2003 Winter - Valuation Discounts & Premium S Corp Valuations

FOCUS ON:VALUATION DISCOUNTS AND PREMIUMS

S CORPORATION VALUATION

Valuation Discounts and Premiums Insights

S Corporation Valuation Insights

ESOP Taxation Insights

Professional Practitioner Insights

Also in this issue:

Willamette Relocates Washington, D.C. Area Office to Arlington, Virginia

Willamette Management Associates Insights

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FOCUS ON:VALUATION DISCOUNTS AND PREMIUMS

S CORPORATION VALUATION

Topical Editor for This Issue: Jeffrey S. Buettner

Washington, D.C., Area Office InsightsWillamette Announces Relocation of Washington, D.C., Area Office to Arlington, Virginia . . . . . . . . . . . . . . . . . . . . . . .2


C Corporations With Appreciated Assets: Valuation Discount for Built-In Capital Gains . . . . . . . . . . . . . . . . . . . . . . . .3-8Jacob P. Roosma

Estate/Gift Tax Valuation Professional Guidance from IRS Publications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10-13Jeffrey S. Buettner and Robert F. Reilly

Decoupling State Estate Taxes From Federal Estate Taxes: Will These Changes Affect Estate Valuations? . . . . . . . . .15-16Curtis R. Kimball, CFA, ASA


The Valuation of S Corporation Stock: The Equity Adjustment Multiple . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18-26Daniel R. Van Vleet

ESOP Taxation Insights

EGTRA Provisions Generally Enhance ESOP Attractiveness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .28-29Robert P. Schweihs and Robert F. Reilly

Professional Practitioner Insights

Evaluating the Expertise and Credentials of Business Valuation Practitioners . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31-38Gregg S. Gaffen

Willamette Management Associates Insights

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2003, Willamette Management Associates PartnersInsights is a quarterly publication of Willamette Management Associates and Willamette Capital

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C CORPORATIONS WITH APPRECIATED ASSETS:VALUATION DISCOUNT FOR BUILT-IN CAPITAL GAINS

Jacob P. Roosma

INTRODUCTION

The valuation of a C corporation is a common valuation assign-ment. Experienced analysts routinely value 100% of the stockof a C corporation for such purposes as: merger/acquisitionpricing, estate and gift tax planning/compliance, shareholderbuy/sell agreements, ESOP formationand ERISA compliance, transactionfairness analysis, shareholder disputesand other litigation matters, etc.

The valuation of a C corporationwith appreciated underlying assets isalso a common valuation assignment.A C corporation will have appreciatedunderlying assets when the marketvalue of its owned assets exceeds theincome tax basis of its owned assets.This is a common phenomenon for C corporations whether thecompany is (1) an operating company or (2) an investment orholding company.

When the C corporation owns appreciated assets, a ques-tion arises as to how the analyst should consider the built-incapital gains tax liability. This is the tax liability that would bepaid if (and only if) the C corporation liquidated (i.e., sold) itsunderlying assets at their current mar-ket values. The built-in capital gainstax is determined by (1) the amount ofthe gain on the sale of the assets mul-tiplied by (2) the corporations capitalgains income tax rate.

Particularly with regard to theestate and gift tax arena, there is con-flicting judicial precedent regardingthe valuation effects (if any) of thebuilt-in capital gains tax liability of a Ccorporation with appreciated assets. Some courts have alloweda valuation adjustment (i.e., a valuation discount) of 100 per-cent of the estimated built-in capital gains tax liability in arriv-ing at a business value. Other courts have allowed some valu-ation discountbut less than 100 percent of the subject com-panys estimated built-in capital gains tax liability.

This discussion will summarize the various issues related tothe valuation of a C corporation with appreciated underlyingassets. This discussion will also present a practical frameworkfor quantifying the appropriate valuation adjustment (if any)

related to the capital gains tax contingent liability related tosuch corporations.

REVIEW OF RECENT JUDICIAL PRECEDENT

A review of the relevant judicial prece-dent related to valuation discounts forthe built-in capital gains tax liabilitybegins with the Tax Reform Act of1986 repeal of the General Utilitiesdoctrine. This is because, prior to1986, C corporations could avoidpaying capital gains tax on appreciat-ed assets by making a liquidationelection.

RELEVANT CASE LAW HISTORYThe first U.S. Tax Court decision on the subject since the 1986repeal of the General Utilities doctrine was the Estate of Davis v.Commissioner, 110 T.C. 530 (U.S. Tax Court, June 30, 1998). InDavis, the Tax Court allowed a valuation discount of a little lessthan half of the subject built-in capital gains tax liability. All

federal taxation cases since Davis haveallowed valuation discounts for somepart of (if not all of) the built-in capitalgain tax liability for a C corporationwith appreciated assets.

For example, the relatively recentdecision in the Estate of Simplot v.Commissioner, 112 T.C. 130 (U.S. TaxCourt, March 22, 1999), reversed onother grounds, 249 F. 3d 1191 (9thCir., May 14, 2001), allowed a 100

percent valuation discount associated with the subject corpo-rations built-in capital gains tax contingent liability.

RECENT JUDICIAL PRECEDENTThe Estate of H. Jameson, CA-5, 2001-2 USTC 60,420, is themost recent federal taxation precedent with regard to this val-uation discount issue. In Jameson, the taxpayer died owningthe shares of a personal holding company. The main asset ofthat company was timberland. The Service and the taxpayers

When the C corporation ownsappreciated assets, a questionarises as to how the analystshould consider the built-incapital gains tax liability.

A C corporation will haveappreciated underlying assetswhen the market value of its

owned assets exceeds the incometax basis of its owned assets.


44

estate disagreed on how the built-in capital gains taxes (whichwould be incurred on the sale of the timber or on the sale ofthe land) would affect the value of decedents interest in thecorporation.

At the trial level, the Tax Court allowed a valuation discountfor the capital gains tax liability that the holding companywould incurbut only the capital gains taxes from its ongoingtimber sales. The Tax Court disallowed a valuation discountbased on the immediate sale of the timberland. Instead, theTax Court concluded that a willing buyer of the timberlandwould operate it on an ongoing business. The taxpayerappealed the Tax Court decision to the U.S. Court of Appeals.

