For some time, "tax affecting" the earnings of a pass-through entity (PTE) by the U.S. Tax Court has been disallowed in the valuation of PTEs for federal tax purposes.

Let's back up. A PTE is a partnership, limited liability company or an S corporation. These types of entities do not pay entity-level federal income tax as would be the case with C corporations. Instead, all of the earnings and tax attributes flow to the owners, who pay one level of tax at their individual income tax rates. Avoiding the entity-level tax means that PTE earnings are not taxed first at the entity level, and then again when paid out to the owners.

Now, why does tax affecting matter with the valuation of PTEs, which for the most part are privately owned, closely held entities. No market for the interests in PTEs exists as is the case with companies listed on stock exchanges, i.e., public companies.

In the valuation of PTEs, the data used by appraisers is derived from public company-based sources of information. Public companies are all C corporations that pay federal income tax at the C corporate rate. In addition, the shareholders pay a second level of tax on the dividends and gains. The boards of public companies presumably make decisions based on an awareness of these tax rules and rates.

However, in developing income-based approaches to valuing the PTE ( such as the discounted cash-flow approach or the income-capitalization approach), appraisers use the public market data of the C corporations. The discount, known as the weighted average cost of capital (WACC) or capitalization rate, is developed with this public data. In effect, using the C data produces a C-based valuation.

The Internal Revenue Service (IRS) and the Tax Court historically took the position that the earnings of a PTE had to be taken into account without any reduction for income taxes, which resulted in an increase in the cash flows and hence the value of a PTE relative to a C corporation. In effect, the PTEs were significantly more valuable than an equivalent C corporation.

On the other hand, much of the appraisal community believed that the earnings of the PTE should be tax affected. That is, treated as if the PTE paid a C-type federal income tax. The idea is that if public C data is used to create the indication of value, then the PTE's earnings should be reduced to reflect an entity-level tax.

To the extent that the appraisal community tax affected the earnings, many then took the next step and adjusted values to reflect the difference between the C-level calculation and the one tax level of the PTE owners. That way the public company data could be used in the process (C-based data), with any adjustment for the lack of the C-level tax on the earnings being considered as a second step. If the second step demonstrated value to the PTE owners, then a premium could be added to the C-level value.

A number of techniques exist to calculate such a premium. One of the more frequently used is the S corporation Economic Adjustment Model (SEAM). Several others were developed by appraisers, and the Delaware Court of Chancery has a similar approach.

The net effect of tax affecting generally resulted in valuations significantly less than what IRS concluded. For a long time, the Tax Court bought the IRS position of not tax affecting (reducing) the cash flows of PTEs.

That position of the Tax Court now appears to be changing. Two cases this year have allowed tax affecting in federal tax matters: Estate of Aaron U. Jones v. Commissioner, T.C. Memo. 2019-101 (August 2019) and Kress v. U.S. (U.S. District Court, E.D. Wisconsin, March 25, 2019). A lot will be written about these two cases by others and a detailed analysis is beyond this writing.

Assuming that tax affecting will become widespread, another interesting question arises: What tax rate should be used for tax affecting? The choices are the individual taxpayer rate of the owners, the C-type entity income tax rate with or without a second-level premium, or some mix of rates.

This blog will look into those options in the next entry, Tax Affecting Part 2: What Rate to Use?