Debate on tax affecting plays out in new divorce case

BVWireIssue #60-2
September 19, 2007

The debate on the valuation of S corporations has “bedeviled the professional appraisers’ community for some time,” notes the Massachusetts Supreme Court, which just issued its opinion in Bernier v. Bernier (Sept. 14, 2007).  On one side of the debate are the Tax Court decisions in Gross v. Commissioner (affirmed by the 6th Circuit in 2001) and its progeny, which generally disavow tax affecting S corporation earnings.  On the other side is Del. Open MRI Radiology Assocs. v. Kessler (2006), in which the Delaware Chancery Court performed its own tax affecting analysis in a statutory fair value appraisal action. 

In the Bernier divorce, “the debate over tax affecting played out in the diametrically opposed positions taken by the parties’ experts.”   The husband’s expert treated the couple’s S corporations as if they were C corporations, applying a 35% “average” tax rate to earnings to reach a $7.85 million valuation.  The wife’s expert declined to apply C Corp rates to arrive at a $16.4 million value.  The trial judge—citing Gross and an old IRS training manual—adopted the “tax affected” value of the husband’s expert.  But the reliance on the training manual was “misguided” according to the Mass. Supreme Court, and the application of Gross incorrect.  After reviewing the case law and pertinent literature, it “generally” adopted the Del. Radiology valuation metric.  “Careful financial analysis tells us that applying the C corporation rate of taxation to an S corporation severely undervalues the fair market value of the S corporation…”  For a copy the Court’s careful and comprehensive analysis, click here.
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