In its review of the Tax Court decision in Jameson, the FifthCircuit noted that the stock value for estate tax purposesdepends on the timberlands fair market value on the taxpay-ers date of death. Any sale of the subject company shareswould cause a transfer of the timberlandwhich would triggerthe built-in capital gains tax liability. The estates valuationexperts noted that the only sound economic strategy for ahypothetical willing buyer of the holding company would bean immediate liquidation of the timberland, thereby triggeringthe 34 percent capital gains tax.

According to the Appeals Court, the Tax Court should nothave assumed that there was a strategic buyer for the timber-land that could have continued to operate and produce tim-ber. Instead, the Fifth Circuit stressed that a fair market valueanalysis depends on a hypothetical (instead of a specific) will-ing buyer. Therefore, according to the Fifth Circuit, the TaxCourt erred in disallowing a 100 percent valuation discount forthe built-in capital gains tax liability.

LESSON FROM JUDICIAL PRECEDENTA review of the relevant judicial precedent indicates that,recently, federal courts are consistently allowing a valuationdiscount for the built-in capital gains tax contingent liability.The critical issue in most recent court cases is not: if a valuationdiscount should be allowed. The critical issue is: how much ofa valuation discount for built-in capital gains tax should beallowed.

ACQUIRING THE STOCK OF A C CORPORATION WITHAPPRECIATED ASSETS

Certainly, buyers are willing to make stock acquisitions of Ccorporations with appreciated assets. Of course, these buyersrecognize that the target C corporations come with an associ-ated built-in capital gains tax liability. Such acquisitions areconsummated if the transaction purchase price is sufficientlydiscounted to reflect the economic impact of the built-in cap-ital gains tax liability.

In fact, if the transaction purchase price (i.e., the C corpo-ration value) is appropriately discounted for the effect of thecapital gains tax on the target company appreciated assets,

the acquirer will realize the following economic benefits fromthe acquisition:

1. the acquirer (i) buys control of the target company appre-ciated underlying assets at a price discount and (ii) earnsinvestment returns based on the discounted purchaseprice; this has the same economic effect as an interest freeloan, and

2. the effective interest free loan is contingent; that is, itdoes not have to be repaid (i.e., the acquirer does notactually pay the corporate capital gains tax to the InternalRevenue Service) to the extent that the acquired appreciat-ed assets decline in value (to their income tax basis) overtime.

Therefore, some valuation analysts have argued (and somecourt decisions have held) that the value of a C corporationshould be greater than the subject companys net asset valueadjusted (i.e., discounted) for a full 100 percent of the built-incapital gains tax liability.

THE BUILT-IN CAPITAL GAINS TAX LIABILITY

To illustrate the valuation impact of the built-in capital gainstax liability, lets assume that Target Company (a C corpora-tion) owns a single asset: a marketable security with (1) a fairmarket value of $1,000 and (2) a $ zero inside tax basis. Letsassume (1) the corporate income tax rate is 34 percent and (2)the individual income tax rate is 20 percent.

Lets assume that Buyer acquirers 100 percent of the stockof Target Company for $660. This $660 transaction purchaseprice is Target Companys $1,000 net asset value discountedby the $340 built-in capital gains tax liability on its singleappreciated assets. Target Company has no other liabilities.

Lets assume that Buyer can borrow $340 and then pur-chase the subject single asset (that is, the same marketablesecurity) directly for $1,000. In each case, Buyer has invested$1,000 to buy the underlying assetof which $660 is financedby equity and $340 is financed by debt. Buyer will then earninvestment returns associated with an asset worth $1,000.

STOCK PURCHASE VERSUS DIRECT ASSET INVESTMENT

The economic differences (1) between acquiring 100% of thestock of a C corporation and (2) making a direct investment inthe underlying asset (through the use of borrowing) are:

1. The direct investment in the underlying asset requires thepayment of cash interest expense during the investmentholding period, a factor in favor of the acquisition of the Ccorporation stock.

55


2. The debt associated with the direct investment in theunderlying asset is (i) fixed and (ii) not contingent on earn-ing any particular rate of return on the underlying asset, afactor in favor of the acquisition of the C corporation.

3. The direct investment in the underlying asset has a greatertax basis (i.e., $1,000) than the investment in the C corpo-ration stock (i.e., $660), a factor in favor of the directinvestment in the underlying asset.

4. The acquisition of the C corporation stock means that all ofthe investment returns will be subject to double taxation(i.e., once at the corporate level and once at the distribu-tee/shareholder level), a factor in favor of the direct invest-ment in the underlying asset.

There is a potential economic disadvantage of acquiringthe C corporation stock (with the built-in capital gain liability)relative to a direct investment in the underlying appreciatedassets. This relative economic disadvantage depends onwhether (1) the amount of the built-in capital gains tax liabili-ty of the C corporation is less than (2) the avoided cost of debtservice from the direct investment in the underlying asset.

VALUATION ADJUSTMENT ILLUSTRATIVE EXAMPLE

In the following discussion, we will present the comparativeafter-tax results of these two investment alternatives: (1) theacquisition of C corporation stock versus (2) underlying appre-ciated assets. We will analyze these two investment alternativesover a ten year investment holding period.

We will consistently use the valuation variable assumptionspresented in Table I in our analyses.

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In addition, we assume that the debt interest expense iscapitalized. The capitalized interest expense will increase theincome tax basis of the directly purchased underlying asset.

It is noteworthy that our illustrative example assumptionspresent the most favorable case for measuring the economicadvantage of the acquisition of the C corporation stock (rela-

tive to the direct purchase of the underlying asset). For exam-ple, all of the analyses assume that (1) the inside tax basis ofthe C corporation assets is zero and (2) the avoided cost ofborrowing (i.e., the debt interest rate) is equal to the expect-ed rate of return on the asset investment.

BASE CASE SCENARIO ANALYSIS

Table II below presents the calculations of the expected after-tax returns (i.e., profit) of the two investment alternatives: (1)stock acquisition of C corporation and (2) direct purchase ofthe underlying asset.

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The analysis summarized in Table II indicates that Buyer iseconomically indifferent between these two investment alter-natives. That is, the after-tax returns of these two investmentalternatives are identical.

Hereinafter, we will refer to Table II as the base case sce-nario analysis. This base case scenario is next adjusted for anormal spread between (1) the borrowing/interest rate and (2)the investment rate of return. This adjusted base case scenariois presented in Table III below.

