In response to last week’s item on tax-effecting (BVWire #102-2), Nancy Fannon (Fannon Valuation Group) responded:

If attorneys (or analysts) are taking the position that S corp. earnings should not be tax-affected, it is because they do not really understand the difference between corporate level taxes and personal level taxes, and how each of these different taxes affect shareholder returns (value) in the public and private markets.  Some analysts and courts (Delaware and Massachusetts most notably) have taken a “short-cut” method to recognition of the benefit of avoidance of dividend (personal) taxes by reducing the amount of corporate income tax recognized.  When this is done, analysts should realize that doing so is ONLY a short-cut method for realizing the benefit of avoided dividend tax (by the S corporation investor) that they are accomplishing. 

Further, the benefit that an S corporation shareholder receives for avoiding such dividend tax compared to a publicly traded C corporation investor (whom we compare the S corporation investor to, as that is the source of our rate of return—public markets) is likely not nearly as much as we have presumed years ago as this debate developed.  Ask yourself:  How much dividend tax do institutional investors pay? (Institutional investors who have taken over the market since the 1960’s).  How much have dividend rates changed over the last forty years?  How have holding periods changed? 

Do ALL forms of entities engage in tax avoidance behavior?  Of course! S-corporation investors are not the only investors who seek to avoid taxes; it is the composition of the market, combined with the tax-saving mechanisms that all types of firms and all types of investors engage in that make this issue far more complex than simply “not deducting income tax.”  That doesn’t mean our methodology needs to be more complex—but what it does mean is that we need to recognize the effects of these market realities on the magnitude of any “premium” one would ascribe to the income approach of any pass-through entity.

Join Fannon and Keith Sellers (University of North Alabama) on May 26 for the BVR webinar Pass Through Entity Valuation Update: The Significant Impact of Academic Research on the Debate. CPE credits are available.