowledgment. They’re very pleased and they’re all excited.

Then they closed the book and they saw the title, Valuing Pass-ThroughEntities, and they said, “What’s a pass-through entity?”

So the way I explained it to them was, number one, it has nothing to dowith your bowels. It’s not a pass-through in that sense.

What it is is it’s the type of company where there’s no income tax paid atthe entity level, rather the revenues, expenses, and all of the other taxattributes pass-through to the owners.

That contrasts with a C corporation. Public companies are typically Ccorporations, where there is a tax at the entity level. There’s a second taxwhen dividends are paid out of the company and received by theshareholders.

So with a pass-through entity, there’s one level of taxation at the ownerlevel. With a C corporation, you have two.

SURRAN: OK, I understand what you are saying about the differences betweentaxation of a C corporation and that of a pass-through entity. So howprevalent are pass-through entities?

BARR: Well, it’s quite prevalent. Annually, the IRS releases all sorts of differentdata, including the number of federal forms 1065, 1120S and 1120 formsthat are filed. 1065 is partnerships and LLCs, 1120S is S corporations,and 1120s are C corporations.

The statistics show a very clear and consistent trend, and that is there aremore and more pass-through entities in the form of LLCs, partnershipsand S corporations than C corporations being filed each year.

The number of pass-through entities keeps growing. For the year-ended2012, 78 percent of all entities that file U.S. federal income tax returnsare pass-through entities.

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SURRAN: Wow. That’s an amazing statistic. I didn’t realize how prevalent pass-through entities are? What are some of the economic consequences ofowning an interest in a pass-through entity versus owning the equivalentinterest in a C corporation?

BARR: Well, let’s say, as an investor, I could buy an ownership interest in a pass-through entity and in a C corporation. Just hypothetically speaking, theyboth generate $500,000 of pre-tax income at the entity level. Which entitywould provide me with greater after-tax returns?

With the pass-through entity, there’s no tax at the entity level, assumingthat that $500,000 is available to me to pull out of the company and that Idon’t need money to be retained in the business. I’m better off on an after-tax basis as an owner of the pass-through rather than the C corp becausewith the pass-through all of that income is taxed to me.

So that if, let’s say, at $500,000, I’m in the 40 percent tax bracket, thatmeans there’s $200,000 of tax. I keep $300,000 after tax.

With the C corporation there’s a tax at the entity level. Again, assume thatthere’s a 40 percent tax rate, $300,000. The $300,000 is dividended out tome.

Well, I’ve got a dividend tax that I have to pay on that, which is roughly20 percent plus the Medicare tax. But using just the 20 percent, 20 percentof $300,000 is $60,000, I wind up with $240,000. $240,000 versus$300,000, very clear difference between the two.

SURRAN: Eric, I think I am beginning to understand the difference between a pass-through entity and a C corporation. Are there valuation issues that arespecifically related to pass-through entities? If so, what are they?

BARR: Well, that’s the big issue facing the valuation professional. With so manycompanies, 78 percent of all companies being pass-through entities, it’sone of the most important and critical issues that we as businessappraisers have to deal with. Here’s what the issue is the valuationmultiples are derived from public company valuation multiples.

So if the public companies are C corporations and their valuationmultiples or capitalization rates derive from those public multiples, there’sthe assumption that there are two levels of income tax. But with pass-throughs, there isn’t. There’s only one level.

So how do you reconcile that?

How do you address the fact that your multiples are based on two levelsof tax but the entity that you’re valuing only has one? Clearly, there has tobe some adjustment made. That’s what I call the pass-through entity, orPTE, conundrum.

SURRAN: That does sound like a conundrum. So how do you usually deal with that?

BARR: Well, in my book, Valuing Pass-Through Entities, I’ve researched anumber of different cases, including Gross v. Commissioner, Estate ofAdams v. Commissioner, and many others. I’ve seen that those caseswhich relate to valuation dates prior to the 2003 change in tax law underPresident Bush all said that there should be no tax-affecting adjustment.

