March 01, 2016

Estate of Gallagher v. Commissioner (TCM 2011-148) is another of the several Tax Court cases following Gross v. Commissioner (TCM 1999-254) concerned with the issue of valuing a minority interest in a pass-through entity.1For more than 15 years taxpayers and business appraisers alike have been frustrated by the position of the IRS (with the unwavering support of the Tax Court), that the valuation of pass-through entities is performed in the same manner that the valuation of a C corporation’s shares might be. According to the IRS, the only difference in the two approaches is that the Federal tax rate to be used in the case of the pass-through entity is that its Federal tax rate is zero.

Many articles exist which delve into the subject matter of the Gallagher case. We shall not replicate those efforts here. This article seeks to refute the theoretical underpinnings of the zero tax rate argument of Gallagher, Gross and the rest. Next, we still demonstrate that had tax affecting been used, the value of the Gallagher shares would have been substantially lower. Further, we will demonstrate that, when the Guideline Company Method is considered, the tax affected value appears the more reasonable one. Had the Tax Court also used this approach, it would have served as a clear warning that something was amiss with its zero tax rate value.

The Justification for Tax Affecting

The business appraisal community almost uniformly insists that some manner of tax affecting must be performed when valuing a pass-through entity. After several trials on the matter, however, the Tax Court has not relented.2 After reviewing the record of the various trials, it is clear that the efforts of the appraisal community to convince the court of its error have been weak and unpersuasive. In fact, based on the evidence presented (or not presented), it is no surprise that the decision in Gross remains undisturbed. The Court has asked for evidence to support the taxpayers’ (and their appraisers’) positions but very little has been offered. Some of the arguments tendered have been erroneous and most simply ipse dixit.

The basic premise assumed by the IRS and, as supported in Gallagher and Gross, is that the history of valuation theory has always held that personal taxes are ignored. In fact, the academics agree that financial theory (e.g., Modern Portfolio Theory and the Capital Asset Pricing Model) depends upon the simplifying assumption that all investors have the same personal tax rate.

There are a host of empirical studies performed by renowned financial economists that demonstrate that changes in personal taxes affect the market.3 If this is so, why in our valuations of C corporations is no analysis usually performed of personal level tax affects?

But why would they be? Here an apple is being compared to an apple. “Fair market value” assumes the willing buyer and seller are hypothetical parties with an indistinguishable, or, “average” profile. The hypothetical seller and the hypothetical buyer are presumed members of the same, monolithic “market” with undifferentiated characteristics, including their tax profiles.

So far, identifying the exact nature of this average profile has proved elusive.4 Thus, the hypothetical buyer is viewed as a composite of the marketplace. This includes individuals in states with heavy tax burdens (such as California), individuals in states with low tax burdens (such as Texas), tax exempt investors, investors with tax loss carry forwards, foreign investors, sovereigns, etc. If the weighted average tax burden of the market participants equated to statutory rates it would be a sheer coincidence.

Valuation multiples and discount rates already embed information from the market participants’ tax characteristics. For the public stock market, which is an overwhelmingly C corporation environment, rates of return are based upon current income (dividends) and appreciation (capital gains). When an individual investor, be it a mutual fund, endowment fund or individual, decides to buy or sell stock, there can be no doubt that after-tax considerations are a key component of the decision. In this way, such considerations find their way into the market price and, thus, affect the overall market (pre-tax) rate of return.

However, this generalized impact of personal taxation is implied only for the type of investment typical of the marketplace (i.e. common stocks). If one were to create a situation whereby a certain, identifiable and distinct class of buyers (clientele) was uniquely harmed (benefited) by the tax structure of the company, the value to those investors would be decreased (increased). Furthermore, the pricing effect of this situation should be observable and quantifiable.

In fact, there are numerous examples of this phenomenon in the marketplace. One such example is the Master Limited Partnership (“MLP”). Usually owning energy infrastructure such as pipelines, MLPs are flow-through entities which, for a period of time, at least, generate very low (or no) taxable income but which high levels of cash flows and, therefore, pay significant distributions.5 The best evidence that this type of entity (which seeks to maximize personal tax benefits) was the most advantageous from a market value standpoint is the fact that by the early 2000s almost every entity owning energy infrastructure had converted to the MLP structure.

