Leicester makes some excellent points, responds Nancy Fannon (Fannon Valuation Group).  He is also making some critical assumptions (which Del. Radiology also made), including that:  

• the S Corp benefits are perpetual;   
• the retained net income is as valuable as distributed income (it’s not);
• there are no detriments to operating as an S Corp compared to a C Corp (there are many); and
• the same tax rates apply to capital gains as to ordinary income.

Moreover, the key issue is and always has been the avoidance of the dividend tax, Fannon says.  “Many analysts have omitted a deduction for corporate income taxes when they value an S corporation.  However, to do so treats the S corporation as if it (and its investors) avoids the tax on corporate income instead of the tax on dividends.  This is simply not true, and has led to widespread misapplication of appropriate methodologies for valuing S corporations.” 

This specific issue lies at the heart of the various conflicting court decisions—and forms the focus of the upcoming release, Fannon’s Guide to the Valuation of Subchapter S Corporations: 

When we value an S corporation using the income approach, the only rate of return we have available comes from C corporations in the publicly traded stock markets.  Immediately, we find that the rate of return does not match the cash flows.  The public stock market investors set their rate of return requirements based on an expectation of having to pay a dividend tax when they receive their cash returns.  We use this same rate of return to value the S corporation cash returns, yet investors pay no dividend tax.  Thus, for the income approach, we have to account for this benefit.  

In such clear, concise language, Fannon’s Guide strips away the complexity surrounding S Corp valuation and presents a Simplified Model, analytically accurate (including its treatment of key assumptions) and easily conveyable to clients as well as courts.  To pre-order your copy, click here.