Subsequently, there was a 2007 case involving a 2004 valuation, whichsaid that there should be a valuation adjustment and an income taxadjustment for pass-through entities. That was Delaware MRI v. Kessler,and they presented a model, which when you apply that model both to the

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2004 case and to the pre-2003 cases came up with results that wereentirely consistent with the court decisions.

I use a modified version of that Delaware MRI model because theDelaware MRI model, although conceptually sound and entirely consistentwith all of the other cases, was based on the facts and the circumstancespresented to the court in that instance. So I’ve made some slightmodifications to that to incorporate other potential facts andcircumstances. That’s what I use.

SURRAN: Thanks, Eric. We’ll return to your commentary in a minute.

QUINLAN: Abraham Lincoln caused the pass-through entity, PTE, conundrum. Yes,that’s right. We can blame Honest Abe, who on October 3, 1862 signed theAct of 1862, the first law authorizing a U.S. income tax on individuals.The new law also provided for additional sales and excise taxes andintroduced the inheritance tax. In 1872, after the Civil War, the income taxwas eliminated even though it proved to be a substantial revenuegenerator. Then in 1913 the Sixteenth Amendment made the income tax apermanent source of revenue for the federal government.

During the period from 1913 to the present we have seen a wide range inthe federal individual tax rates in the maximum income bracket.Immediately following its inception, federal individual statutory tax ratesin the maximum income bracket soared during World War I, dipped duringthe Roaring Twenties, and then rose to new heights during the GreatDepression and World War II, peaking at 90 percent. Those rates wouldlater plummet by approximately 20 percent in the 1960s and then againunder President Reagan in the 1980s to a low of 28 percent.

Since 1990, federal statutory individual income tax rates in maximumincome brackets have ranged between 30 and 40 percent. Very profitablebusinesses with taxable income in the maximum statutory income bracketand operating as PTEs would be subject to these tax rates at the individualowner level. Alternatively businesses could operate as a C corporation andincur income taxes at the entity level.

Throughout the history of the Internal Revenue Code a pattern hasemerged, and that is the following. Congress passes tax laws, taxpayersinterpret these laws, the IRS then challenges taxpayer interpretations,taxpayers and the IRS then decipher court decisions and then Congressagain passes new laws.

Let’s return to Becky Surran and Eric Barr to learn more about theimplications of income taxes on business value.

SURRAN: OK, Eric. Let’s talk more about the implication of income taxes. Whatabout them? How do income taxes impact business value?

BARR: The business owner’s interested in what he can keep in his pocket at theend of the day, after tax. So the after-tax returns to the owner is reallywhat’s critical. It’s the primary value driver for most business owners.

So it’s important to consider the fact that income taxes are paid once withpass-through entities, paid twice with C corporations. It’s a primaryconsideration, or it should be a primary consideration, when valuingowner-managed companies.

SURRAN: Have changes in income tax laws and income tax rates impacted businessvalue and, if so, how?

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BARR: Well, Becky, I’ve been filing tax returns for a long time. I wouldn’t sayhow long you’ve been filing them for, but what I can say is that when taxrates change, the after-tax returns change.

When you have major tax law changes, it impacts the after-tax returns toowners and the value of a business entity.

Clearly, if you think about, years ago when for more than 40 years themaximum tax rate for individuals exceeded 90 percent, people forget, butthat’s where the rate was. It exceeded 90 percent for more than 40consecutive years. Now the maximum tax rate is less than 40 percent.

After-tax returns in those two scenarios, obviously, are vastly different.

When you take a look at the tax rates before 2003 and after, you can seethat it’s very different. Before 2003, dividend income was taxed nodifferently than ordinary income. So it was subject to maximumindividual income tax rates north of 35 percent.

With the George Bush tax cuts, the maximum rate was 15 percent. So youhad this substantial 20 plus percent decrease. That impacts after-taxreturns and impacts valuation adjustments.

SURRAN: Eric, what guidance can our viewers gain from the tax court and othercases addressing business valuation?

