DISSECTING THE IRS JOB AID ON S CORPORATION TAX ......VALUATION STRATEGIES 15 Rather than providing useful new guidance on how to tax affect S corporation income, the Job Aid offers

14 VALUATION STRATEGIES

DISSECTING THE

IRS JOB AID ONS CORPORATION TAX-AFFECTING

RO B E RT J. G RO S S M A N

VALUATION STRATEGIES 15

Rather than providinguseful new guidance on how to tax affect

S corporation income, the Job Aid offers little more than acompendium of

information that isalready available.

These two new documents were pre-pared by representatives of the LargeBusiness and International DivisionNRC Industry, Engineering Program,and the Small Business/Self-EmployedDivision, Estate and Gift Tax Program.The first document, “Valuation of Non-Controlling Interests in Business Enti-t ies Elec t ing to be Treated as SCorporations for Federal Tax Purpos-es,”1 (hereafter, the Job Aid) is the sub-jec t of this ar t icle. The seconddocument, offering guidance on rea-sonable compensation issues,2 will beaddressed by the author in a futurearticle in this journal.

BackgroundThe October 29, 2014 release of thesedocuments is not the first time thatinternal agency documents have beenmade available to practitioners andtaxpayers outside the IRS in recentyears. The first occurrence was in thesummer of 2010, when a documenttitled “Discounts for Lack of Mar-ketability: Job Aid for IRS ValuationProfessionals”3 was first inadvertently“leaked” to the business valuation com-munity. On September 1, 2010, it wasofficially posted to the IRS website.4The two recently-released IRS docu-ments are also available on the Ser-vice’s website. 5

The release of this series of JobAids has been hailed by many as a

new era of communication and under-standing between the IRS, taxpayers,and practitioners. However, in theopinion of the present author and oth-ers, releasing these additional docu-ments in such a formal manner seemsto be an attempt to influence practi-tioner behaviors in specific practiceareas without statutory support. Thefront cover of each Job Aid specifi-cally notes: “not Official IRS Position”and “prepared for reference purposesonly.” Further, the cover qualifier ofeach Job Aid adds that “it may not beused or cited as authority for settingany legal position.” If one were toapproach the impact of the documentfrom the point of view of a tax pro-fessional, he or she might argue thatthe content of the documents is noth-ing more than a compendium ofinformation already available in thehistory of the two issues that theyrespectively address. As nothing isprecedential in these releases, the con-tent must be viewed with a cautiouseye and an understanding that whilethe Service may be instructing itsinternal team to follow the path of theinformation contained therein, thatinformation is in no way intended tobe a legal requirement, or even freeof taxpayer challenge as to technicalpropriety.

Perplexing Issue. The new Job Aidaddresses one of the most perplex-ing theoretical issues facing businessvaluation practitioners today. Essen-tially, the question is simply whetherit is appropriate to tax-affect eco-nomic benefit streams derived froman S corporation when valuing a non-

controlling equity interest in that cor-poration. In fact, the Executive Sum-mary notes:

With respect to the attribute ofpass-through taxation, absent acompelling showing that unrelatedparties dealing at arms-lengthwould reduce the projected cashflows by a hypothetical entity lev-el tax, no entity level tax shouldbe applied in determining the cashflows of an electing S Corporation.In the same vein, the personalincome taxes paid by the holder ofan interest in an electing S Cor-poration are not relevant in deter-mining the fair market value ofthat interest.

Lack of New Information. As was thecase with the earlier DLOM Job Aid,the new Job Aid contains little freshinformation. Predictably, the Service’sposition in the release is based pri-marily on a series of five key Tax Courtdecisions, dating back to 1999. In thatyear, the Tax Court first decided Gross,6a case that forever changed the land-scape for valuing equity ownershippositions in electing S corporations bydisallowing the tax-affecting of an eco-nomic benefit stream. The Tax Courtfollowed up Gross with four cases thatwill be discussed briefly below. Sufficeto say that, in general, each of thosecases served to attack traditional val-uation protocol of reducing expectedfuture economic benefit streams forthe economic effect of entity-levelincome taxes in the valuation of a non-controlling S corporation equity own-ership interest. As time has passed,several additional cases have piggy-

16 VALUATION STRATEGIES September/October 2015 S CORPORATIONS

ROBERT J. GROSSMAN, CPA/ABV, ASA, CVA, CBA,MST, is a partner in Grossman Yanak & Ford LLP,Pittsburgh, Pennsylvania. His practice includes thedevelopment and implementation of diverse strate-gies to enhance equity holder understanding of val-ue and how to manage, preserve, and grow value.