ADJUSTED BASE CASE SCENARIO

In Table III, the normal spread is based on the historicalexcess of (1) public market equity rates of return compared to(2) the risk-free rate of return. Historically, large cap company

Purchase of Purchase ofTarget Company Underlying Asset

Stock with Borrowing$ $

Estimated Year 10 Value 2,594 2,594Inside Tax Basis of Assets - 2,594Sale Proceeds Less Inside Tax Basis 2,594 -Less: Corporate Income Taxes (882) -Sale Proceeds Available to Owner 1,712 2,594

Less: Investment Basis (660) (1,000)Equals: Taxable Gain on Investment/

Personal Income 1,052 1,594

Less: Personal Income Taxes (210) (319)

Pre-debt After-tax Cash Inflow 1,501 2,275

Less: Outstanding Asset Purchase Debt - (340)Less: Capitalized Interest Expense - (542)Add: Income Tax Benefit from

Interest Expense - 108

Terminal Value 1,501 1,501

Less: Original Equity Invested (660) (660)

Net After-tax Gain 841 841

Value of the underlying asset: $1,000

Inside tax basis of the underlying asset: $0

Transaction purchase price of the C corporation Target Company $660

Expected rate of return on investment: 10%

Borrowing interest rate: 10%

Corporate income tax rate: 34%

Individual income tax rate: 20%


66

equity rates of return have averaged approximately 13 per-cent. The historical annual excess of (1) large cap companyequity rates of return compared to (2) long-term risk-free(Treasury bond) income return has been approximately 8 per-cent.

From a lenders perspective, the acquisition debt used forthe direct asset purchase is well secured by the value of thecollateral (i.e., the appreciated underlying asset). The directasset purchase debt is also secured by the existence of putoptions, as will be discussed later.

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Considering the put options, the asset purchase debt isarguably risk-free to the lender. This assumption supports an 8percent interest rate spread.

In the analysis presented in Table III, the direct asset invest-ment alternative clearly generates a greater after-tax benefitthan does the purchase of the C corporation (TargetCompany) stock.

The analysis summarized in Table III assumes both (1) pos-itive expected rates of return as well as (2) positive actual ratesof return throughout the ten-year investment horizon. Now,lets assume that the investment becomes worthless immedi-ately following the purchase.

Under these assumed circumstances, the investment in theC corporation stock alternative generates an economic benefit(i.e., the net after-tax loss is less) compared to the directinvestment in the underlying asset alternative. In this scenario,when Buyer acquires the C corporation stock, it loses $660.When Buyer purchases the underlying asset, (1) it loses $660

and (2) it has to repay the $340 loan. However, in the directpurchase of underlying asset alternative, the buyer has a taxbasis of $1,000.

In the direct asset purchase alternative, Buyer can coverthis contingency by purchasing a put option. The put optionwill have a strike price equal to the market value of the securi-ty in an amount equal to the value of the security times thecorporate tax rate. The intrinsic value of the put option wouldexactly offset the amount by which (1) the return on theinvestment in the C corporation exceeds (2) the return of thedirect investment under any combination of tax assumptionsand basis assumptions.

Where Target Company has any positive tax basis in thepurchased assets, we assume that the sale at a loss will gener-ate an income tax benefit equal to (1) the income tax ratetimes (2) the amount of the loss. To the extent that there is noinside income tax benefit available from the loss, the putstrategy should be correspondingly adjusted.

PUT OPTION STRATEGY

Whether or not the direct asset purchase alternative is moreattractive than the purchase of Target Company stock dependson (1) the price of the put relative to (2) the financial advan-tage of the direct asset purchase.

The analyses presented in Tables II and III above calculatethe year 10 after-tax benefit of the two investment alterna-tives. These analyses allow for the differences in income taxand in financing costs. The price of the put option should bemeasured in todays dollars for purposes of comparing (1) thetwo investment alternatives (2) with the put option.

We should, therefore, adjust the amount of the year 10value to a present value. The discount rate for this calculationis adjusted to reflect the fact that the excess of the year 10benefit of the direct asset investment alternative is after indi-vidual income taxes.

The rate of return assumption is, therefore, adjusted toreflect the fact that the year 10 benefit is after-tax. This adjust-ment is based on individual income tax rates. The presentvalue of the after-tax amount of excess return is the maximumamount the direct asset investor would pay for the put option.

The maximum price of the put option using real worldassumptions amounts to approximately 53 percent of thevalue of the underlying asset. Based on real world assump-tions, Buyer would pay no more than 53 percent of the assetvalue of the direct asset investment alternative for the putoption.

SUBCHAPTER S ELECTION

The period for the financial analysis presented in Tables Ithrough III is 10 years. The selection of the 10 year time peri-

Purchase of Purchase ofTarget Company Underlying Asset

Stock with Borrowing$ $

Expected Year 10 Value 3,395 3,395Inside Tax Basis of Assets - 3,395Sale Proceeds Less Inside Tax Basis 3,395 -Less: Corporate Income Taxes (1,154) -Sale Proceeds Available to Owner 2,240 3,395

Less: Investment Basis (660) (1,000)Taxable Gain in Investment/

Personal Income 1,580 2,395

Less: Personal Income Taxes (316) (479)

Pre-debt After-tax Cash Inflow 1,924 2,916

Less: Outstanding Purchase Debt - (340)Less: Capitalized Interest Expense - (214)Add: Income Tax Benefit from

Interest Expense - 43

Terminal Value 1,924 2,405

Less: Original Equity Invested 660) (660)

Net After-tax Gain 1,264 1,745

77


od is based on the ability of Buyer to elect to be taxed underSubchapter S of the Internal Revenue Code. By making such anS election, the Buyer could avoid the built-in capital gains taxliability entirely by continuing to own the appreciated assetsfor a 10-year holding period.

Accordingly, lets expand the analytical model to allow forthe avoidance of the capital gains tax entirely. This assumptionregarding the deferral/avoidance of capital gains tax makes theacquisition of the C corporation stock more attractive than thedirect purchase of the underlying assets.

However, the price that Buyer will pay for the C corpora-tion stock is affected by the illiquidity of the S election. Thatprice reflects the fact that the asset cannot be soldand there-fore lacks marketabilityfor the statutory 10-year holdingperiod. A sale of the appreciated asset within the 10-year hold-ing will generate a lower rate of return than a direct purchaseof the underlying asset.

THE LACK OF MARKETABILITY ADJUSTMENT

This lack of marketability impact is measured by setting (1) theafter-tax terminal value of the C corporation alternative equal

to (2) the after-tax (post-debt) terminal value of the directasset purchase alternative. By solving for the beginning dollaramount of the stock required to be inside the C corporation,we can estimate the amount of stock necessary to provide anequivalent rate of return to the direct asset purchase alterna-tive.