BARR: It’s really critical to understand the court’s thinking in all of the relevantcases. That’s much more important than what the ultimate decision wasbecause the facts and circumstances of a particular case may not apply toyou. But the thinking and the conceptual foundation that the court used toderive that conclusion will always apply.

So I think that when you look at cases like Gross v. Commissioner andDelaware MRI v. Kessler, it’s important to understand the court’sthinking. The thinking that they had in each case, what I pulled from it, isthat nobody’s going to pay more for a business than what the owner canput in his pocket.

Taxes do matter. Those are the two primary things.

SURRAN: Eric, let’s talk more about the examples of pass-through entity businessvaluation case law you mentioned. How do the court’s findings differ andhow are they similar?

BARR: With Gross v. Commissioner, which is the granddaddy of cases, and thatinvolved a valuation date in the mid-90s. This was before the Bush taxcuts. In that instance, dividend income of C corporations was taxed nodifferently than ordinary income. So it was a very high rate. Theeconomics of owning a pass-through versus a C corporation were verydifferent.

The tax costs of owning a C corporation was immense, much greater thanit was after the change in 2003. Because with the change in 2003, the taxon dividend income plummeted from a high- or mid-30s down to 15percent.

So the relative advantage of being a pass-through to a C corporation,instead of it being extremely sizable, was chopped almost in halfdepending on the level of taxable income that you’re dealing with. Sothat’s a major difference. That’s a factual inconsistency between the casesdecided with valuation dates before 2003 and after the change.

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SURRAN: Eric, earlier you talked about the Delaware MRI v. Kessler case. What isthe modified Delaware MRI model and how does it address the guidingprinciples contained in the cases that we just talked about?

BARR: Becky, we had talked about some other cases. In Delaware MRI v. Kessler,which is a fair value case decided by the Delaware Chancery, in itsreasoning, it cited Gross v. Commissioner and a host of other federalcases. Based on the fact that the income tax rates had changed and the taxon dividend income had changed, Delaware MRI came up with amethodology which effectively reverse engineered the income tax ratebased on the facts presented.

The modified Delaware MRI model, which is what I propose is theappropriate way to go about valuing pass-through entities in my book,takes that model and makes some very minor tweaks to take intoconsideration the possibility that there may be an entity-level tax.

Because we know that there are entity-level taxes on pass-through entitiesin New York City, for example, and other localities throughout the country.

And also takes into consideration the possibility that income might beretained in the business, either for growth or working capital needs, or fordebt service or for other reasons.

SURRAN: Is the modified Delaware MRI model used solely for the incomeapproach?

BARR: Yes, but the concepts contained in the modified Delaware MRI model alsoapply to the market approach where, under the market approach, thevaluation multiples from guideline public companies have two levels oftaxation. If the subject company only has one level of taxation, again,there has to be some adjustment that’s taken into consideration.

SURRAN: Is a fractional ownership interest in a pass-through entity equal to thevalue of the entire entity multiplied by the subject percentage interest?

BARR: Well, Becky, that really depends on facts and circumstances because ifyou’re dealing with a control interest then very possibly it does work outthat way. If you’re dealing with a non-controlling interest, that has specialrights, similar to what you might find with preferred stock where theremight be a preferential distributions or participation rights or rights ofconversion.

You might have a situation where that minority interest has a value that’sgreater than a pro rata share, but you also have situations, if you’re dealingwith a minority interest, where it’s worth less than a pro rata share becauseof discounts for lack of control or discounts for lack of marketability.

SURRAN: What suggestions do you have for accountants with regards to theseissues? What should they be doing?

BARR: Well, if a CPA doesn’t have the valuation talent in-house, they should seekto bring somebody in, a friendly business appraiser valuation consultantwho could, number one, protect the relationship with the client, but alsocomplete the service offering to the client.

You know, we’re dealing in a time where many small to midsizebusinesses don’t have access to capital. It’s becoming increasingly difficultfor many companies to sell their business as a result of a lack of capitalout there.

