Where does this increase in value come from the view of the IRS? It comes from the fact that an S-Corporation is not directly liable for corporate income tax on their earnings, whereas a C-Corporation is. According to the IRS, the absence of this corporate-level tax results in a higher level of earnings which in turn results in a higher value to the company.
Does the absence of corporate-level income tax mean the earnings are not taxed? Of course not. We all know the IRS would not permit earnings to exist in a for-profit company without being taxed. In an S-Corporation, the earnings are taxed, but instead of the corporation paying the tax, the individual shareholders pay it.
For many years, there has been a general consensus among business appraisers that before calculating the value of the company, the earnings of an S-Corporation should be tax affected (reduced for corporate income taxes). Tax affecting the earnings would result in the same value for the S-Corporation as an identical C-Corporation. Many business appraisers would adjust the discount for lack of marketability to account for the ability of an S-Corporation to make distributions to its shareholders—which, as dividend income, are not subject to tax. The adjustment would be dependent on the level of distributions expected to be made and may or may not result in a higher value for the S-Corporation.
Although this methodology may have some sound economic principles, the IRS and the tax court hold fast to their “no tax affecting” theory, so appraisers have had to find a theoretically sound method to quantify the difference in value resulting from the S-election. At the present time, there are three or more models that can be used to measure the premium associated with the S-election. Each model starts with the subject company being valued as if it were a C-Corporation (i.e. the earnings are tax impacted). The models then calculate a premium or multiple to convert the C-Corporation value to an S-Corporation value. None of these models should be used in a black box—without consideration of the facts and circumstances of the subject company as well as interest being valued. It should also be noted that, to my knowledge, none of these models have been specifically adopted by the IRS or the courts.
One of these models, the S-Corporation Economic Adjustment Model (SEAM), developed by Dan Van Vleet of Willamette Management, calculates a multiple to convert the C-Corporation value to an S-Corporation value. The basic premise behind the model is the difference in net economic benefit experienced by shareholders of C-Corporations and shareholders of S-Corporations. This approach is based upon the theory that S-Corporation shareholders experience a premium of net economic benefit from the ability to receive distributions that are not taxed as dividends. The multiple calculated needs to be considered in light of the specific assumptions built into the model.
And if gifting an S-Corporation stock is part of your estate plan, proceed with caution. The appraisal of the stock must properly address the tax affecting issue. If the appraiser fails to properly address this issue, the gift may be appraised at a value greater than you expect. IBI