August 29, 2016

The pending U.S. Tax Court decision in Cecilmay discredit the current IRS view that it is improper to “tax affect” the operating earnings of pass-through entities when using the Discounted Cash Flow (“DCF”) method.  In Cecil, the subject S corporation is an 83-year-old family business, the Biltmore Company, which operates the Biltmore Estate in Ashville, North Carolina.

All valuation experts in the Cecil matter, including the IRS expert, have tax affected the earnings of the Biltmore Company when using the DCF method to derive value.  In addition, valuation experts for both the taxpayer and IRS have used the Van Vleet Model to address the valuation-related tax differences between C corporations, S corporations, and their respective shareholders.

From the perspective of the valuation profession, the core issues in this case are twofold: (1) whether it is appropriate to tax effect the earnings of a pass-through entity when applying the DCF Method and (2) whether valuation adjustments are necessary in order to properly estimate the equity value of a pass through entity when tax affecting has been used in the analysis.

The DCF Method

The DCF method is a generally accepted valuation method for valuing operating companies. When using this method, analysts project a measurement of earnings for the subject S corporation and discount these earnings to their present value using a discount rate.  Typically, the discount rate used in the DCF method is derived from empirical studies of publicly traded shares of C corporations.  Consequently, the discount rate reflects corporate income taxes and shareholder-level dividend and capital gains taxes.

S corporations are not subject to federal corporate income taxes. However, S corporation shareholders are subject to shareholder-level ordinary income taxes on their pro-rata share of the earnings of the S corporation.  In addition, S corporation shareholders avoid dividend and capital gains taxes to the extent of accumulated earnings and profits.  Consequently, the application of a C corporation discount rate to the earnings of an S corporation is not mathematically or conceptually sound without appropriate adjustments to reflect the tax differences between these two types of corporate entities.

Although the DCF method is accepted and typically used in tax related valuations, there is a substantial disagreement between the IRS and the valuation profession regarding the issue of tax affecting the earnings of pass-through entities such as S corporations. The origin of this dispute dates back to the 1999 U.S. Tax Court decision in Gross v. Commissioner2 (“Gross”).

The Gross Case

In Gross, the IRS was successful in convincing the Tax Court that tax affecting the earnings of the subject S corporation, when using the DCF method, was not appropriate.  Ever since then, the IRS has maintained this mantra.  This argument has been persuasive in six other Tax Court cases (Heck3, Wall4, Adams5, Dallas6, Guistina7 and Gallagher8) as well.  In fact, the IRS has not yet lost this argument in Tax Court to date.

In Gross and other related Tax Court cases, taxpayer experts have used a DCF method and applied an entity-level corporate tax rate to the projected earnings (i.e., the earnings are “tax affected”) of the subject S corporation.  However, these experts then fail to make corresponding adjustments for the S corporation shareholders avoidance of dividend and capital gains taxes.  Consequently, these valuations have failed to adequately address the tax attributes of the C corporation discount rate and the full spectrum of tax related differences between C corporations, S corporations, and their respective shareholders.  The Tax Court has found these valuations to be less than convincing and have sided with the IRS on the issue of tax affecting.  As one might expect, the elimination of the tax affect in the DCF method substantially increases the value of equity of the subject S corporation and the taxpayer generally faces a significant adjustment in taxes due.

The basic concepts that proponents of the Gross decision adhere to are twofold: (1) only corporate entity-level taxes should be reflected in the valuation analysis and (2) S corporations are not subject to corporate entity-level taxes.  Consequently, in the minds of Gross proponents, tax affecting is not appropriate.  This naïve position lacks logic, empirical support, and mathematical reasoning in that it ignores the relevant statutory tax differences between C corporations, S corporations and their respective shareholders.  In addition, the notion that shareholder-level taxation is irrelevant to a valuation analysis is inconsistent with market realities.  If shareholder-level taxation is irrelevant, why are there REITs and MLPs?  Why are hedge funds and private equity funds structured as limited partnerships?  Why were S corporations created in the first place?  Why have pass-through entities been the most dominant and fastest growing type of corporate structure in the U.S. during the past 30 years?  Of course, the answer is, “all taxes matter.”