It would be a lesser amount because both (1) the cost ofborrowing and (2) the built-in capital gains tax are avoided.The amount, however, has a bearing on whether or not Buyeris willing to lock up the asset ownership position, that is, toforgo marketability, for 10 years.

In the example presented in Table IV, the valueusing realworld assumptionsis $803. Therefore, $803 inside the CCorporation that elects S corporation status will generate thesame post-tax benefit as a $1,000 direct asset purchase invest-ment. However, the client asset purchase differs in one impor-tant respect from the stock acquisitioni.e., in the degree ofmarketability of the investment.

The buyer of the C Corporation stock must not sell theunderlying assets for a period of 10 years. This 10 year holdingperiod will avoid triggering the built-in gain (BIG) tax on thesale of the underlying assets. And this $803 value implies a lack

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AlternativesI II III

Direct Purchase of S ElectionAsset Target Equivalent to the

Investment Company Stock Stock Purchasewith with with

Borrowing S Election Borrowing$ $ $

Year 0 Value = $803 $2,841

Year 0 Value = $1,000 3,395 3,395

Sale Proceeds less Inside Tax Basis - - -Less: Corporate Income Tax Rate - - -Sale Proceeds Available to Owner 3,395 3,395 2,841

Less: Investment Basis 1,000 660 660Personal Gain on Investment/Taxable Income 2,395 2,735 2,181

Less: Personal Income Taxes 479 547 436

Pre-debt After-tax Cash Inflow 2,916 2,848 2,405

Less: Outstanding Purchase Debt 340 - -Less: Capitalized Interest Expense 214 - -

Add: Income Tax Benefit from Capitalized Interest Expense 43 - -

Terminal Values 2,405 2,848 2,405

Less: Equity Invested 660 660 660

Net After Tax Gain 1,745 2,188 1,745


88

of marketability discount of 19.7 percentas compared to a$1,000 asset purchase price. Most analysts would agree thatthe lack of marketability discount for a 10 year asset invest-ment holding period (i.e., a period of no marketability) is atleast 19.7 percent.

Another way to analyze this issue is to solve for the begin-ning amount of 10 year holding period stock that equals thedirect asset investment alternative. Ifthe $1,000 freely traded value wouldbe discounted by more than the capitalgains tax, then the direct asset invest-ment is clearly the economically advan-tageous alternative. In that alternative,there would be no borrowing and noput option.

SIMPLIFYING ASSUMPTIONS

For purposes of the analysis presented in Exhibit IV, we madethe following simplifying assumptions:

Transaction costs are ignored. Dividends are assumed to be zero. The price of a 10 year put option is estimated using market

volatility, current risk free rates of return, an assumption ofzero dividends, and a 10 yearduration in the Black-Scholesoption pricing model.

The Black-Scholes optionpricing model may not the bestanalytical procedure for estimat-ing the price of a long-termoption. Moreover, the price of aseries of put options covering theinterest component of the directasset investment alternative isignored.

If we assume the cost of these options was the same asthe put on the principal (which is probably overstating thecase), then the basic conclusion remains the same.

The price of put options is not considered in the estimateof the discount for lack of marketability. This discount isused in measuring the rate of return on the direct assetinvestment in order to set it equal to the C corporationasset. This assumption does not change the basic conclu-sion.

Income taxes are estimated as follows:1. The income tax benefit of the interest deduction is sim-

ply considered an addition to tax basis in year 10, andthe individual capital gains tax rate is used. To theextent that a current interest expense deduction isavailable at ordinary income tax rates, it is an econom-ic benefit to the direct asset investment alternative.

2. The income tax basis in the put option is ignored in allcalculations.

3. The proceeds from the exercise of the put option isassumed to offset the loss on the underlying asset. Theincome tax benefit of the loss is calculated at theassumed individual income tax rate.

4. Losses at the individual taxpayer level are assumed togenerate an economic benefit equal to the income taxrate times the amount of the loss.

5. Losses inside the Target CompanyC corporation are assumed togenerate income tax benefitsequal to (1) the corporate incometax rate times (2) the amount ofthe loss.

6. State and local income taxes areignored.

SUMMARY AND CONCLUSION

Each S corporation valuation dependson its unique set of facts and circumstances. However, thereappears to be no financial advantage to (1) the stock acquisi-tion of a C corporation with built-in capital gains relative to (2)the direct purchase of the underlying assets and a put option.

Accordingly, no willing buyer would pay a price premiumfor the acquisition of the C corporation stock over the tax-

adjusted net asset value of the targetcompany. No willing buyer wouldpay a price premium over the targetcompany tax-adjusted net assetvalue, and no willing seller wouldaccept less than the target companytax-adjusted net asset value.

The principal reason for this out-come is the fact that 100 percent ofthe gains inside the target corpora-tion are subject to double taxation.This double taxation offsets the

apparent financial benefits described in the introduction. Norational tax adviser will advise a client to structure his/hertransactions in a way that will subject investment returns todouble taxation if it can be avoided.

The apparent economic advantage of (1) buying the C cor-poration stock and (2) electing S corporation status is morethan offset by the fact that the underlying assets become non-marketable for a 10 year holding period.

Any asset holding period of less than 10 years will cause thedirect asset purchase alternative to generate a greater after-taxrate of return that the acquisition of C corporation stock alter-native.

Jacob P. Roosma is a partner and director in our New York office.He can be reached at 646/658-6240 or at [email protected] expanded version of this article is available in the OnlineLibrary--Presentations section of our firms Web site,www.willamette.com.

. . . there appears to be no financial advantage to (1) the stockacquisition of a C corporation with

built-in capital gains relative to (2) the direct purchase of the

underlying assets and a put option.

Most analysts would agree thatthe lack of marketability

discount for a 10 year assetinvestment holding period (i.e., aperiod of no marketability) is at

least 19.7 percent.

Willamette Management Associates

THE STANDARD OF EXCELLENCE

Founded in the 1960s, Willamette Management Associates is one of the oldestand largest independent valuation consulting, economic analysis, and financialadvisory firms. From offices in principal cities across the country, we serveclients ranging from substantial family-owned businesses to multinational cor-porations. Our independent advisory services relate to: transaction pricing andstructuring, taxation planning and compliance, and litigation support and dis-pute resolutions.