Once again, the business valuationcommunity has been made privyto internal Job Aids intendedprimarily for use by InternalRevenue Service valuation analysts.

backed on the general thinking of thecourt in the earlier decisions.

Overview of Grossand its ProgenySo that the origin of this issue can befully understood, it is necessary to pro-vide an overview of each of these val-uat ion decisions. Summaries arepresented below in the order in whichthe cases were decided by the Tax Court.

Gross. This consol idated caseinvolved a deficiency of gift tax for theyear 1992 with the common questionposed as to the value of certain sharesof corporate stock transferred by gift.The shares transferred represented giftsof small, minority interests of G & JPepsi-Cola Bottlers, Inc., an Ohio cor-poration that elected in 1982 to betaxed as an S corporation under theInternal Revenue Code.

The expert for the taxpayers arguedfor reduction of the earnings stream

of the S corporation by an assumedcorporate tax rate of 40%. The expertthen capitalized that earnings streamby a rate commensurate with equiva-lent Subchapter C corporations. Hethus felt that he had matched after-tax earnings with an after-tax capi-talization rate. The expert for thegovernment applied a similar thoughtprocess, with one critical distinction.He assumed that the corporate taxrate was 0% since he foresaw no rea-son to expect that the corporation’s Scorporation status would not contin-ue. Further, the expert dismissed thetaxation of the corporate earnings atthe shareholder level as irrelevant. Itis important to understand that thegovernment’s expert also used anafter-tax discount rate, arguing thatthe entity-level earnings had previ-ously been tax-affected by a rate of0%. Thus, he, too, argued that he wasproperly matching after tax earningswith an after-tax risk rate.

The court agreed with the govern-ment’s expert and disallowed the tax-affect ing of the earnings stream,thereby substantially increasing thevalue of the gifted shares. Note thatthere were several important (and dis-tinguishing) facts present in the casethat influenced the court’s decision,including the fact that the companydistributed far more cash flow (approx-imately 100%) than that necessary tofund the individual shareholders’ annu-al tax liabilities on the pass-throughincome. Thus, under the S corpora-tion tax regime, these excess amountswere found to essentially represent tax-free dividends. Additionally, an agree-ment restricting the transfer of the G& J shares by and among the membersof the Gross family group existed atthe date of the gifts, with express pro-visions restricting transfers that couldcompromise the company’s S corpo-ration status. Consequently, continuedmaintenance of the company’s S statuswas deemed by the court to be assured,thus preserving the associated tax ben-efits. These distinguishing facts werecritical in properly assessing the issuein this case and are repeated through-out the cases that followed and the nar-rative in the new Job Aid.

Wall. In this case,7 a dispute aroseover the value of nonvoting capitalstock transferred in January 1992 to anumber of trusts, with the taxpayers’children named as beneficiaries. Thetaxpayers and the Internal RevenueService each presented expert reportswith both experts using market-basedand income-based approaches to val-ue the shares.

Interestingly, both experts tax-affected the future cash flow projec-tions. The taxpayers’ expert used ahypothetical income tax rate of 34%,while the expert for the Service applieda rate of 40%. The case contains com-ments on the testimony of the tax-payers’ exper t regarding genera ldisagreement within the business val-uation community on the matter oftax-affecting. The opinion notes thatthose advocating tax-affecting arguethat the most likely buyers for an Scorporation may not meet the InternalRevenue Code qualification require-ments to maintain S corporation sta-tus and the S corporation benefit, if

VALUATION STRATEGIES 17S CORPORATIONS September/October 2015

any, would be lost. The opposing andcontrasting argument addressed in thecase is that the use of fully-tax-affect-ed cash flow streams discounted by anafter-tax rate of return attributes novalue whatsoever to the associated taxbenefits of S corporation status.

Ultimately, the opinion of the TaxCourt dismissed the tax-affecting byboth parties’ experts, citing the Grossdecision.

Heck. At issue in Heck8 was the val-uation of 630 shares (a 39.6% non-control l ing , nonmarketable Scorporation stock interest) in F. Korbeland Bros., Inc. (Korbel) at the date ofdeath of a decedent.

Both parties provided expert opin-ions to the Tax Court regarding thevaluation of the shares in question.They both used an income approach,while only the IRS’s expert used a mar-ket approach. The court rejected themarket approach and agreed that theincome approach, as well as the dis-counted cash flow method availablethereunder, was most appropriate.However, in making this statement, thecourt found fault with both experts’calculations. To overcome the perceivedcalculation problems, the court’s opin-ion noted that “it was deconstructingeach expert’s DCF analysis, and assem-bling our own.”