However, now, with declining energy markets, the downside of this structure is becoming apparent. Because many MLPs paid out so much in distributions, the partners’ tax bases have become eroded. This can lead to all sorts of negative tax consequences.6 When these negative personal tax characteristics are present, they have a definite impact on the market value of these securities.7

Besides MLPs, real estate investment trusts (“REITs”), and preferred stock are other market investments whose price performance is affected by personal taxation. REITs are corporations which avoid the corporate level tax by passing 90% or more of its income on to its shareholders in the form of dividends. Dividend distributions for tax purposes are allocated to ordinary income, capital gains and return of capital, each of which may be taxed at a different rate. From a market standpoint the relatively high yields (compared to dividend paying stocks) enhances value. The fact that these dividends are taxed at higher rates than common stock dividends is a drawback. Given the fact that REITs are highly correlated with U.S. Large Company Stocks and have a zero percent federal income tax rate8, one would think REIT securities would significantly outperform these stocks. However, over the 40 year period ending in 2014, the total return on REITs has been 12.8% while the S&P 500 has returned 12.2%.9 While a slight premium is observed, it is not of the magnitude which would exist if the annual income tax differential was the only differentiator in the determination of value.

Individuals wishing to own preferred stocks earn lower yields than they would otherwise because one clientele, U.S. corporations, is exempt from taxation on 80% of preferred dividend income. Individuals do not enjoy this benefit. Thus, corporations are the primary buyers of these securities and their unique tax benefit drives up the prices of these securities.

Consider the normal C corporation minority interest valuation conducted using the Discounted Cash Flow (“DCF”) method. Net cash flow is considered for a discrete period (say, five years) and then, as a perpetuity, in the residual value. The present value of these flows is computed. Implicit in this assumption is that the C corp shareholder will be receiving his pro-rata share of the net cash flow. Theoretically, since this is a C corporation, that “distribution” is a dividend which is taxed at the dividend tax rate — a personal tax. However, as described previously, if we presume all hypothetical buyers have the same personal tax situation, this is irrelevant. But like the holder of interests in entities such as MLPs and REITs, the pass-through equity holder has a very different tax structure than the C corp shareholder. Thus, the simplifying assumption of CAPM that all investors have the same personal tax rate is not reasonable when comparing S corps to C corps.

The pre-tax rate of return of the stock market applicable to investments in C corps is a long term average — many analysts use data going back to 1926. At the current time, the long term (arithmetic) average rate of return on the largest (decile) capitalization U.S. stocks is 11.15%. Since 1926, the U.S. corporate income tax rate has varied from 11 to 53% and has averaged 38%. If the historical tax rate had been 0%, the returns earned by C corporations would have been substantially different. Companies would have had more capital to invest to grow their businesses or would have paid substantially higher dividends. Of course, this presumes the loss of the tax revenue would not have had a counterbalancing negative impact on the U.S. economy. Nevertheless, the foregoing shows the folly of applying the long term market rate of return in valuing an entity with a presumed zero percent tax rate.

The problem with valuing a minority interest in a pass-through entity is that there is no direct market from which to capture comparable data. The pass-through entity from an operational standpoint may be an exact duplicate of a publicly-traded C corp but the pathway by which cash flow finds its way into the pockets of their equity holders is very different.

The only reasonable manner by which to value a minority interest in a pass-through entity by the Income Approach, then, is to impose a hypothetical C corp tax rate in the cash flow projections. Without doing so, there is absolutely no guidance one can observe from the C corp dominated capital markets. In the same way that the taxable market for stocks and bonds serves as a comparative benchmark for the valuation of MLPs, preferred stock, and REITs, the “tax affected” pass-through entity’s cash flow is converted into a currency which can be understood, analyzed and valued. At this point, the value must be adjusted to take into account the tax differences.

There are essentially two ways this might be done under DCF. One would be to adjust the discount rate. The other would be to adjust for the difference in the various tax rates encountered by the C corp and pass-through entity cash flows.10

There is no proven academic or empirical data to adequately support a reliable method for adjusting the discount rate. It is a promising field of research and, in the future, robust and reliable data might be developed which would enable this methodology. At the current time, however, this remains a work in progress.

In our opinion, the only reasonable method is to adjust for the variances in the tax rates. One often used method is the S Corporation Economic Adjustment Method (“SEAM”).11 This is also referred to as the “Van Vleet Model.” It works equally well on all pass-through entities.12 Much has been written on this topic and I encourage the reader to inquire further. If this methodology had been employed in the case of Gallagher, a substantially lower value would have resulted. However, the pass-through structure does add value, or, a tax benefit premium. Figure 1 demonstrates how the tax differentials are translated into a premium which is applied to the value of the tax affected income of the subject entity.