VALUATION CONSULTING SERVICES

Our business, securities, and property valuation services relate to: purchase orsale of business, purchase price or sale price allocation, federal income taxa-tion, gift and estate taxation, ad valorem property taxation, bankruptcy andreorganization, refinancing and restructuring, intellectual property transfers,intergenerational wealth transfer, like-kind exchanges, and financial reportingand GAAP compliance.

ECONOMIC ANALYSIS SERVICES

Our economic analysis services relate to: transfer pricing and licensing, remain-ing useful life estimation, royalty rate estimation, economic damages and lostprofits, infringements and deprivations, eminent domain and expropriation,and shareholder litigation.

FINANCIAL ADVISORY SERVICES

Our financial advisory services relate to: fairness opinions for mergers, acquisi-tions, liquidations, and divestitures; solvency opinions for highly leveragedtransactions; ESOP formations and ESOP stock transactions; and manage-ment/employee leveraged buyouts.

FOR MORE INFORMATION

Visit our Web site at www.willamette.com or contact the partner in charge atour nearest office.

111 S.W. Fifth Avenue 8600 W. Bryn Mawr Avenue 4501 North Fairfax DriveSuite 2150 Suite 950-N Suite 900Portland, OR 97204 Chicago, IL 60631 Arlington, VA 22203503 222 0577 773 399 4300 703 235 4600503 222 7392 (fax) 773 399 4310 (fax) 703 235 4610 (fax)Three Embarcadero Center 305 Madison Avenue 1355 Peachtree Street, NESuite 2350 Suite 5000 Suite 1470San Francisco, CA 94111 New York, NY 10165 Atlanta, GA 30309415 733 6900 646 658 6220 404 870 0601415 733 6910 (fax) 646 658 6230 (fax) 404 870 0610 (fax)

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11001100

INTRODUCTION

Valuation analysts who practice in the federal estate gift andestate taxation arena often seek professional guidance withregard to the valuation of unique assets, properties, or businessinterests. In particular, valuation analysts often seek profes-sional guidance with regard to the identification and quantifi-cation of business valuation/security analysis valuation adjust-ments. The more common of these valuation adjustmentsinclude: (1) discount for lack of marketability, (2) discount forlack of ownership/operational control, (3) premium of owner-ship control, (4) discount for key management/customerdependence, (5) and so on. Typically, valuation analysts firstresearch the relevant professional business appraisal standards,security analysis literature, and business valuation organizationpublications/ course materials. When these reference sourcesare lacking, valuation analysts may next research the relevantstatutory authority, judicial precedent, and administrative rul-ings. This is particularly true for valuations that will be subjectto judicial scrutiny.

When seeking professional guidance related to a taxationvaluation analysis, analysts first consider the statutory authori-ty and judicial precedent related to the specific income, trans-fer, or estate and gift tax issue. However, when such guidanceis still not adequate, analysts may seek guidance from InternalRevenue Service pronouncements. Even though such pro-nouncements may not have legal standing with regard to suchmatters, valuation analysts know that there are numerousService pronouncements and publications that provide profes-sional guidance with regard to preferred valuation methodolo-gies, procedures, data sources, and reporting.

This discussion will provide an overview of the most com-mon Service pronouncements and publications. This discus-sion will summarize the relative precedent value (or lack there-of) of these pronouncements with regard to federal estate andgift taxation valuation matters. This overview will help valua-tion analysts understand the relationship and relative authori-ty of Service pronouncements for purposes of relying on thatsource of professional guidance for estate gift tax-related valu-ations.

Since the publication of the first income tax regulations in1914, the Service has provided a great deal of professionalguidance to valuation analysts. The following summaries pro-vide brief descriptions of (1) federal taxation authority and (2)important Service pronouncements and publications. Eachsummary includes a description of the topic, publication title(with abbreviation), brief commentary on the purpose of thepublication, and a citation to relevant examples.

FEDERAL TAX LAW

The following authorities constitute the law with regard tofederal taxes.

Internal Revenue Code (IRC) (e.g., IRC Section 2001estate & gift tax imposition and rate of tax)

The Internal Revenue Code codifies all federal tax lawsincluding income, estate, stamp, gift, excise, and othertaxes. To implement the Internal Revenue Code, the leg-islative branch of the federal government (1) designatedthe Treasury Department to supervise administration andenforcement of the federal tax laws and (2) created theInternal Revenue Service. The Internal Revenue Code is thefinal statutory authority with regard to federal taxationissues.

The first codification of the nations various tax laws wascreated by the U.S. Congress in 1939 and was entitled theInternal Revenue Code of 1939. Congress recodified all ofthe tax laws in the Internal Revenue Code of 1954. The cur-rent codification of the U.S. tax laws is the Internal RevenueCode of 1986.

The Internal Revenue Code is divided into subtitles,chapters, subchapters, parts, subparts, sections, subsec-tions, paragraphs, subparagraphs, and clauses. Subtitle Aincludes the tax law related to income taxes. Subtitle Bincludes the tax law related to estate and gift taxes.

Code of Federal Regulations (CFR) (e.g., T.26 CFR Ch. 1Pt. 20 estate tax)

The Code of Federal Regulations is the annual accumula-tion of executive agency regulations published in the dailyFederal Register, combined with all regulations issued previ-ously that are still in effect. Title 26 of the Code of FederalRegulations pertains to the Internal Revenue Code, andPart 1 of Title 26 relates to federal income tax.

INTERNAL REVENUE SERVICE PUBLICATIONS

The Service regularly publishes its official positions, includingthe following:

Regulations (e.g., Regs. Sec. 54.4975-11 ESOPrequirements)

Regulations explain Service positions, set rules of opera-tion, and provide details on complying with the federal

ESTATE/GIFT TAX VALUATION PROFESSIONALGUIDANCE FROM IRS PUBLICATIONS

Jeffrey S. Buettner and Robert F. Reilly


1111


income, gift, and estate tax laws. Regulations are typicallyclassified into three general categories: (1) legislative, (2)interpretative, and (3) procedural. Regulations ofteninclude examples with computations. These examples areintended to assist taxpayers (and valuation analysts) inunderstanding the actual statutory language.

Regulations represent the official Treasury Departmentinterpretation of the Internal Revenue Code. The courtsgenerally accord regulations the full force and authority asthe Internal Revenue Code, as long as they are reasonableand consistent with the statutory provisions they interpret.Before final regulations are issued, a notice of proposedrulemaking must be issued. And, the public must be givena chance to comment on the proposed rules.