Neither expert in this case tax-affected the earnings of Korbel. Thecalculation prepared by the taxpay-ers[esq ] expert was based on the pre-tax earnings of Korbel that werediscounted by an after-tax weightedaverage cost of capital. Thus, the expertdid not tax-affect the cash flow stream.The expert for the Service used a sim-ilar discounted cash flow method andan after-tax weighted average cost ofcapital. Numerous differences withinthe details of applying the method-ologies were challenged and modifiedin the decision, with the court adopt-ing cer tain posit ions of eachexperts[esq ] calculation.

With respect to after-tax weightedaverage cost of capital, the court (asthe Wall court had done earlier) citedthe Gross decision. The estate’s expertadded 10% to his 25% discount forlack of marketability (for a total dis-count of 35%) to account for a right offirst refusal to which the shares were

subject, and disadvantages of the dece-dent’s shares representing a minorityinterest, which he referred to as “agencyproblems.” Alternatively, the govern-ment’s expert determined that a 15%discount for “liquidity” was appropri-ate, as well as a 10% S corporation dis-count. The S corporation discount wasintended to compensate for risk asso-ciated with the uncertainty that the Scorporation would distribute sufficientcash flows to meet the shareholders’tax liabilities arising from the pass-through of the corporate income, andwhether Korbel’s S corporation statuscould be maintained throughout ahypothetical sale. He also included a25% discount for lack of marketabili-ty.

The court decision notes that theexpert for the Service seems to viewthe S corporation status as a benefitbut “fail[s] to quantify the relevantadvantages and disadvantages.” In theend, the court adopted the estate’sexpert’s findings and approach andapplied a 35% discount for lack of mar-ketability to the entire business oper-ating value, plus all nonoperatingassets. In effect, all operating and non-operating assets of the company werediscounted by this amount.

Adams. Adams9 is an estate tax casewherein valuation of an S corpora-tion ownership interest was, again, atthe center of the dispute. In this case,the expert for the estate used theincome approach and the capitaliza-tion of cash flows method allowablethereunder. Instead of electing to tax-affect the S corporation earnings inthis case, the expert developed anafter-tax discount rate using the build-up model (BUM) and then convertedthe derivative capitalization rate to apre-tax capitalization rate.

The expert’s assumption in con-verting the capitalization rate to pre-tax was that the S corporation earnings

of the subject company were also pre-tax and, by making the conversion, hewas properly matching the capitaliza-tion rate with the before-tax prospec-t ive earnings st reams. The cour tdisapproved of the treatment adoptedby the estate’s valuator and, althoughthe court acknowledged the estate’sexpert as being “more thorough,” itdeemed the methodology employedby the expert to be in error. CitingGross once more, the court reasonedthat the S corporation earnings streamhad been tax-affected at the corporatelevel and, in fact, the rate at which theearnings stream had been tax-affectedis zero. Thus, use of a pre-tax capital-ization rate, under this analysis andopinion, results in a mismatch of a pre-tax rate against after-tax earnings.

A significant fact distinguishingAdams from the earlier cases is that


1 Job Aid for IRS Valuation Analysts, “Valuationof Non-Controll ing Interests in BusinessEntities Electing to be Treated as SCorporations for Federal Tax Purposes,”10/29/2014.

2 Job Aid for IRS Valuation Professionals,“Reasonable Compensation,” 10/29/2014.

3 Job Aid for IRS Valuation Professionals,“Discount for Lack of Marketabilty,” 9/25/2009.

4 Available at http://www.irs.gov/pub/irs-utl/dlom.pdf.

5 See http://www.irs.gov/Businesses/Valuation-of-Assets.

6 TCM 1999-254, aff’d 272 F.3d 333, 88 AFTR2d2001-6858 (CA-6, 2001).

7 TCM 2001-75. 8 TCM 2002-34. 9 TCM 2002-80. 10 TCM 2006-212. 11 TCM 2011-148. 12 114 AFTR2d 2014-6848 (CA-9, 2014).

the equity ownership interest undervaluation was a 61.6% controlling,nonmarketable interest. It is the onlycase in this series of decisions thatincludes this distinguishing feature.

Dallas. This decision10 was renderedafter an extended four-year break inthe issuance of new Tax Court casesaddressing the S corporation tax-affecting issue. Dallas is a gift tax casein which many of the key facts, as wellas the court’s final finding, parallelthose set forth in the Gross decision.

