At the recent NYSSCPA business valuation conference in New York City, Daniel Van Vleet (Stout Risius Ross) told the audience that the Van Vleet model (S corporation economic adjustment model) is being used for the first time in a pending U.S. Tax Court case. What’s more, both the IRS and the taxpayer are using it in this case, says Van Vleet.
Ongoing conflict: A much-debated issue in the valuation community is tax affecting the earnings of a pass-through entity (PTE), and there is no definitive answer. The tax-affecting issue has been argued in a number of Tax Court cases (most notably the Gross case). In all of these cases, the IRS and the Tax Court have refuted the notion that shareholder-level taxes affect a firm's value, so the valuation conclusions in these cases were based on earnings not being tax affected. The valuation community disagrees, so a number of models were developed that are designed to reflect the impact of shareholder taxes on value.
The pending case is Cecil et al. v. Commissioner of Internal Revenue, and it involves a gift of shares in the Biltmore Co., which operates the famous Biltmore estate, a Gilded Age mansion built by the Vanderbilts that is now a tourist attraction. The Cecils (descendants of the Vanderbilts) valued the stock gift at $20.88 million, but the IRS said those shares are actually worth $95.29 million. The valuation difference is due to the Cecils’ use of going-concern value, while the IRS says a liquidation value makes more sense. Details of the case and specifics on the valuations have not been disclosed because the case is ongoing.
Model update: In addition to the Van Vleet model, the other models include the quantitative marketability discount model (QMDM) by Z. Christopher Mercer, the Roger Grabowski model, the Chris Treharne model, and the Delaware Chancery model. Regarding the Delaware Chancery model, Van Vleet wrote an article in the Summer 2015 issue of the ASA Business Valuation Review titled “Delaware Open MRI and the Van Vleet Model.” This article addresses application issues as well as the mathematical relationship of the Delaware Chancery model and the Van Vleet model.
In addition, a recent book provides a suggestion for a new, more direct approach to PTE valuation. The book is Taxes and Value: The Ongoing Research and Analysis Relating to the S Corporation Valuation Puzzle,by Nancy Fannon (Meyers, Harrison & Pia) and Keith Sellers (University of Denver). The book draws on extensive academic research to demonstrate how historical market returns can be adjusted to estimate a cost of capital appropriate for the valuation of a PTE.
A large percentage of closely held companies operate as PTEs, so valuation experts need to be aware of the techniques that can be used to determine the additional value such an entity may have because of its tax status.
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