Converting from C to S corp. may be costlier than you think

In their article "Now Is the Time: Converting a C Corporation to an S Corporation or LLC" (The Tax Adviser, Aug. 2012, page 534), authors Michael Lynch, David Casten, and David Beausejour present a compelling argument in favor of electing flowthrough-entity status for existing C corporations. However, before "pulling the trigger" and converting to a flowthrough entity, taxpayers and their advisers should consider at least one additional issue: the appraised fair market value (FMV) of the entity for gift, estate, and income tax purposes. If business owners' succession planning involves the gift or bequest of all or part of their stock in the business entity, they should be aware that a change from a C corporation to an S corporation or other flowthrough entity could increase the appraised FMV of the entity by 50% or more.

While FMV appraisals may combine multiple valuation techniques (e.g., income-based approach, market-based guideline company approach, and cost-based approach), the Tax Court has held that the discounted cash flow (DCF) method is sufficient to properly value the stock of closely held business entities. Under the DCF valuation method, a higher appraised FMV for a closely held business will result if it is a flowthrough entity than if it is a C corporation, because a flowthrough entity does not pay income tax and a C corporation does, and thus the business's cash flow will be greater as a flowthrough entity.

Recognizing that the benefits of reduced entity taxes are at least partially offset by higher shareholder taxes, many business valuation analysts mitigate the increase in appraised FMV by "tax-affecting" the cash flow of the flowthrough entity. Tax-affecting refers to the practice of reducing the earnings stream of a business for hypothetical corporate-level or owner income taxes. While this issue is not new, it is still relevant, as illustrated in the ongoing case of Estate of Giustina, T.C. Memo. 2011-141, rev'd and remanded, 586 Fed. Appx. 417 (9th Cir. 2014), where the appraised FMV of a noncontrolling partnership interest was increased by the Tax Court when it disallowed an adjustment to predicted cash flows to account for the income taxes that would be owed by the owner of the partnership interest.

Similarly, on Oct. 29, 2014, the IRS stated in an internal document, "A Job Aid for IRS Valuation Analysts":

With respect to the question of pass-through taxation, no entity level tax should be applied in the valuation analysis of a non-controlling interest in an electing S Corporation, absent a compelling demonstration that independent third parties dealing at arms-length would do so as part of a purchase price negotiation.

Given the positions of the IRS and the Tax Court, shareholders contemplating making gifts of stock should obtain an appraisal of their C corporation and make gifts of all or part of the stock in the business entity before making an S corporation election. This action may reduce both the amount of gift tax imposed and complications if the gift tax return is audited. Due to the income tax adjustment in DCF valuations of flowthrough entities, these appraisals may face greater scrutiny and risk of challenge by the IRS. If litigation is required to defend a taxpayer's valuation, the taxpayer is at additional risk. Indeed, these cases often come down to a battle of expert witnesses.

Tax advisers should be fully aware of the magnitude of potential valuation changes when converting from a C corporation to a flowthrough entity and understand the increased level of uncertainty in the appraised valuation of S corporations (resulting not only from an IRS examination but, more importantly, from any judicial resolution of the FMV of the transferred interest), and should incorporate this information when advising clients who are considering a change in the type of entity.

The purpose of this article is to alert taxpayers and tax advisers that the Tax Court's refusal to recognize any form of tax-affecting when valuing a flowthrough entity has the effect of treating two otherwise identical business interests as having significantly different FMVs.

The example "C Corp. FMV vs. S Corp. FMV" illustrates the issue by estimating the value of the same company as both a C corporation subject to a combined federal and state income tax rate of 40% and an S corporation. Using a widely accepted income approach with an example capitalization rate of 15%, this example demonstrates the striking difference in appraised FMVs.

FMV is calculated by dividing net income by the capitalization rate. As the example illustrates, by eliminating corporate income taxes, an entity's subchapter S election yields an FMV that, in this simplified example, is 67% greater than the FMV of a C corporation.

TAX-AFFECTING IN DCF VALUATIONS NOT ACCEPTED BY THE TAX COURT

The higher value illustrated in the example is a predictable result if the valuation of an S corporation or a partnership is litigated in Tax Court. In at least six cases in the past 16 years where plaintiffs have made tax-affecting adjustments to cash flows of flowthrough entities when using the DCF valuation method, the court has not recognized them.

The burden in these cases has been on the taxpayer's expert to explain to the court why tax-affecting should be allowed, and the taxpayers' experts in these cases have been unable to convince any Tax Court judge to recognize tax-affecting as an accepted appraisal valuation technique that is grounded in economic theory. (Besides Gross, discussed next, and Estate of Giustina, mentioned above, the cases are Wall, T.C. Memo. 2001-75; Estate of Adams, T.C. Memo. 2002-80; Dallas, T.C. Memo. 2006-212; and Estate of Gallagher, T.C. Memo. 2011-148 (discussed below).)

TAX COURT ON TAX-AFFECTING AN S CORP.'S CASH FLOW

For federal tax purposes, the seminal case on tax-affecting an S corporation's cash flow in a DCF valuation is Gross, T.C. Memo. 1999-254, aff'd, 272 F.3d 333 (6th Cir. 2001). The case involved a dispute between taxpayers and the IRS over the FMV of shares of stock in an S corporation for gift tax purposes. Valuation experts for both the taxpayer and the Service used the DCF method to estimate the S corporation's value. In so doing, the taxpayer's valuation expert tax-affected the S corporation cash flows, while the expert for the IRS did not.

The Tax Court found that the IRS's expert had applied a DCF method of valuation that was well-accepted by the court. In support of tax-affecting the cash flows, the taxpayer's expert argued that the IRS had accepted the taxpayer's gift tax returns in prior years that had used tax-affecting in the DCF valuations that were attached to the returns. The court pointed out that the IRS is not precluded from correcting an error.