Among a number of complex issuesassociated with the determination ofvalue of the subject equity ownershipinterests, the issue of tax-affecting rep-resented a major hurdle for the tax-payer. The taxpayer provided expertreports from two appraisers, both ofwhom tax-affected the earnings of thesubject company in determining value.The first expert used an income taxrate of 40%, while the second used arate of 35%. The fundamental preceptargued in the case was that the corpo-ration would lose its S corporation sta-tus after a hypothetical sale of thecompany’s stock. In addit ion, theexperts argued that the facts in Dallaswere distinguishable from Gross in thatcash distributions in the attendant case

were specifically tied to income taxesdue from shareholders as a result ofthe pass-through income, whereas, inGross, almost all of the earnings weredistributed annually.

The court rejected both arguments.First, it ruled that there was no evi-dence presented to suggest that thecompany would have expected to loseits status as an S corporation at anypoint. Second, the opinion noted thatthe company had a long history of dis-tributing sufficient cash to meet allattendant tax obligations, and therewas no evidence presented that wouldsuggest that the practice would end.

Finding the taxpayer’s exper ts“unpersuasive,” and noting that “therewas insufficient evidence that thehypothetical parties would tax-affectthe S corp earnings,” the court ruledthat tax-affecting the company’s earn-ings was not appropriate.

Common Thread. Several more-recentfederal court cases, including Gallagher,11

and Giustina,12 have resulted in a disal-lowance of tax-affecting, but the foun-dational blocks for the current positionof the Internal Revenue Service can beeasily identified in the five early casesdiscussed above. A critical commonthread in all of the cases (except Adams)

is that the equity ownership interestsunder valuation are noncontrolling. Thisis an exceedingly important distinction,in that the hypothetical buyer for a non-controlling interest in an S corporationis likely to be vastly different than thehypothetical buyer for a controllinginterest. This basic precept appears toserve as the basis for the new Job Aiddeveloped by the Service. Little men-tion is made of controlling interests init and since “non-controlling” is part ofthe new Job Aid’s title, it seems fair toassume that the information containedtherein may not be relevant or applica-ble to the valuation of controlling inter-ests in S corporations.

Analysis by SectionThe Job Aid is partitioned into fourprimary sections: • Executive Summary. • Discussion and Analysis. • Assessment and Synthesis. • Appendices. It is interesting that the document

numbers only 32 pages, while literallythousands of pages have been dedicat-ed to this topic over the last 15-plusyears. The Job Aid[esq]s first section,the Executive Summary, addresses thefundamental tax law framework con-tained in Subchapter S of the Code,which dictates the qualification require-ments for obtaining S corporation sta-tus. The presentation is basic andwithout explanation, simply listing themost common statutory requirements.

It is noteworthy that from this briefoverview of the statutory rules, the JobAid leaps to a broad and, generallycloudy conclusion that:

The Valuation Analyst should payspecific attention to the risks atten-dant in a non-controlling interest inan electing S Corporation and howthese risks are most properly rec-ognized. Adjustments to the costof capital and the minority andmarketability discounts may or maynot be appropriate based on thespecific facts and circumstances.

Discussion and Analysis Section Thesecond section of the Job Aid sets outa brief introduction, followed by sixseparate subsections addressing thefollowing items: • Identification of Property to be Valued.


Releasing thesedocuments seems to be an attempt to

influence practitionerbehaviors withoutstatutory support.

• Valuation—Background andApproach.

• Additional Factors for Consideration. • Evidence-Based Valuation Analysis. • Theory-Based Valuation Analysis. • Weighting of Factors and Approaches. After reintroducing readers to the

Gross decision, the Introduction sim-ply provides the process by which theJob Aid was developed and sets up thebalance of the document. The first sub-stantive topic of this section, The Iden-tification of the Property to be Valued,sets out the obvious, and accurate, state-ment, “In any valuation engagement,the threshold question is the identifi-cation of the property to be valued.”

The primary content of the balanceof that section topic addresses taxitems related to classification of enti-t ies as S corporat ions for federalincome tax purposes and the “check-the-box” regulations, including a veryminimal discussion of Treasury Reg-ulations 301.7701-1 through 301.7701-3, governing ent ity classif icat ionselection. While the issue of entityclassification can be quite complex(and presents tax practitioners withsignificant challenges), the Job Aid,itself, does not provide ample guid-ance to gain this understanding. Thedocument does, however, point outthat, “Valuation Analysts should famil-iarize themselves with the pertinentState and local laws, including tax laws,applicable to the specific business enti-ty to be valued.” Again, this statement,while logical and conveying commonsense, does not really provide anyadditional technical guidance to prac-titioners or taxpayers.

