Tax Reform’s Potential Impact on the S Corporation Valuation Debate

The Trump Administration and the “Big Six”[1] have provided a general framework for tax reform and are promising to release more details as early as this week.  While tax reform is still subject to significant changes in scope and direction, we are left to ponder a number of possibilities when it comes to future C corporation and pass-through entity tax rates.

For years, a debate has continued about the valuation treatment of pass-through entities, including S corporations, LLCs and partnerships, versus otherwise comparable C corporations.[2]  The taxation of C corporations is two-fold.  The earnings of a C corporation are subject to tax at the entity level at corporate income tax rates, with a top marginal federal rate of 35%.  Then, if the C corporation declares and pays dividends to owners, those dividends are taxed at the personal level at dividend tax rates, with the top marginal federal rate being 20% (23.8% including the net investment income tax).  On the other hand, pass-through entities are generally not subject to entity-level taxes.  Rather, the income of the entity is passed through (allocated) to its owners pro-rata based on ownership for income tax purposes, and the owners are responsible for sending a check to the government for their share of the entity’s income.  This tax liability is quantified based on personal income tax rates.  Routinely, pass-through entities declare distributions to help their owners satisfy this pass-through tax obligation.  This distribution, itself, is not a taxable event.

On its face, the pass-through entity provides a tax advantage, in that earnings are only taxed once.  There is no second layer of tax on dividends.  But the devil is in the details.  Does this advantage exist if the pass-through entity is not a regular dividend payor?  What if the tax rate on C corporation earnings is lower than the tax rate on passed-through S Corporation earnings due to higher marginal personal income tax rates?  Is one of the entity structures more favorable when it comes to loss carryforwards or carrybacks?  These are just a few of the issues that arise.

Meanwhile, in the estate and gift tax valuation arena, closely held business owners have consistently faced challenges by the Internal Revenue Service about the valuations of interests in S corporations and other pass-through entities.  The IRS started many years ago taking the stance that these entities were not taxable entities, and that valuations should be uniformly higher due to the elimination of taxes.  This stance can be roughly illustrated as follows:

How can it be that a reduction of a 40% tax leads to a 67% increase in value?  The math is correct, but this approach misses the point.  S corporations and other pass-through entities are not tax-exempt entities.  Their owners are subject to federal, state and/or local taxes on pass-through income.  To use an effective tax rate of zero gives no consideration to the pass-through tax liability.

Valuation professionals generally agree that the pass-through structure has its advantages, and conduct an analysis on a case by case basis to ascertain whether or not the advantages have material economic value.  In cases where a pass-through entity is profitable and makes distributions over and above the pass-through tax liability, appraisers may opine that there is a valuation premium that is warranted between 5% and 25%.  Here is a cursory summary of how one might compute such a premium:

The Court of Chancery of the State of Delaware took a similar conceptual approach, albeit with different mathematical computations, in the notable Delaware Open MRI vs. Kessler case in 2006.  In that case, a fair value shareholder oppression matter involving a squeeze-out merger, the Court took the approach that a hypothetical tax rate below the often-used C corporation tax rate of 40% should be applied to account for the elimination of a second layer of tax on corporate earnings (i.e., lack of a dividend tax).

To summarize, the premiums computed above are largely a function of the dividend payout ratio and the dividend taxes avoided.  Appraisers may also go further by ascribing some value to the build-up in basis on the S corporation stock.  To the extent that an S corporation generates profits and retains those profits, a shareholder’s basis in the stock increases by his or her pro-rata share of those retained profits, creating potential capital gains tax savings in a future liquidity event.

The portion of tax reform that seems to be at the top of the priority list is corporate tax rates.  President Trump, the “Dave Camp 2014 House Plan,” and various business leaders and associations are calling for reductions in federal corporate tax rates from 35% to as low as 15% to 20%.  The primary reasons cited are to spur economic growth and to increase the global competitiveness of U.S. corporations, which are subject to tax rates higher than competitors pay in many overseas jurisdictions.  This dynamic has been cited as driving a wave of corporate inversions.  According to the Tax Foundation, the U.S. has the fourth highest statutory corporate income tax rate in the world, levying a 38.91% tax on corporate earnings.  The worldwide average statutory corporate income tax rate, measured across 202 tax jurisdictions, is 22.96%.  When weighted by GDP, the average statutory rate is 29.41%.[3]

What might a reduction to federal corporate income tax rates imply for C corporation valuations?  Using the example above, here is an illustration:

The above table is instructive, but purposely simplistic.  We note that many U.S. corporations have effective tax rates lower than the top marginal corporate rate, have operations both domestically and abroad, and/or have other unique tax circumstances.  Excluding unprofitable companies, approximately 30% of publicly traded companies with enterprise values between $25 million and $5.0 billion had effective tax rates of 31% or less from 2014 to 2016.  The median was approximately 35%.[4]

What does the above illustration mean for the S Corporation valuation debate?  The advantage of being an S corporation compared to a C Corporation seemingly diminishes because the difference in effective tax rates on entity income might be skewed in favor of the C corporation.  Effective tax rates on S Corporation income are driven by personal income tax rates.  The highest marginal federal personal income tax rate is 39.6% and, with state and local taxes, especially in higher taxed jurisdictions, the total effective rate can rise to 45% or more.  Suddenly, if we have an S Corporation domiciled and operating in a high tax state, the situation could look as follows:

As you can see, the concept of an S Corporation premium is turned on its head in the example above.  It would appear economically unfavorable to elect S corporation status in this case, as the dividend savings are dwarfed by the higher effective tax rate on entity income.  This dynamic is present in some cases today, but might become more prevalent should tax reform generate substantial reductions in C corporation tax rates.  Offsetting the discount above, at least to some degree, might be the benefits from the build-up in tax basis that occurs in the context of an S corporation.

We are also aware of some proposals to reduce “pass-through tax rates.”  The idea would be not only to reduce effective tax rates for C corporations, but to reduce rates for businesses structured as S corporations, partnerships and LLCs.  Pulling this off, however, would seem more challenging and could create unintended consequences and new tax loopholes.  Lower “pass-through tax rates” would again change the S corporation premium conversation.  If “pass-through tax rates” are reduced to 30%, for example, the analysis might lead to the following:

You may also be wondering “What about my C corporation?”  A reduction in corporate tax rates is likely to imply higher values.  The appraiser would tax affect earnings at a lower rate, driving up earnings and the present value of future cash flows, all other factors held constant.  Will guideline public company multiples similarly reflect the change in tax rates?  There is often too much noise to tell, as some public companies face unique tax circumstances, and equity markets would start to “price in” the probability of a rate cut well in advance of its occurrence.  In other words, we are unlikely to see an instantaneous jump in equity prices when tax cuts are passed, as markets may already be factoring in some probability of occurrence, and will continue to factor in the chances of tax reform and the degree of tax cuts as the legislative process moves forward.

To summarize, a change in business tax rates, if it occurs, would have significant ramifications on C corporation and S corporation valuations, and could change the course of the debate over S corporation valuations and premiums.  Having said this, we continue to await more details on tax reform, with the legislative process in its early stages.  We would welcome any questions or comments you may have on this topic.

Todd G. Povlich, CFA, ASA

Todd is a Partner at MPI and is based in the firm’s New York City office. Since joining MPI, Todd has determined the value of closely held securities of companies and partnerships in many industries for a variety of purposes.