‘Just say no’ to tax-affecting: Analysts respond

In last week’s BVWire, we quoted an IRS attorney as saying that he stood firm on the legal as well as IRS precedent that absolutely rejects tax-affecting the value of pass-through entities. As you might imagine, the remarks (the opinion of the speaker, not the IRS) generated some feedback from fellow panelists at the ASA LA Symposium:

“I have not heard the IRS take this position before,” [implying that not tax affecting S corporation income is formal IRS policy] said Chris Treharne (Gibraltar Business Appraisals, Inc.). ”It’s also important to be aware of the models that strongly recommend adjusting for S Corp differences,” he added—referring to his own model as well as those by analysts Chris Mercer, Dan Van Vleet, Roger Grabowski, and Nancy Fannon.

You need to be able to go to court and persuade the judge that tax affecting is justified. Remember, the 6th Circuit in the Gross appeal said: ‘All you did was give us a choice between 0% and 40% [for the pass-through income tax rate]. That’s not the same as saying ‘don’t tax affect.’  Also, recognize that there may be adjustments for dividend tax avoidance and basis build-up benefits.
Continuing, Treharne said, “I’m aware of one of the authors of one of the models who has done subsequent work for the Gross family.  He has always tax affected the S corporation’s income.  To my knowledge, he has never been challenged.  I also tax affect income and have successfully defended my position to the IRS.”  Treharne later added (after the ASA LA panel) that he has only been challenged once on the issue in the 12 years since the Gross decision.

Treharne also indicated that he’s spoken off the record with an IRS manager who agreed that tax affecting S corporation income typically is appropriate.  “The bottom line is that is our professional obligation to prove to the judge that tax affecting is appropriate.  Judge Halpern of the U.S. Tax Court repeatedly made the point that he writes the ending to the story we tell.  We have to tell a good story.”

”Historically, the court cases say no to tax-affecting,” said Mel Abraham (www.valuationeducation.com). But the situation may be analogous to built-in capital gains, in which the courts and cases started off by saying no but have recently start to come around (at least in the 5th and 11th Circuits; the 9th and others have yet to rule). “So we do need to look at the [S Corp] valuation models and question whether the conclusion in any one case is supported by the facts. You shouldn’t blindly follow any mechanical approach, not without this kind of factual analysis,” he observed. “The relevance and reliability of any analysis are even more important these days, in light of Daubert.”

Finally, Judge Halpern weighed in, with more of a Socratic question for the analysts than an answer.  “If I own proprietorship and transfer all of my assets to [my own] S corporation, then have I lowered my value?”

Time was running out for the ASA panelists, though Treharne noted, “If you use discount rates derived from publicly traded companies [inferring that the Ibbotson and Duff & Phelps data is derived from public C corporations], you should tax affect the valuation of proprietorships, too, and partnerships,” and promised to ponder the question on his way to the LA airport. Perhaps, after pondering what one court called this “bedeviling” topic, you’ll email your thoughts to the BVWire editor.