The section concludes with anoth-er broad statement that:

The suggestion by some commen-tators that a Valuation Analyst mustapply, as a matter of conventionalpractice, a valuation paradigmbased on taxable corporations (Ccorporations) to entities that donot pay tax ignores a major factu-al component, that the entity beingvalued has chosen its form, includ-ing its pass-through tax status, forbusiness reasons.

Importantly, the Job Aid furthernotes, “If a valuation is to be persua-sive, it must be based on the actualattributes of the interest being valued.

Accordingly, pass-through entitiesshould be, where at all possible, com-pared to other pass-through entitiesin the valuation process.”

While the statement is accurate,there are a number of difficulties inapplying the concept in the real worldof business valuation. There is rarelysufficient economic, financial, andother information within currentavailable resources to facilitate a directone-on-one comparison with anyaspect of the valuation process. Thatbeing said, it becomes incumbent onthe valuator under professional stan-dards to attempt to research and iden-tify credible sources of informationthat allow for meaningful applicationto the subject company under valua-tion. Oftentimes, as is well known,this information is imperfect andrequires both mechanical and judg-mental modification and adjustmentto reflect the subject company’s attrib-utes. Collecting collaborative data onS corporations, costs of capital specificto those entities, and specific pricingmandates and valuation multiples islikely to be difficult, at best, and pos-sibly a fruitless effort, given current-ly available resources. Though somestudies have started to be published,little credible and widely-accepted evi-dence exists at this time. This limita-t ion dr ives the need to look atafter-tax data more commonly avail-able to the business valuation com-munity.

Background Section. The next sub-section, titled, Valuation—Backgroundand Approach provides some generaldiscussion on Rev. Rul. 59-60.13

Additional Factors Section. TheAdditional Factors for Considerationsubsection discusses the availability ofpublic market data published by Ibbot-son Associates (Morningstar, Inc.),14

and the fact that the information gath-ered by Ibbotson “reflects entity-leveltax in the calculation of reported rates-of-return.” The discussion goes on topoint out, “some commentators havesuggested that if the Ibbotson rates-of-return are to be used in a presentvalue calculat ion of the earningsstream…of an electing S Corporation,the S Corporation earnings streamshould be reduced to reflect an imput-ed C Corporation tax liability.”

The Job Aid offers no commentaryor resolution to this observation. Itsimply notes that:

It is far from clear that the buyersand sellers of interests in electingS Corporations actually analyzetheir investments in this manner. Asignificant feature of the S Corpo-ration election is to eliminate thepayment of tax at the entity level.This is an important economicattribute that must be recognizedin the valuation of an interest inan electing S Corporation.

An economic reality of any elect-ing S corporation is the expectationthat the company will, ultimately, dis-tribute sufficient cash flow necessary toprovide investing shareholders withthe means to pay the required federaland state income taxes on the corpo-ration’s income. If such were not thecase, the investors would require a sig-nificantly higher rate of return to allowfor the satisfaction of those corporateliabilities passed-through to the share-holder group. Moreover, the provisionof these monies to shareholders to fundthe shareholder-level tax liabilities aris-ing from the reporting of corporationincome at the shareholder levelacknowledges the lack of availabilityfor the funds for other uses within thecorporate operating entity. Thus, theeconomic effect is to force the S cor-poration to distribute cash to pay tax-es on its income.

A second common theory set outin this section notes that some havesuggested “in the context of a pass-through entity the definition of entity-level tax should include all of the taxassociated with the entity’s operations.”The Job Aid concludes that this sug-gestion redefines the valuation stan-dard and moves it from fair marketvalue to investment value while comin-gling entity-level and investor-level


13 1959-1 CB 237. 14 The Morningstar data originally reported byIbbotson & Associates was discontinued and isnow available through Duff & Phelps.

15 Guenther and Sansing, “The Effect of Tax-Exempt Investors and Risk on StockOwnership and the Dividend Tax Penalty,”(Kellogg School of Management atNorthwestern University, October 2007).

16 Dhaliwal, Krull, Li, and Moser, “Dividend Taxesand Implied Cost of Equity Capital,” 43 J. ofAccounting Research 675 (December 2005).

taxes. The discussion sets out a num-ber of difficulties that might arise invaluator selection of an appropriateindividual income tax rate.