The taxpayer's expert also attempted to justify his use of tax-affecting the cash flows by arguing that such an adjustment compensated for certain difficult-to-quantify costs of S corporation status. His reasons for tax-affecting included: (1) Cash distributions may be limited on all shareholders, which would require them to pay the tax on the S corporation income with their own money; (2) the corporation could lose the S election in the future and the corporate tax would apply; and (3) S corporations are at a disadvantage in raising capital. The court did not find these arguments compelling, stating,

[The taxpayer's expert] has not convinced us that such an adjustment is appropriate as a matter of economic theory or that an adjustment equal to a hypothetical corporate tax is an appropriate substitute for certain difficult to quantify disadvantages that he sees attaching to an S corporation election. We believe that the principal benefit that shareholders expect from an S corporation election is a reduction in the total tax burden imposed on the enterprise. The owners expect to save money, and we see no reason why that savings ought to be ignored as a matter of course in valuing the S corporation.

CONTROVERSY IN THE SIXTH CIRCUIT

On the appeal by the taxpayer in Gross to the Sixth Circuit, a concurrence on the valuation issue over a strong dissenting opinion held that the Tax Court's valuation was not clearly erroneous, stating on the tax-affecting issue:

Valuation is a fact specific task exercise; tax affecting is but one tool in accomplishing that task. The goal of valuation is to create a fictional sale at the time the gift was made, taking into account the facts and circumstances of the particular transaction. The Tax Court did that and determined that tax affecting was not appropriate in this case.

In each of the subsequent six cases tried in the Tax Court, judges rejected tax-affecting and other attempts to lessen the substantial increase in value for flowthrough entities.

A RECENT TAX COURT CASE

In Estate of Gallagher, T.C. Memo. 2011-148 (supplemented by T.C. Memo. 2011-244), the most recent Tax Court opinion on this issue, the taxpayer's expert tax-affected his result under the DCF method by making three adjustments to the result to account for certain shareholder benefits associated with the flowthrough nature of the entity: an increase in value to account for tax savings on all future projected distributions in excess of tax distributions; an increase in value to reflect the future value of the company's deductible goodwill, discounted back to the valuation date; and an increase in value to account for the company's extra marginal debt tax shield.

The taxpayer's expert argued that, by making such adjustments, tax-affecting is proper under Gross, citing the Tax Court's statements that "the principal benefit that shareholders expect from an S corporation election is a reduction in the total tax burden imposed on the enterprise" and that such savings should not be ignored in valuing an S corporation. The taxpayer's expert argued that with the aforementioned three adjustments, the valuation reflected the full economic value of the flowthrough-entity status, thus satisfying the Tax Court's directive in Gross.

In Gallagher, the Tax Court summarily dismissed the tax-affecting through the three adjustments. It also stated that its opinion in Gross did not address the propriety of imposing other adjustments, such as those made by the taxpayer's expert in determining FMV, to similarly reflect such tax savings. The taxpayer's expert failed to convince the court of the accuracy of his adjustments and, therefore, the court disregarded them.

Clearly, without a compelling reason, the Tax Court will not respect the concept of tax-affecting the earnings of flowthrough entities in a DCF valuation.

CHOOSE EXPERTS CAREFULLY

Case law with respect to expert testimony in valuation cases has developed certain well-established principles: "A determination of fair market value is factual, and a trier of fact must weigh all relevant evidence of value and draw appropriate inferences" (Caracci, 118 T.C. 379, 391 (2002)). "In valuation cases, the Court relies heavily on expert testimony" (Okerlund, 53 Fed. Cl. 341, 345 (2002)), and "each party relies primarily upon an expert's testimony and report to support the respective positions on valuation" (Caracci, at 393). "The Court weighs the credibility of an expert's testimony in light of his or her qualifications and the evidence before the Court. The Court may either accept the expert opinion in its entirety, accept portions of the expert's opinion, or reject the opinion altogether and reach a determination on its own after examining the evidence in the record" (Okerlund, at 345).

In addition, it is understood that valuations represent approximations. "The valuation process is an 'inexact science' requiring reasonable practical, and rational approximation based upon all information before the court" (Okerlund, at 345, quoting Kraft, 30 Fed. Cl. 739, 765 (1994)).

The discretion that judges wield in valuation cases should give taxpayers and their experts pause, knowing that experts' assumptions and decisions are subject to scrutiny by the IRS, opposing counsel, the opposing expert, and the judge. An expert who tilts assumptions in favor of his or her client runs the risk of being disregarded or ignored by the trial judge, who has the ultimate authority to determine the FMV based solely on his or her independent analysis. Therefore, taxpayers should take special care in selecting valuation advisers by their credentials, familiarity with tax implications, and experience in valuing the particular type of business interest (see "Questions to Ask Potential Business Appraisers").

Practical tips

• When possible, make gifts of stock prior to electing S corporation status.
• Get an appraisal to avoid understatement penalties and to shift the burden of proof to the IRS.
• Pick valuation experts carefully; a good expert should be able to give a similar value for either side.
• In DCF valuations, the Tax Court will use a zero tax rate for S corporations and will not readily accept the valuation professional's workarounds intended to achieve a different result.
• Judges have discretion to challenge or reject every decision, assumption, and estimate used in the valuation calculation.
• The appeal standard in valuation cases is a fairly high hurdle. Normally, the trial court must have made "a clear error in interpreting the facts" or reach a conclusion that is "clearly erroneous."
• If the business entity is currently an S corporation, consider revoking the S election to get a lower appraised value for the stock.