Buy-Sell Agreements Process-Busting Valuation Issues (Part 2 of 4)

(Excerpted from Chapter 20 of the book Buy-Sell Agreements for Closely Held and Family Business Owners)

Tax-Affecting Earnings in Tax Pass-Through Entities

Some appraisers believe S corporations are inherently more valuable than C corporations. They say, in effect, that since there is no corporate-level tax on earnings, the earnings should not be tax-affected for valuation purposes.

Other appraisers, like me, believe S corporations should be valued as if they were C corporations. Earnings (and those of other tax pass-through entities) should, therefore, be taxed at full corporate rates prior to capitalization in the valuation process.

The issue arises because there is a real economic benefit to being a tax pass-through entity relative to being a C corporation, and particularly if there are regular distributions of earnings. For purposes of this oversimplified discussion, assume that the federal corporate and individual tax rates are each 40%, and there are no state taxes. Assume also that before any taxes are paid, a C corporation and an otherwise identical S corporation earn $100 per year.

  • The C corporation must pay $40 in federal income taxes, leaving $60 in the corporation to either distribute or to retain to support growth.
  • The S corporation must pay no federal income taxes. However, the $100 of income is “passed through” to its owners, who in turn must pay their personal taxes on that income. In our example and in real life, the great majority of the time, the S corporation will write checks to its owners in an amount totaling $40 to pay their taxes. This leaves $60 in the corporation to either distribute or to retain to support growth.

The C corporation and S corporation are each left with $60 of retained earnings after writing checks to the IRS and the shareholders, respectively. It is, therefore, my opinion that there is no divergence of value between S and C corporations at the level of the enterprise. The benefit of the S corporation lies in its effect at the shareholder level.

The difference between C and S corporations arises when distributions are made by the C corporation or distributions in excess of those necessary to pay taxes are made by the S corporation.

  • If the C corporation pays a dividend of, say, the $60 of after-tax earnings, its shareholders will pay a tax on dividends of, let’s assume 20%. The tax paid by the individual stockholders, therefore, totals $12, and they have an after-tax benefit of $48.
  • If the S corporation distributes its $60 of after-tax earnings, its shareholders will pay no more taxes, and the after-tax benefit is therefore $60.

Since $60 (S) is greater than $48 (C), one argument suggests S corporations are worth more than C corporations. Another argument suggests that since S corporations pay no federal income taxes, they are worth more than C corporations. Both arguments are wrong. Once again, I have written about this issue, and you may want your advisors to take a look at the references. (Business Valuation: An Integrated Theory, Z. Christopher Mercer and Travis W. Harms (Wiley & Sons, 2007))

My recommendation is that if your business is housed in a tax pass-through entity, your buy-sell agreement should state that it is to be valued as if it were a C corporation. Here is why, using the example above. Assume that the appropriate multiple for valuation purposes is 10 times the after-tax earnings for the C corporation:

  • The C corporation is valued at $600 (i.e., 10 times after-tax earnings of $60). The shareholders get a 10% “earnings yield” on their investment at this valuation.
  • If the S corporation is also valued as if it were a C corporation, its value is also $600 (i.e., 10 times the after-tax earnings of $60), and its shareholders also get a 10% “earnings yield.”

Now consider the alternative argument. If the S corporation is valued at 10 times after federal tax ($0) earnings of $100, then its value is $1,000, and not $600. If you happen to be a seller under your buy-sell agreement, you would get your share of $1,000. You would be happy, because you would get a lot more money than your share of $600 would represent.

The remaining owners might not be so happy. They still have to pay taxes of $40, so the S corporation has only $60 left. Their “earnings yield” is only 6%, which is a lot less than the expected 10% in the example.

If you know you will always be the seller – and you had better be the first seller – then perhaps you would want your S corporation valued without tax-affecting earnings. I say you had better be the first seller because if you were not, everyone else would figure out your game and it wouldn’t work anymore. And, you would lose by overpaying to the first seller.

Again, my recommendation is that your buy-sell agreement should make it clear to future appraisers that your company is to be valued as if it were a C corporation. My company is an S corporation that has an employee stock ownership plan. I sold some of my stock to it a few years ago. Our appraisal was prepared as if we were a C corporation, as are the recurring annual appraisals that form the basis for our buy-sell agreement. Need I say more?

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