You have a Baby Boom generation that’s aging, so there will be many,many companies that will be up for sale in the not-too-distant future, and

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with a business ownership interest, you’re dealing in many instances withthe largest single asset that the business owner has.

So it’s critical to understand what that ownership interest is worth, whatactions enhance value, and how to package that company in a way thatdown the road it is more marketable and has more value. So it’s a criticalissue for CPAs.

SURRAN: Eric, what are the documentation issues involved with this process, thevaluation process?

BARR: It’s important to understand the historical results of the operations of acompany before one can estimate what the future cash flows will be. Now,as accountants we’re trained to look at financial statements and taxreturns, but in many owner-managed businesses, the reported numbersdon’t truly reflect the economic returns of the business.

There are many instances where an owner might be pulling out far morethan reasonable compensation, or less than reasonable compensation, orthere might be some non-recurring expenses that go through the business.

We’ve recently gone through several winters where in one year we had anice storm in October, and in another year we had a hurricane, anddepending on the business, you might have significant non-recurringevents.

The business appraiser has to be able to look at the numbers, pull out thenon-economic items, whether it’s owner purposes or other, pull out thenon-recurring items, storm damage and other non-recurring events, to seewhat the recurring cash flows are to the owner, and only then, based onthe true economic returns, can one come up with an accurate, reliable,understandable and defendable valuation conclusion.

SURRAN: How about the IRS? Is there a likelihood that the IRS will challenge aCPA’s valuation?

BARR: It’s important to understand that with the valuation in connection with agifting of an ownership interest, an estate tax return, an employeetransaction, or a related party transaction, that there’s a risk that the IRSwill examine.

And so it’s important to prepare your valuation under the assumption thatit will be challenged by the IRS and not cut corners.

If you cut corners, and then you have to defend it later on, it’s a veryawkward position. And that really brings up another point, which is thatthe accountant of record for a company, the accountant who prepares thefinancial statements or the tax returns is not the accountant who should bepreparing the valuation.

And here’s why. First of all, it creates an independence issue. If somebodyis preparing a valuation, under the accounting rules, that impairsindependence for the accountant who issues a reviewed financialstatement or an audited financial statement. And it also impacts thecredibility of the accountant if they have another income stream from thatclient, if it’s later challenged and one has to testify in court.

So accountants who are the accountant of record for a particular companyshould stay away from doing business valuations for that company.

SURRAN: Any other issues that our viewers should be aware of?

BARR: Yes, the area of business valuation is a highly controversial area. Whatmight be of value to one person may not have the same value tosomebody else. You know, I liken it to beauty in the eyes of the beholder.

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ript Well, value, like beauty, is in the eyes of the beholder.

The value to the holder of an ownership interest might be vastly differentthan the value to the buyer because the buyer may bring into play certainsynergies with their operations, the ability to eliminate certain costs, theopportunity to expand a product line, or a customer base, and derive muchmore value from that ownership interest than the seller. So the perspectiveof what is it that we’re valuing, and in the hands of which party, becomescritical. Those are standard of value issues.

And it’s also important to realize that the IRS is all over estate and gift taxvaluations, and be very careful about getting involved in preparing abusiness appraisal if you are unable to defend that appraisal in court.

SURRAN: Eric, we’ve covered a lot of ground today. If you could leave our viewerswith one final thought, what would that be?

BARR: Valuation is a discipline that is fairly new, unlike medicine, or law, with a100+ years of history, guidance, guidelines and standards. Our standardshave really only been around for 20 years as a formal profession. So it’ssomething that’s evolving, but with the evolution of the valuationstandards, what used to be very disparate findings, over time people arecoming closer and closer.

It’s important, if you get involved with the valuation practice, to reallyunderstand the case law and the standards because otherwise if you’reinvolved in providing these services without that foundation, you’re notdoing yourself a service, and you’re certainly not doing your client aservice.

SURRAN: Eric, a lot of great information. Thanks for being with us today.

BARR: It’s been my pleasure, Becky, thank you.