 

Figure 1 illustrates what the value of Gallagher would have been had tax affecting and the SEAM premium been employed. We have included the effects of Kentucky state taxes, as this is germane. In addition, the Opinion stated that the highest individual income tax rate in 2004 was 39.6%, but we believe the appropriate federal rate was 35%. Following is a discussion of the Guideline Company Method found in the Opinion but which the Court rejected. In our opinion, the Court should have admitted the methodology but corrected the apparent over estimation of value according to its own assessment of the subject company as found in the Opinion. This market-derived value would have served as a clear indication that there was a mismatch with the Court’s DCF valuation.

The Forgotten Guideline Company Analysis

The Tax Court rejected, in its entirety, the Market Approach submitted by the government’s expert. After reviewing the record we find the Court’s finding that he “improperly relied” on the guideline company to be unjustified, at least for the reasons cited.

According to the Opinion, the Court’s rejection rested upon the differences of PMG with the four comparables cited. However, the only cogent differences cited were size and the fact that PMG had no internet strategy in 2004. The implications, then, are that PMG is riskier and slower growing than the comparable group. These are characteristics which the appraiser should take into account in his multiple selection. Unless extreme, these are not grounds for rejection of the use of this approach. Revenue Ruling 59-60 states that for a company to be considered comparable it only needs to be “generally similar”. In Gallagher, it seems the Court was judging by a standard even more exacting than market participants. How much weight might have been given to the GCM is another question. It would seem that DCF would be the preferred approach to value — but not the only one.

Concerning size, while it is true that PMG was smaller than the guideline companies in almost every category, it was not so small as to render a comparison with these companies not meaningful. For example, PMG’s EBITDA was 60% of that of Journal Register Co. and Pulitzer, Inc. Journal Register and Pulitzer’s EBITDAs (both slightly over $100 million) were about 60% of Lee and only about 35% of McClatchey. Does this mean Journal Register and Pulitzer could not be compared to these larger companies?

To be sure, PMG’s small size and negative trend in its expected growth rate (partially explained by its lack of internet strategy) are significant valuation differences. In fact, based on the evidence in the Opinion, PMG’s expected future net cash flow was negative in real terms. The average EBITDA growth rate of the comparable group was 10% (2005 compared to 2004).

In our opinion, were PMG publicly-traded, it would be valued far below the 11.75X median multiple of the four comparable companies. Accordingly, the 10.6X multiple determined by the government’s experts seems to be too high.13 PMG’s projected five year compound growth rate in revenues (2%) is vastly lower than the group’s growth rate. This, in and of itself, would argue for a lowering of the multiple from the median by at least two multiples.14 Furthermore, small size is equally a value differentiator for PMG. Part of PMG’s weighted average cost of capital (“WACC”), as calculated in the Opinion, relates to the size premium, which is about 4%.15 The corresponding premium for the larger comparables is about 2%. This also equates to an EBITDA multiple reduction from the group’s median of about another two multiples.16

Based on the “double whammy” of size and negative (real) growth in cash flow, a multiple of 8X (about 1/3 below the group’s low end) seems appropriate.17 In looking at other valuation multiples suggested by the use of an 8X EBITDA multiple, PMG’s Value/Revenue multiple would be 3.1X — almost exactly equal to the 3.0X median of comparable group. Further, PMG’s Market/Book Value ratio would be 3.6X, significantly above the median of the group (2.8X).18

According to the Opinion, the WACC determined by the Court appeared to have mostly followed the Build Up approach suggested by the government’s expert. Included in the process is the curious addition of a control premium. Since we are valuing a minority interest and the cash flow projections do not appear to be adjusted in a way to suggest control is being exercised, the conversion of the value to a control value seems improper.19 Furthermore, the mechanics of the adjustment are certainly unusual and probably incorrect. Nevertheless, we will leave undisturbed this portion of the Court’s Enterprise Value analysis (except to correct a math error as we later describe). However, in our analysis we consider the DCF-derived value a marketable, minority interest value (“MMIV”).

The MMIV determined by the government’s expert’s guideline company method was $435 million (at an EBITDA multiple of 10.6X). Based upon the risk and size revisions we suggest above, the MMIV would be about $285 million. The Tax Court’s DCF-derived Enterprise (Control) Value was $461 million.20 When this is “stepped down” to a marketable, minority interest value by the Court’s minority interest discount of 23%, the MMIV becomes $355 million. Thus, the Court’s MMIV is 25% greater than the adjusted market approach.