Thirdly, this subsection of the JobAid notes that while some have sug-gested that the identity of the personwho pays the tax is not relevant to thevaluation problem, this propositionoverlooks the fact that tax structuresand rates differ between corporate andindividual taxpayers in ways too greatto render them irrelevant.

There is nothing new in the abovethree points, issues with which valua-tors have struggled mightily since theopinion in Gross was first rendered. Itis noteworthy, however, that while theJob Aid does a competent job of iden-tifying many of the difficult problems,it offers its employees no guidance onhow best to deal with those issues inthe context of an examination of val-ue. This failure to include any mean-ingful new guidance or theoreticalapproaches to dealing with these com-plexities renders the Job Aid somewhatless than useful in aiding either theService’s employees or the business val-uation community.

The Job Aid does minimally speakof “control interests” in this section,setting out the opinion by some thatwhere these interests are involved, thereis no difference between electing SCorporations and publicly-traded CCorporations. It notes that this positionoverlooks “important valuation factorsthat are influenced by the public mar-ketplace” and lists some of these fac-tors. The commentary seems to havemissed the point, as few valuators com-plying with professional standardswould use publicly-traded guidelineinformation (under an income or mar-ket approach) without making appro-priate adjustments in consideration offactors such as those listed in the JobAid. The argument against the asser-tion that controlling interest valuationsof S corporations versus C corpora-tions are similar is in the definition offair market value and the fact thatmany potential buyers in the hypo-thetical universe of buyers would notqualify as S corporation shareholdersunder the Internal Revenue Code.

Another matter addressed in thissection of the Job Aid points out an

additional issue regarding the Ibbot-son data. Since that data is after enti-ty-level tax, but before shareholder(investor)-level tax, consideration ofshareholder-level taxes in the valua-tion of S corporation ownership inter-ests represents a “mismatch” and afundamental error in the valuation ofthese interests.

In fact, though not yet argued beforethe Tax Court, studies have shown thatthe effect of shareholder taxes on CCorporation dividends and gains doeshave a market impact on rates of returnset out in the Ibbotson data. Exampleof such studies include work by DavidA. Guenther and Richard Sansing,15 aswell as by Dan Dhaliwal, Linda Krull,Oliver Zhen Li, and William Moser.16

An excellent discussion of these stud-ies and the application of the researchto cost of capital in determining thevalue of equity ownership interest in Scorporations can be found in the book,Taxes and Value, authored by Nancy J.Fannon and Keith F. Sellers.17 Thistreatise was published after the releaseof the Job Aid, and the studies notedabove are not referenced in the Ser-vice’s document.

The Additional Factors for Consid-eration subsection goes on to addressthe importance of shareholder agree-ments in valuing noncontrolling equi-ty ownership interests in electing S

corporations, noting that, “perhaps thetwo most significant investor concernsare the distribution policy…and thedifferential tax rates that might existbetween the corporate level and theshareholder level.” While this infor-mation is well-known to informedpractitioners within the business val-uation community, it is good to knowthat the Service is in agreement withcurrent thinking within that commu-nity with regard to distribution poli-cies. In addition to other provisionswithin any shareholder agreement,obviously, distributions, or lack of dis-tributions, can have an impact on thevaluation of these equity interests.

With respect to appropriate taxrates, this section addresses varyingcircumstances that might call for anapplied rate different from the maxi-mum statutory, and marginal rate.Again, the issue has been framed forsome time in the business valuationcommunity but specific guidance for ameans to calculate the “correct” taxrate does not exist, and the Job Aidprovides no further clarification onthis issue.

Hypothetical Buyers and Sellers.

Perhaps the most interesting elementin the Additional Factors for Consid-eration subsection is the commentaryon “The Universe of HypotheticalBuyers” and “The Hypothetical Seller.”


As nothing isprecedential, the content must be viewed with a cautious eye.

Both concepts are, of course, integralto understanding the fair market val-ue standard of value and both requirecare and study by valuation analysts.With respect to the former, the JobAid notes that it is essential to care-fully study the buyer universe as “theidentity of the available hypotheticalbuyer for a given interest…will deter-mine many things about the natureof the transfer, including the Federaltax status of the transferred interest.”Interestingly, the commentary notesthat “Valuation theory tells us that, ifa mixed universe of potential buyersexists, it is the buyer that does notsuffer entity level taxation that willdrive the ultimate transaction price, allother things being equal.”

Therein lies the rub—“all otherthings being equal.” Most transactionpractitioners would note that while thebuyer would obviously prefer tax-freestatus at the entity level, there are manyinfluences on acquisition entity struc-ture in any business purchase. To sug-gest that the buyer that does not sufferentity level taxation will drive the ulti-mate transaction price is to signifi-cantly simplify the consideration ofthe hypothetical buyer.

