The last issue of BVWire covered the New York business divorce case involving the valuation of a 50% interest in the company that makes AriZona Iced Tea. The ruling prompted comments from Gil Matthews (Sutter Securities Incorporated), who tells BVWire: “In my judgment, there are two substantial problems with the decision, both of which result in a material windfall to the continuing shareholder.”

Tax rate: In its decision, the court applied a higher tax rate to AriZona as an S corp than would have been applicable if it were a C corp, Matthews points out. The plaintiff’s expert conservatively valued AriZona as if it were a C corp and used a 38% tax rate. But the court noted that this rate was unsupported in the valuation report and in the expert’s testimony. Instead, the court applied a 43.5% rate based on taxes payable on AriZona’s pass-through income.

“This conclusion is illogical because a company structured as an S corp cannot be worth less than it would be if it were a C corp,” says Matthews. “C corps must pay corporate tax prior to making distributions (dividends) to shareholders, who then pay additional tax on the dividends. Investors use pass-through entities to avoid double taxation and to reduce the effective tax rate on income. This double taxation cannot be circumvented by paying high salaries or bonuses to controllers of C corps because payments in excess of ‘reasonable compensation’ are subject to substantial additional tax and/or penalties.”

Matthews urges valuation experts to read the Delaware MRI (898 A.2d 290, Del. Ch. 2006) decision for a realistic valuation of an S corp versus a C corp. This case is available at BVLaw.

DLOM: The plaintiff’s expert argued for zero DLOM because the company was successful and there were a number of “expressions of interest” from potential acquirers. The defendant’s expert asked for a 35% DLOM. The court decided a 25% DLOM was appropriate. This “results in the petitioner receiving 3/8ths of the value of the company, inequitably valuing the continuing shareholder’s half-interest at 60% more than the petitioner’s half-interest,” says Matthews. The court gave four reasons for applying a 25% DLOM. One of the reasons is the transfer restrictions in the owners' agreement, which is relevant to a DLOM, says Matthews. But the other three reasons the court gave seem “questionable,” he says.

• AriZona did not have audited financials. “However, the opinion also states that ‘Arizona's financial statements can be readily audited, particularly when the shareholders are no longer battling with each other,’” Matthews says.
  
  
• Extensive litigation between the shareholders. “However, the petitioner should not be penalized for litigating and, in any event, the litigation will be concluded when the petitioner is paid,” he says.
  
  
• Uncertainty about AriZona’s S corp status. “However, the court concluded that S corp status did not add to the company’s value,” Matthews observes.

Find an extended discussion of Ferolito v. AriZona Beverages USA LLC, 2014 N.Y. Misc. LEXIS 4709 (Oct. 14, 2014), in the January issue of Business Valuation Update; the court’s opinion will be available soon at BVLaw.