Tax Affecting

We use empirical data derived from publicly traded C corporations to determine the discount rate used in the DCF method. Consequently, tax affecting the earnings of an S corporation when using the DCF method is not only permissible, it is appropriate.  However, tax-affecting is not the only adjustment required.  Since the tax-affected DCF Method provides a C corporation equivalent value of S corporation equity, this indication of value must be adjusted to reflect the relevant tax differences between C corporations, S corporations and their respective shareholders.  In addition to the Tax Court, other courts have weighed in on this important concept.

In 2006, the Delaware Chancery Court accepted tax affecting for an S corporation in Delaware Open MRI.9  In its published decision, the Delaware Chancery Court constructed an adjustment to the corporate tax rate used in the DCF Method in order to reflect the tax differences between C corporations, S corporations and their respective shareholders. In 2007, the Massachusetts Supreme Court upheld a lower Massachusetts court decision allowing both the use of tax affecting and the Delaware Chancery Court calculations in the valuation in Bernier v. Bernier10.

The Delaware Chancery Court calculations are not really a valuation model and are subject to significant limitations in order to use them properly in a DCF method analysis. The June 2015 edition of the Business Valuation Review presented an article titled “Delaware Open MRI and the Van Vleet Model”.11  This article addresses the mathematical equivalency of the Delaware calculations and the Van Vleet Model as well as the application limitations of the Delaware calculations.  Despite the application differences in these two approaches, the bottom line is that both the Delaware Chancery Court and the Van Vleet Model are on the right conceptual track.

The Van Vleet Model

Published in the March 2003 edition of Trusts and Estates magazine12 and developed by Daniel R. Van Vleet, the Van Vleet Model provides an algebraic equation referred to as the S corporation Equity Adjustment Multiple (“SEAM”). This model addresses the much-debated issue of how to value pass-through entities (PTEs) such as S corporations and Limited Liability Companies when C corporation data is used to estimate such value.13  In other words, the SEAM may be used to adjust the equity value provided by a tax-affected DCF method in order to arrive at a conceptually supportable value of S corporation equity.

The SEAM corrects for the differences in entity-level and shareholder-level taxation between C corporations, S corporations and their respective shareholders. Depending on the tax rate inputs used in the equation, the SEAM may provide an indication of S corporation equity value that is greater than, less than, or equal to the value of C corporation equity.  It all depends on the mathematical relationship among the tax rate inputs to the SEAM equation.  All experts in the Cecil case have tax affected the DCF Method and experts for both the taxpayer and IRS have applied the SEAM in their analysis.


The first S corporation Tax Court case challenging the use of tax-affecting within the DCF model was the 1999 Gross decision.  The Cecil case is currently in deliberations and we may have a decision later this year.  U.S. taxpayers and the valuation profession at large hope that 2016 will be the year that the issue of tax affecting and the proper valuation of pass-through entities such as S Corporations will finally be put to rest.  If that occurs, it will have taken 17 years to resolve this important valuation issue.

[1] William A.V. Cecil, Sr., Donor, et al. v. Commissioner, Docket Nos. 14639-14, 14640-14
[2] Walter L. Gross, Jr. et al. v. Commissioner, T.C. Memo 1999-254, affd 272 F. 3d 333 (6th Cir. 2001)
[3] Estate of Richie C. Heck v. Commissioner, T.C. Memo 2002-34
[4] John E. Wall v. Commissioner, T.C. Memo 2001-75
[5] Estate of William G. Adams, Jr. v. Commissioner, T.C. Memo 2002-80
[6] Robert Dallas v. Commissioner, T.C. Memo 2006-212
[7] Estate of Natalie B. Giustina et al. v. Commissioner, T.C. Memo 2011-141
[8] Estate of Louis Paxton Gallagher et al. v Commissioner, T.C. Memo 2011-148
[9] Delaware Open MRI Radiology Associates, P.A., Petitioner, v. Howard B. Kessler, et al., Respondents, C.A. No. 275-N, Court of Chancery of the State of Delaware, April 26, 2006.
[10] Judith E. Bernier v. Stephen A. Bernier, Supreme Judicial Court of Massachusetts, 449 Mass. 774 (2007), September 14, 2007.
[11] Van Vleet, Daniel R., “Delaware Open MRI and the Van Vleet Model”, Business Valuation Review, American Society of Appraisers, Volume 34, Number 2, June 2015.
[12] Van Vleet, Daniel R., “A New Way to Value S Corporation Securities”, Trusts & Estates Magazine, March 2003
[13] For a more in-depth discussion of the Van Vleet Model see “In Defense of Tax Affecting”, Frazier, William H. Below.