Regulations are generally first issued to the public inproposed form. A proposed regulation generally is givenlittle weight as a legal precedent. Nonetheless, it may berelevant to the business appraiser. This is because a pro-posed regulation reveals the direction of Service policy in aparticular area. Sometimes, a proposed regulation will beissued stating that taxpayers may rely on it until theissuance of a final regulation.

After a major statutory change (i.e., to the InternalRevenue Code), the Service often issues temporary regula-tions. These are usually effective upon publication.Temporary regulations give taxpayers (and valuation ana-lysts) guidance on procedural or computational mattersuntil the Service (and the Treasury Department approves)final regulations. Temporary regulations are always issuedconcurrently as proposed regulations.

Treasury Decisions (e.g., T.D. 8940)When the Internal Revenue Service Commissioner, with theapproval of the Treasury Secretary, has finalized the instruc-tions and interpretations of a regulation, a TreasuryDecision is issued. A Treasury Decision includes a preamblestatement that describes the contents of the new final orproposed regulation in a manner sufficient to apprise areader who is not an expert in the subject matter of therulemaking document.

The promulgation date of a Treasury Decision is thedate the document is filed by the Federal Register for publicinspection. Such regulations are effective for the periodcovered by the law section they interpret unless theyspecifically provide otherwise.

Revenue Rulings (Rev. Rul.) (e.g., Rev. Rul. 59-60)A revenue ruling is an official interpretation by the Serviceof the tax laws, related statutes, tax treaties, and regula-tions that has been published in the Internal RevenueBulletin. A revenue ruling states the Service position on howthe law is applied under certain facts. A revenue ruling mayhave any of the following effects on other Service pro-

nouncements: amplify, clarify, distinguish, modify, obso-lete, revoke, supersede, supplement, or suspend.

Revenue rulings are published by the Internal RevenueService National Office in the Internal Revenue Bulletin forthe information and guidance of both taxpayers andService officials. Revenue rulings do not have the force orthe authority of regulations (or of federal court cases).

Revenue rulings simply present the Service view of thetax law. And, the Service may not rely on a revenue rulingthat is contrary to a regulation.

A taxpayer may rely on a revenue ruling (1) if the factsof his or her case are substantially the same as those in theruling and (2) if the ruling has not been superseded.Revenue rulings generally apply retroactively, as do modifi-cations or revocations of revenue rulings. Soon after it isreleased, a revenue ruling is published in the weeklyInternal Revenue Bulletin.

Revenue Procedures (Rev. Proc.) (e.g., Rev. Proc. 971-9,1997-1 C.B. 644)

A revenue procedure is an official statement of the Servicepractice and procedure (1) that affects the rights or dutiesof taxpayers under the Internal Revenue Code or (2) thatcontains information the Service believes should be publicknowledge. Revenue procedures are first published in theInternal Revenue Bulletin and later in the Cumulative Bulletin.

As the name suggests, revenue procedures are Servicepronouncements that usually deal with the proceduralaspects of tax practice. Although revenue procedures donot have the force and effect of regulations, they do havethe same precedential value as revenue rulings.

Federal Register (F.R.)The Service is required by law to give interested persons anopportunity to participate in the rulemaking process. TheFederal Register is published daily. It is the medium for mak-ing federal agency regulations and other legal documentsof the executive branch available to the public.

The Internal Revenue Bulletins (I.R.B.)The Internal Revenue Bulletin is the authoritative publicationof the official rulings and procedures of the Service. It ispublished on a weekly basis. The IRB is intended to serve asa means of promoting the uniform application of tax lawson the part of both (1) the Service and (2) the taxpayers(and their professional advisors).

Cumulative Bulletin (CB)In order to provide a permanent reference source, the con-tents of the weekly Internal Revenue Bulletin are consolidat-ed semiannually into an indexed Cumulative Bulletin. In theillustrative citation presented above regarding revenue pro-


1122

cedures, Rev. Proc. 97-19 is the nineteenth revenue proce-dure that was issued in 1997. Rev. Proc. 97-19 is printed inVolume 1 of the 1997 Cumulative Bulletin, on page 644.

Internal Revenue Manual (IRM) (e.g., IRM Sec. 87appeals technical & procedural guidelines)

The Internal Revenue Manual is a compilation of instructionsby the Service for the guidance of its employees whenadministering the various tax laws. The IRM does not haveany legal precedent standing. However, it is useful to valu-ation analysts in that it (1) clarifies the meaning of specifictax terms, (2) amplifies the regulations, and (3) sets forththe Service position on numerous topics. Also, the IRMrequires Service employees to deal with taxpayers in aspecified manner.

The IRM sets forth the policies, procedures, instructions,and guidelines for the Service organization and its opera-tions. The IRM addresses the day-to-day conduct of Serviceexaminations, agents, appeals officers, and other person-nel. Although the Service is bound by the procedural rulesit adopts, the IRM policies and guidelines are not legallybinding. This is because the IRM procedures are directoryand not mandatory.

The value of the IRM as a professional guidance tool tothe valuation analyst is to indicate the direction of thinkingby the Service on a particular technical issue. The Service iscurrently in the process of completely reorganizing theIRM. The objective of the IRM is the chief line of communi-cation of Internal Revenue Service National Office policy tofield agents.

IRS Valuation Training for Appeals OfficersThis appeals officer course book provides valuation analystswith the Services insights into valuation concepts andmethodologies. Some of the specific areas discussed in thecourse book include: (1) the financial analysis and valuationof closely held corporations and (2) methods for valuingreal estate, tangible personal property, art objects and col-lectibles, preferred stock, and intangible assets and intel-lectual property. In addition, this course book discusses val-uation discounts and premiums, restrictive stock transferagreements and stock buy-sell agreements, and valuation-related tax penalties.

Announcements, Notices, and News ReleasesNotices and announcements are used by the Service toprovide guidance on a particular topic or procedure.Inernal Revenue Service notices and announcements maybe relied on by taxpayers. They are considered substantialauthority for purposes of the valuation accuracy-relatedpenalty. In terms of legal authority, announcements andnotices are the equivalent of revenue rulings and revenueprocedures (according to Revenue Ruling 87-2).

Internal Revenue news releases (IRs) are used to (1)update taxpayers on compliance statistics, (2) remind tax-payers of recent changes in the Internal Revenue Code, (3)announce administrative appointments within the IRS, and(4) release certain revenue rulings and procedures. The IRs,announcements, and notices are issued periodically, buttheir official publication is in the Internal Revenue Bulletin.

