AriZona case sparks discussion of value of S corp versus C corp

BVWireIssue #147-3
December 17, 2014

In a previous BVWire, commenting on the AriZona business dissolution case, Gil Matthews (Sutter Securities Inc.) made the statement that “a company structured as an S corp cannot be worth less than it would be if it were a C corp.” This is due to the different tax structures and excess compensation issues.

“He's wrong with the blanket statement that there's no logical way that an S corp can be worth less than a C corp,” says James B. Lurie (CapVal-American Business Appraisers LLC). “It may be true for very large corporations, but where the company is smaller, compensation is legitimately high so it can absolutely be true. This can be the case particularly in states with very low C corp taxes. Generalizations are dangerous.”

Matthews responds: “When S corporations are being valued in oppression or fairness cases, earnings must be normalized, so that excessive compensation must be adjusted. In any event, any buyer of an S corp will consider normalized earnings, not reported earnings impacted by excess compensation,” Matthews points out. “When earnings are appropriately normalized, a business must be worth more as an S corp than as a C corp. The difference is minimal for very small corporations that are subject to low marginal corporate tax rates. Mr. Lurie is correct if the context of the valuation does not require normalization, such as valuing a minority interest in an S corp for tax purposes, since an S corp is not limited by the taxes on excessive compensation that affect C corp distributions.”

Lurie picks up on this point: “This is also true in the case of smaller S corps in certain states,” he says. “In Ohio, there's no effective income tax on C corps. When you have a C corp that makes less than $50K pretax, the federal tax is only 15%. If taxed as an S corporation, the income could be passed through at the shareholder's personal rate, which might well approach a combined rate of 40%. Bingo! Disposable cash flow from the C corp is greater than the S corp. So it depends, and, as I said, generalizations are dangerous.”

“As an investment banker for 55 years, my experience has been with larger companies,” says Matthews. “I can see where my generalization can break down for companies without seven figure earnings.”

A digest and the court's opinion for the case that sparked this discussion, Ferolito v. AriZona Beverages USA LLC, 2014 N.Y. Misc. LEXIS 4709 (Oct. 14, 2014), are available at BVLaw (subscription required).

Extra: Matthews will conduct a webinar on Jan. 13, 2015, How Courts View Cost of Capital in Appraisal and Fairness Cases, which will examine how cost of capital determinations should be performed for trial and deposition.

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