“The Massachusetts Supreme Judicial Court in Bernier and Judge Strine of the Delaware Chancery Court in Del. Radiology both got it right,” says Mark Leicester, CPA/ABV, JD, LLM (Director of Business Valuation and Litigation Services, RSM McGladrey, Inc.; Burlington, MA).  Leicester testified on behalf of the wife in Bernier v. Bernier, the divorce case discussed in last week’s BVWire™.  The debate on S corporation valuation lay at the heart of the case, as it did in Del. Open MRI Radiology Assocs. v. Kessler (Del. Chancery 2006).     

“When I testified in Bernier in 2002,” Leicester explains, “the individual, marginal ordinary income tax rate and the dividend tax rate were the same.  Therefore, the tax avoided was the federal corporate income tax, not the dividend tax, and so not tax affecting [the S corporation earnings] for federal corporate tax was the correct method at the time.”

Since then, the Feds lowered the tax rate on dividends to the capital gains rate.  Because the combined federal/state corporate tax is now approximately the same as individual tax rates (about 40%), the tax avoided today is the dividend tax, Leicester says. The most accurate tax affecting methodology is to “apply the income tax to S corporation earnings and adjust that result to an equivalent, pre-dividend-tax, C corporation cash flow, and then value that cash flow stream.” 

That’s essentially what the Court did in Del. Radiology—and what the Tax Court declined to do in Dallas v. Commissioner, decided in 2006 but concerning a pre-2003 valuation of an S Corp (i.e., before the change in tax rates).  “The Tax Court could have (and should have) distinguished the situation on that basis alone,” Leicester says.  “But…I don’t think the Tax Court got it then, and it still may not get it now.”