ADVANCE RULINGS AND DETERMINATIONS

Advance rulings and determination letters provide a responseto taxpayers (1) as to their status for tax purposes and (2) as tothe tax effects of their proposed acts or transactions.

Private Letter Rulings (PLR) (e.g., IRS PLR 200130006(August 6, 2001))

A private letter ruling is a written response issued to a tax-payer by the IRS National Office. A private letter rulinginterprets and applies the tax laws to a taxpayers specificset of facts. Private letter rulings constitute a historicalrecord of interpreting the Service position. They have ahigh level of credibility since the Service is unlikely toreverse itself once it has established a position on a certaintax issue.

The Service generally has the discretion to issue letterrulings whenever it is in the interest of sound tax adminis-tration to do so. In certain tax areas, however, rulings aremandatoryi.e., the taxpayer must request a ruling andthe Service must issue one in response. Although each let-ter ruling states that it can only be relied on by the tax-payer to whom it is addressed, some courts have used a let-ter ruling as an indication of the Service position on a par-ticular issue.

In the above illustrative citation, the first four digits ofthe number indicate that the letter ruling was issued in2001. The date in the parentheses indicates that it wasissued on August 6, 2001, in fact.

The next two digits indicate the week in which the let-ter ruling was issued (here, the 30th week). The last threedigits indicate the ruling for the week (here, the 6th).

Determination LettersA determination letter is a written statement issued by anIRS district director in response to a written inquiry by ataxpayer. A determination letter applies the principles andprecedents previously announced by the IRS NationalOffice to a taxpayers specific set of facts.

Each determination letter is based on a specific set oftaxpayer facts and circumstances. And a determination let-ter can only be relied on by the taxpayer to whom it isaddressed. However, business appraisers can use determi-nation letters to better understand the Service position onspecific issues.

1133


Technical Advice Memorandums (TAM) (e.g., TAM9801001 (January 1, 1998))

Technical advice memorandums are written determinationscontaining advice or guidance furnished by the ServicesNational Office upon request of a district director. InternalRevenue Service district directors may request technicaladvice on any technical or procedural question that devel-ops during an audit or during the claim of a taxpayer.Generally, the legal force and effect of a TAM is the same asthat of a private letter ruling.

Letter rulings are issued on the request of the taxpayerand may address prospective transactions. In contrast toletter rulings, technical advice memorandums (1) are givenonly on request of the government and (2) concern onlycompleted transactions. However, a taxpayer may ask thegovernment to request a technical advice memorandumon a particular issue arising during a transaction proceed-ing.

In the above illustrative citation, the example was thefirst technical advice memorandum to be issued in the firstweek of 1998. The issue date of this TAM was January 1,1998.

Technical Memorandums (TM)In order to summarize and explain published regulations,the Service issues Technical Memorandums. TMs state theissues involved, identify controversial legal or policy ques-tions, discuss the reasons for the approach taken, and pro-vide background information.

NEW TYPES OF IRS PRONOUNCEMENTS

The following are examples of several new types of InternalRevenue Service pronouncements.

Information LettersAlthough the Service has issued general information lettersfor many years, they just became available for public dis-closure in 2000. Information letters are written statementsissued to a taxpayer that call attention to an establishedinterpretation of tax law without applying it to a specificset of taxpayer facts and circumstances.

Information letters are sometimes issued (1) when ataxpayer requests general information from the Service or(2) when a taxpayer requests a private letter ruling ordetermination letter, but fails to comply with all of the pro-cedural requirements. Since information letters do not havethe effect of a private letter ruling, the Service is not boundby information letterseven with regard to the individualtaxpayer who receives the letter.

Market Segment Specialization Program Guides(MSSPs)

MSSPs consist of industry-specific guides used to trainInternal Revenue Service examiners (1) to understand and(2) apply audit techniques needed in a particular marketsegment. A market segment generally consists of anindustry or a profession. However, in some instances, anissue requiring specialized auditing techniques may com-prise a market segment.

Although MSSPs cannot be relied on as a precedent, aknowledge of these guides can be of use to both taxpayersand analysts (1) not only when confronted by an audit sit-uation, but also (2) as an aid in avoiding an audit alto-gether.

Chief Counsel AdviceChief Counsel Advice is written advice or instruction fromthe Internal Revenue Service National Office component ofthe Office of Chief Counsel that is issued to field employ-ees. It conveys (1) a legal or Service position on a revenueprovision or (2) a legal interpretation of law relating to theassessment or collection of a liability under a revenue pro-vision.

A revenue provision includes the Internal RevenueCode, regulations, revenue rulings, revenue procedures,other published or unpublished guidance or tax treaties.

The following guidance are also included in this cate-gory of Service pronouncement release: (1) field serviceadvice, (2) technical assistance to the field, (3) service cen-ter advice, (4) litigation guideline memorandums, (5) taxlitigation bulletins, and (6) criminal tax bulletins.


In order for a valuation analyst to effectively rely on InternalRevenue Service pronouncements for professional valuationguidance, it is important for the analyst to have a workingknowledge of Service publications. It is also important for thevaluation analyst to understand both (1) the content of and (2)the relative precedent value of the various Service pronounce-ments.

This is particularly true for valuation analysts who rely onInternal Revenue Service pronouncements for professionalguidance valuation with respect to federal taxation matters.

Jeffrey Buettner is a senior associate of our firm and is resident inour Chicago office. Jeff can be reached at 773/399-4338 or at [email protected]. Robert Reilly is a managing director ofour firm and is resident in the Chicago office. Robert can be reachedat 773/399-4318 or at [email protected].

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1155



DECOUPLING STATE ESTATE TAXESFROM FEDERAL ESTATE TAXES:

WILL THESE CHANGES AFFECT ESTATE VALUATIONS?Curtis R. Kimball, CFA, ASA

INTRODUCTION

Due to the Economic Growth and Tax Relief Reconciliation Actof 2001 (EGTRA), the state-level death tax credit is phasedout over a period of years. The state death tax credit was orig-inally created as direct cash tax payment program to the statesthat offset federal estate taxes. Consequently, many statesexpect steep declines in their estate taxcollections as a result of the EGTRA fed-eral estate tax phase-out.

