A much-debated issue in the valuation community is tax affecting the earnings of a pass-through entity (PTE), and there is no definitive answer. The tax-affecting issue has been argued in a number of Tax Court cases (most notably the Gross case). In all of these cases, the IRS and the Tax Court have refuted the notion that shareholder-level taxes affect a firm’s value, so the valuation conclusions in these cases were based on earnings not being tax affected. The valuation community disagrees, so a number of models were developed that are designed to reflect the impact of shareholder taxes on value.
Subchapter S corporations, partnerships, LLCs and other entities are not subject to federal income tax. They are known as pass-through entities in that income passes through them to be taxed at the personal level. When using a market approach to value a Subchapter S corporation, a partnership, or some other entity not taxed as a C corporation, valuation analysts do not restrict selection of guideline companies to only other pass-through entities. Similarly, when using an income approach to valuing pass-through entities, analysts use market data (usually not pass-through entities) for cost of capital rates.
For the first time, it has been revealed that the Van Vleet model (S corporation economic adjustment model or “SEAM”) is being used in a U.S. Tax Court case. What’s more, both the IRS and the taxpayer are using it in this case. The case is Cecil et al. v. Commissioner of Internal Revenue, and it involves a gift of shares in the Biltmore Co., which operates the famous Biltmore estate, a Gilded Age mansion built by the Vanderbilts that is now a tourist attraction. The Cecils (descendants of the Vanderbilts) valued the stock gift at $20.88 million, but the IRS said those shares are actually worth $95.29 million. The valuation difference is due to the Cecils’ use of goingconcern value while the IRS says a liquidation value makes more sense. While details of the case and specifics on the valuations have not been disclosed because the case is ongoing, we will continue to report updates on what could be a landmark case.