The discussion in this section goeson to address the need to include, with-in the hypothetical pool, buyers able toqualify as pass-through entities. Again,

this conceptual s tatement seemsexceedingly clear, but there is a lack ofguidance on how best to ensure thatthe pool includes all hypothetical buy-ers. The Job Aid adds no clarity to thatdetermination process. The importanceof specific provisions within a share-holder’s agreement that restrict trans-ferability of shares are discussed in thissubsection, as well. These restrictionslimit buyers to those that allow for pro-tection of the S Corporation’s tax sta-tus by prohibit ing t ransfers tononqualified holders and providingrights of first refusal. Most often, theseprovisions affect noncontrolling equi-ty interests. Both the distribution dis-cussion and the commentary regardingtransfer restrictions follow the case lawfirst set out in Gross and followed inother cases. Though it is now formal-ized in the Job Aid, the informationpresented is well-known and simplyreflects current common practice inthe business valuation arena.

This section also includes a briefdiscussion of “The Hypothetical Sell-er.” The salient point made here is thatthe hypothetical seller is an integralelement of the definition of fair mar-ket value – a point no one disputes.The document states that given apotential hypothetical buyer who isable to benefit from S corporation sta-tus and, therefore, pay a higher price,

the hypothetical sel ler would notchoose a buyer subject to entity-lev-el tax and an inability to pay the high-er price. Once again, the Job Aidoversimplifies the issue. It is impossi-ble to argue against such thinking ina vacuum, but it is more likely thatany number of differences in buyersand transactions could influence val-ue and not just tax status, though thatitem could, and does, impact value,as well.

Finally, a short discussion in thissection centers on “The HypotheticalSale,” reiterating the concepts notedabove, and ending with a quote fromthe Tax Court opinion in Mueller:18

Although we have, in prior opin-ions, identified types of hypothet-ical buyers, we did so only todetermine which va luat ionapproach, among several reason-able approaches, would result inthe highest bid, and therefore theone most acceptable to a willingseller… The question is not somuch ‘who’, but ‘how’.

The point of inserting this quota-tion seems to be the instruction toInternal Revenue Service personnelthat focus should turn to hypotheti-cal parties and transactions that willresult in the highest bid, thus first sat-isfying the primary motivations of thehypothetical seller. Again, the prob-lem is noted without any solutionsbeing offered. In addition, there issome question in the minds of manyin the business valuation communityas to whether the hypothetical saleshould be accomplished via the out-come with highest probability, allthings considered, or, alternatively, atthe highest bid.

The subsection titled “Identifyingthe Most Important Factors,” is fairlyself-explanatory. Essentially just acatch-all with little explanation, it iden-tifies factors that specifically affect the


The authorswithin the IRSare standing

behind case law.

17 Fannon and Sellers, Taxes and Value: The OngoingResearch and Analysis Relating to the SCorporation Valuation Puzzle (Business ValuationResources, 2015), page 53.

18 TCM 1992-284. 19 Erickson, and Wang, “Tax Benefits as a Sourceof Merger Premiums in Acquisitions of PrivateCorporations,” 82 Accounting Review 359 (2007).

20 Denis and Sarin, “Taxes and the Relative Valuationof S Corporations and C Corporations,” 12 J. ofApplied Finance 7 (Fall/Winter 2002).

valuation of noncontrolling interestsin an electing S Corporation and “may”deserve special attention. The listincludes cost of capital, marketabilitydiscounts, the entity’s ability to raiseboth debt and capital, a potentiallysmaller pool of hypothetical investors(due to S corporation shareholderqualification rules), and the effect ofinvestor-level taxes. There is no ques-tion that each of these items can, anddo, impact value conclusions.

The balance of the Discussion andAnalysis Sect ion of the Job Aidaddresses Evidence-Based ValuationAnalysis , Theory-Based ValuationAnalysis, and Weighting of Factors andApproaches. The Evidence-Based Val-uation Analysis section is bifurcatedinto “A View from the Tax Court” and“A View from Academia,” noting that“the weight to be accorded to theseanalyses will depend upon the validi-ty of their reasoning and the thor-oughness of the data considered.” Thecourt section simply follows the lineof cases previously discussed in thisarticle. The entire listing of relevantopinions is set out in Appendix B to theJob Aid.