By comparison, our tax affected version of the Court’s projections, when adjusted for the SEAM, is 11% below the Market Approach value. However, since we argue that the Market Approach should have been included in the overall valuation conclusion, albeit at a lower weighting, our final MMIV (including the SEAM S corp benefits) becomes $281 million — about 1% above the Guideline Company Method.

Not having the Guideline Company Method value as a data point is significant. Had the Court accepted the approach but adjusted its result based along the lines we suggest, a clear comparison to the Income Approach would have existed. In this way, the Court could have seen that something may have been amiss with the value it determined by its no-tax-affecting DCF methodology.

Conclusion

The Court’s (corrected) MMIV of PMG’s equity would have reflected an EBITDA multiple of 9.5X. If we are correct that this represents a substantially higher value than is appropriate, it serves as a practical example supporting our contention that the non-tax affected cash flows used by the Court over-value an operating business organized as a pass-through entity.


  1. The corporation in Gross was a Subchapter S corporation (“S Corp”) and PMG, LLC, the subject of Gallagher was a limited liability company which elected to be taxed as an S corp.
  2. The Delaware Courts, however, have accepted tax affecting. See Delaware Open MRI Radiology Associates, P.A. v. Howard B. Kessler, et al.
  3. For further information on this topic See: Nancy J. Fannon and Keith F. Sellers. Taxes and Value. (Business Valuation Resources, LLC., 2015): 29-38.
  4. There have been and continue to be efforts to adjust expected effective tax rates or capitalization rates for the estimated composite tax profile of the average market participant but, so far,
    nothing convincing has been developed. There are several thorny problems with this line of inquiry which are beyond the scope of this article.
  5. Usually this describes an MLP in a profitable and growing market.
  6. Kinder Morgan, the energy infrastructure giant which popularized the MLP converted back to a C corporation in 2014.
  7. A minority interest in an S corp or limited partnership shares many of the same characteristics as described above. Basis in a pass-through entity is an enormously complicated topic and
    can greatly impact value in the final analysis. However, regarding the topic of “fair market value” of a minority interest in a pass-through entity, we are not going to delve into this issue
    other than to know qualitatively it is a general investment risk. We still must assume a hypothetical seller and not the individual seller. The point is, that if a unique element of valuation is
    observable and quantifiable and it affects the entire market of hypothetical buyers, it must be considered.
  8. Actually, REITs do pay taxes on any income not distributed, so, this may be as much as 10% of net income.
  9. Source: National Association of Real Estate Investment Trusts.
  10. The more important point is that both approached approaches require tax affecting the cash flows. Unless the Tax Court can be convinced that tax affecting is appropriate, to engage in
    this argument is to put the cart before the horse.
  11. ”Panel Review of New Research Articles in the Field of Business Valuation.” In Proceedings of the Advanced Business Valuation Conference, October 2002, American Society of
    Appraisers, Walt Disney World Resort, Orlando, Florida. The Van Vleet Model has also been published in four advanced valuation textbooks and eight articles and has been presented at
    the national business valuation conferences of every major business valuation organization and society in the United States.
  12. There are, at times, material tax and governance differences between S corps and partnerships but these differences rarely come into play in a typical valuation. Where relevant, they
    should be considered.
  13. Although not used as a comparable, perhaps for its size, the New York Times Co. EBITDA multiple for the latest twelve months ending June 30, 2004 was 11.1x.
  14. Using DCF, a cursory analysis of the effects of a 2% revenue growth on Journal Register indicates a multiple reduction from 11.1x to 9.1x.
  15. Based on Ibbotson size premium.
  16. A test was performed on the implied change in value of Lee Enterprises if its WACC increased by use of the decile nine size premium.
  17. Using DCF, a SEAM adjusted EBITDA multiple is 8X.
  18. The foregoing analysis is subject to the limitations of the text of the Opinion and assumes there are not other significant factors.
  19. While significant analysis of financial factors to be included in the projections was performed. There was no suggestion that these included factors represented a change from the Company’s
    existing practices. Furthermore, the methodology employed to reflect control is criticized in perhaps the most respected of valuation textbooks. Shannon P. Pratt and Roger J. Grabowski,
    eds. “Minority versus Control Implications of Cost of Capital Data.” Cost of Capital (the d.). Hoboken, J.J.: John Wiley & Sons, Inc., 2014. 863. Print.
  20. In the original Opinion, the Court made a mathematical error in the computation of the present value of the residual. This was later corrected in an opinion published a few months later as
    T.C. Memo 2011-244. Our figure varies slightly from the Court’s due to rounding of the present value factors primarily.