[IMGCAP(1)]Until 2001, S Corporations were generally valued like C Corporations. However, after some key court decisions, the process for valuing S Corps has changed.

There is significant disagreement about the role of taxes and their impact on valuation. Valuation professionals have developed new models that seek to address the impact of taxes on relative valuation.

History of S Corporation Valuations
Prior to 2001, S Corps were treated just like C Corps. Revenue Ruling 59-60 provided guidelines from the IRS and assumed that the tax effect was similar to the C Corp tax rate. S Corps were valued using guideline company comparables for public companies. It was assumed the most likely buyer would be C Corps and it was considered best practice to value S Corps in this way. It was also thought that professional investors would consider the tax effect on earnings.

Several tax court cases decided between 2001 and 2006 have changed the way S Corps are valued. The most significant was probably Gross vs. Commissioner, which held that an S Corp has a tax rate, but that tax rate was zero. Before 2001, it was assumed that the S Corp used the C Corp tax rate and there was essentially no difference between an S and a C Corp. The court however, concluded this was incorrect and essentially said the S Corp was 67 percent more valuable. This is because the S Corp is a pass-through entity with no corporate level taxes. An S Corp is treated just like an LLC where the individual or investor level taxes are not pertinent to the value of the company.

This reasoning caused an uproar in the valuation industry. Valuation professionals responded by creating new models, conducting empirical research, and developing new best practices. The
Delaware Chancery Court attempted to reconcile S Corp and C Corp taxation differences at both the entity and investor levels. It hypothetically compared an S Corp with a C Corp investor and determined that while a C Corp may pay as much as 40 percent corporate tax, an S Corp faces taxes on earnings whether distributed or not. The court estimated the incremental tax and came up with a premium closer to 25 percent, not the 67 percent implied in the Gross case.

The IRS developed a Job Aid to help practitioners value S Corps. This aid supported the view of the courts, explaining:

"With respect to the attribute of pass-through taxation, absent a compelling reason…, no entity
level tax should be applied in determining the cash flow of an electing S Corporation.

"In the same vein, the personal income taxes paid by the holder of an interest in an electing
S Corporation are not relevant in determining the fair market value of that interest."

While the job aid states there should be no entity level taxation, it is silent on investor level taxes. Most practitioners disagree with it—the job aid would argue to go back to the 67 percent premium by saying that investor level taxes are not applicable.

Considerations in Valuing S Corporations
When valuing S Corps, every transaction is different and depends on shareholder agreements. The level of dividends paid to shareholders is important. If distributions are only enough to cover taxes, there is no added value in the S Corp structure. In fact, if controlling shareholders do not distribute any dividends to the shareholders, the value could be less because the shareholders are taxed on that income anyway.

Other factors to consider include the terms of the shareholder agreement, the holding period of the transferred interest, the ability to raise equity or borrow, investor level taxation, cost of capital, and
sub-S restrictions.

The ability to raise equity can be challenging for S Corps because they can only have one class of shares and a limited number of shareholders. The ability to borrow can also be complicated. Because
S Corps distribute all of their income to shareholders, it can make banks nervous. Banks may place limits on how much can be distributed to make sure there is enough cash to cover debt payments.

A number of valuation professionals have identified models that seek to address the difference in tax rates associated with an S Corp relative to a C Corp. Each of these models in their own way has taken steps to address the shortcomings in the way the court has ruled.

Other professionals writing on this topic, including Nancy Fannon, argue you should not use a
40 percent rate for corporations given shields and other steps companies take to reduce taxes. Under this logic, she suggests that the premium for an S Corp is probably closer to 11 percent and could be lower depending on other factors.

Are Taxes Important to Investors?  
The IRS Job Aid seems to suggest that taxes do not matter. Fannon, however, argues that instead of determining the tax effect on S Corps, an alternative is to adjust the S Corp for the cost of capital.
An alternative way of looking at it is to raise the discount rate for the various factors that are positive or negative for S Corps relative to C Corps thus bringing down the valuation. Like most conclusions in valuations, the answer depends on the circumstances.

Are S Corps worth more than C Corps? Based on the empirical studies, the general consensus is there is no premium paid for a company without control, but there could be a premium paid in the case of a minority transaction or minority interest. And that premium is only on the minority stake. In our experience, we have not seen clear evidence that the S Corp structure regularly is valued at a premium.

Bryan Browning is managing director at Valuation Research Corporation.

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