It is clear throughout the entire JobAid that the authors within the Inter-nal Revenue Service are standingbehind the case law as the primaryguiding element of their challenges totax-affecting S corporation earnings.Much of what is written within the JobAid, and which has been addressedwithin this article, is simply a reitera-tion of the relevant court decisions.However, valuators would be wise totake these case outcomes with a grainof salt—understanding, as always, thatvaluation is a question of fact. Whilethe cases are insightful, there is muchdiscussion and commentary on therationale behind a number of thosedecisions.

View from Academia. In the “Viewfrom Academia” section, the Job Aidcites just one primary analysis data-based study as academic evidence thatdeserves consideration in the courseof valuing noncontrolling interests inS corporations. The study, authored byMerle E. Erickson and Shiing-wuWang19 concludes that controllinginterests in S corporations are morevaluable than similar interests in equiv-

alent C corporations in a range of 10%to 20% of value. The Job Aid discuss-es this study at length in Appendix Cand notes that the importance of thestudy is not in the conclusion but,rather, in the methodology of theanalysis. An earlier analysis and studyof this issue is also referenced in a foot-note20 but is not discussed.

The Theory-Based Valuation Analy-sis section of the Job Aid addresses, ina very general sense, the theoreticalmodels presented to the business val-uation community since the Gross deci-sion. While not named, it is assumedthat the models referenced includethose advanced by Treharne, Van Vleet,Fannon, Grabowski, etc. The work putforth by these efforts has moved theprofession forward in a major way onthis issue but are essentially dismissedwithin the Job Aid due to the fact thatthe models “have not been testedagainst market evidence to gauge theirreasonableness or accuracy in a realworld context.”

The mechanica l nature of themodels is not based in theoreticalconcepts necessarily requiring marketconfirmation, as noted in the Job Aid.The models al l seem to generallyfunction to quantify the economicbenefits accorded an investor in an Scorporat ion established by f ixedstatutory law. If one is arguing thatthere is an economic benefit accord-ed a federal income tax structure, oneshould only need to go to guiding taxlaw, as enacted by Congress, to under-stand the mechanics of quantifyingthose effects.

In the Weighting of Factors andApproaches section, the Job Aid setsout a number of specific considera-tions and the process by which therelat ive impor tance of each isaddressed within any specific valua-tion. It reverts to Section 7 of Rev.Rul. 59-60, which basically notes that“there is no means whereby the vari-ous applicable factors in a particularcase can be assigned mathematicalweights in deriving fair market val-ue.” This section of the Job Aid leavesreaders with a feeling of dissatisfac-tion, simply suggesting that all of theavailable information must be con-sidered and synthesized using pro-fessional judgment based on expertise

and experience to arrive at a defensi-ble result. The document further noteswhat is a very well known fact, “Thisis not an easy task…”

Assessment and Synthesis. This sec-tion of the Job Aid provides two exam-ples, reinforcing the informationdiscussed earlier throughout the doc-ument, as well as a general summary,again deferring to Rev. Rul. 59-60. Thesummary also lists some additionalspecific factors that should always beconsidered in conjunction with meet-ing professional valuation standards.

Appendices. The final section con-sists of the three appendices noted ear-lier: • Rev. Rul. 59-60. • A View from the U.S. Tax Court. • A View from the Academic Com-munity.

Concluding ThoughtsMore than a decade and half haspassed since the Tax Court’s decisionin Gross first brought the tax-affectingissue to the forefront in the profession.It is unfortunate that it has taken thislong to gain some insight into the Ser-vice’s thinking on this matter. Moreunfortunate, however, especially if itwas intended to serve as guidance, isthat the information contained in theJob Aid offers little more than thatwhich could be easily gleaned from acareful reading of the case law. It isclear that practitioners choosing totax-affect earnings of S corporations inthe valuation of noncontrolling equi-ty interests have an uphill strugglebefore them, should the tax-affectingbe challenged by the IRS. As illustrat-ed in the Job Aid, the Service appearspoised to stand on the foundation pro-vided by the relevant cases.

Practitioners and taxpayers can-not dismiss out of hand the informa-tion set out in the Job Aid. At thesame time, it is critical that readers ofthat document clearly understand thatthe information set forth therein isnot legal statute or any specific guid-ance that is required of valuators, orwhich might be relevant to the iden-tification and quantification of thebenefits associated with holding anon-controlling interest in an electingS corporation. �


Documents

DISSECTING THE IRS JOB AID ON S CORPORATION TAX ......VALUATION STRATEGIES 15 Rather than providing useful new guidance on how to tax affect S corporation income, the Job Aid offers