Impact of Income Taxes on S Stock Valuation

On Nov. 19, 2001, a split Sixth Circuit upheld a Tax Court decision that shareholders must value their S stock without tax affecting the S corporation's income (Gross Jr., 272 F3d 222 (2001), aff'g TC Memo 1999-254).

The petitioners in Gross controlled a closely held S corporation and gifted its stock to their children. The value of the gifts was based on a valuation done by an expert business appraiser. He used a weighted average of several different methods, with heavy emphasis on the discounted cashflow method to determine the stock's fair market value (FMV). The IRS expert appraiser also used the discounted cashflow method, but determined the gifts' FMV to be almost twice the value reported by the taxpayer.

The discounted cashflow method projects future cashflows and applies a discount rate to adjust for risk and the time value of money. The issue was whether it was appropriate to reduce the company's projected future cashflows by the projected shareholder-level income taxes on the S income. (Both parties had applied a lack-of-marketability discount, albeit at slightly different rates.)

The taxpayers had substantial support for their contention. They had made previous gifts valued with a tax effect and the IRS had approved them (presumably in a prior audit). Moreover, two internal Service documents (The Valuation Guide for Income, Estate and Gift Taxes and The Examination Technique Handbook for Estate Tax Examiners) each allow an adjustment for tax-affecting the valuation of S stock, and the Tax Court had permitted this in two earlier decisions; see Maris, TC Memo 1980-444, and Hall, TC Memo 1975-141.

Nonetheless, the Tax Court found (and the Court of Appeals confirmed) that the taxpayers' cashflow was unimpeded by any tax before reaching them and, therefore, should be fully recognized in the valuation process. The court stated "the principal benefit...from an S corporation election is a reduction in the total tax burden...The owners expect to save money, and we see no reason why the savings ought to be ignored as a matter of course in valuing the S corporation."

S shareholders are free to continue tax-affecting the valuations of their shares with the hope of achieving a different result in another circuit. (There was a strong dissent in Gross.) They may also be able to distinguish the facts of their situation from those in Gross, in which the longstanding practice had been to distribute virtually all corporate earnings on a current basis. This made the amount of future cashflow more highly predictable than would normally be the case. Finally, it is possible that a valuation method employing capitalization of tax-affected earnings per-share, rather than tax-affected cashflow, will more likely receive approval.

From Vinu Satchit, CPA, High Point, NC