However, in response to expectedreduction in tax credit payments fromthe federal government, most stateshave not been sitting still. Some 16states1 and the District of Columbia arerevising their estate tax laws. These revi-sions to local tax laws make sure thatstate-level estate taxes wont be effec-tively eliminated with the federal level credit phase-out. As aresult, it is likely that executors will face (1) more complex cal-culations of the estate tax liability and (2) additional filingrequirements at the state level.

This article will describe the successes and failures thatsome states have experienced with regard to the revision oftheir estate tax laws. In particular, this article will focus on whatthese revisions mean to estate execu-torsand to their professional advisors.

PROBLEMS RELATED TO STATEDECOUPLING FROM FEDERALESTATE TAXES

Two immediate problems have occurredas the states decouple their death tax sys-tems from the federal estate tax rules.

First, many of the new state death tax laws are not consis-tent with the new federal estate tax lawsor with each other.As an example, the State of New Jerseys new estate tax lawonly exempts the first $675,000 of assets from state estatetaxeswhile the new federal exemption limit is $1 million ofassets. Therefore, New Jersey estates may owe an unexpectedadditional $32,000 in state estate taxes.

Pennsylvanias tax exemption is $700,000 of assets. And itwill eventually increase to $1 million of estate taxes by 2006.

However, this Pennsylvania tax exemption is also a departurefrom the current federal estate tax exemption amount.

The fact that the federal estate tax rules are themselves amoving target (e.g., federal estate tax exemption amountsincrease to $3.5 million by 2009), creates headaches for bothestate planners and estate executors.

Second, many of the state death taxlaws were passed as temporary mea-sures. For example, Maines new statedeath tax law is only effective for 2002.Also, the Wisconsin new death tax rulesonly cover the years through 2007.

CONSISTENCY OF ESTATE TAXAPPRAISAL STANDARDS

Heretofore, the filing of state estate taxreturns was relatively easy with respect to valuation issues.Copies of federal estate tax valuation reports were typicallyincluded with any state tax returns. The standard of value forthe valuation of estate assets was fair market value for thestate returns. This standard of value was based on the hypo-thetical willing buyer/hypothetical willing seller test. This is thesame standard of value that is promulgated under the federal

estate tax rules.

Although it is too soon to be sure,analysts assume that the same fair mar-ket value value standard will be in effectfor state estate tax returns under the newtax regulations. However, this may not bean entirely valid assumption. This isbecause the states have shown a tenden-cy to differ in accepted valuation proce-dures and rules in other areas of the law.Examples of these differences include (1)

the equitable division of marital assets in the family lawstatutes and (2) the fair value standard under shareholder dis-senters rights statutes.

ESTATE TAX APPRAISAL DISCLOSURE REQUIREMENTS

The current standard for the disclosure of valuations under fed-eral transfer tax filing is set forth in the adequate disclosure

Two immediate problemshave occurred as the states

decouple their death taxsystems from the federal

estate tax rules.

This is because stateshave shown a tendency to

differ in valuation procedures and rules inother areas of the law.


1166

regulations issued by the Service. The Service has issued itsfinal regulations relating to the value of prior gifts for purpos-es of computing estate and gift taxes. The period of limitationson gift taxes will begin to run only if the gift is adequately dis-closed.

The final regulations, issued December 3, 1999, states thatthe submission of an appraisal will meet the adequate disclo-sure requirements with respect to the valuation of any gifttransfer if the appraisal meets therequirements of Regulation Section301.6501(c)-1(f)(3).

FEDERAL ESTATE TAX APPRAISERSTANDARDS

Under Regulation 301.6501(c)-1(f)(3),with respect to the person(s) preparingthe appraisal report, the appraiser mustmeet the following standards:

1. The person must be an individual who holds himself/herselfout to the public as a professional appraiser, or who per-forms appraisals on a regular basis.

2. The appraiser is qualified to make appraisals of the type ofproperty being valued.

3. The appraiser is not (i) the donor, donee, or any employeeof either, or (ii) a member of the family of any of these par-ties.

FEDERAL ESTATE TAX APPRAISAL REPORTSTANDARDS

Also with regard to Regulation301.6501(c)-(f)(3), the appraisal reportmust contain the following information:

1. The date of the appraisal.

2. The date of the transfer.

3. The purpose of the appraisal.

4. A description of the property.

5. A description of the appraisal process employed, includingthe valuation method(s) used.

6. A description of the assumptions used.

7. A description of any hypothetical conditions considered.

8. Descriptions of any restrictions or other limiting conditionspresent.

9. The information considered in determining the value;including all financial information in sufficient detail to

allow the reader to replicate the appraisal analysis and val-uation.

10.The reasoning that supports the analysis, opinions, andconclusions.

11.Any specific comparative transactions utilized in the valua-tion analysis.

12. For fractional interests the fair market value of 100 percentof the entity estimated without regard to any discounts in

valuing the entity or the assets ownedby the entity, unless this information isnot relevant or material in estimatingthe value of the subject interest.


It would be unfortunate for states topromulgate different appraiser/appraisal reporting standards fromthose in the current federal regulations.This is because the Service has been

moving closer to embracing the valuation standards endorsedby (1) the American Society of Appraisers (ASA) and (2) theUniform Standards of Professional Appraisal Practice (USPAP)as promulgated by The Appraisal Foundation.

In October 2001, the Service published its BusinessValuation Guidelines. The Services Business Valuation Guidelinesreflect a wealth of experience in the federal estate tax area par-ticularly with regard to controversies over valuation issues.

Insights readers who would like a copy of the latest InternalRevenue Service (1) Business ValuationGuidelines and (2) checklists for prepar-ing valuation reports should email sucha request to [email protected].

Since the implementation of EGTRA,many states have revised their statedeath tax regulations. This is becausemany states are concerned aboutexpected reductions in the federal tax

transfer payments. High net worth individuals and estateexecutorsand their professional advisorsshould considerthe implications of these changes with regard to (1) estateplanning, (2) estate tax return compliance, and (3) estate val-uations.

Note:

1. Arkansas, Kansas, Maine, Maryland, Massachusetts,Minnesota, Nebraska, New Jersey, New York, Oregon,Pennsylvania, Rhode Island, Virginia, Vermont,Washington, and Wisconsin.

Curtis R. Kimball is a partner and director of our Atlanta, Georgia,office. Curtis can be reached at 404/870-0607 or [email protected].

It would be unfortunate forstates to promulgate

differences in the currentappraiser/appraisal reporting

standards from the federalregulations.

Since the implementation ofEGTRA, many states have

revised their state death taxregulations.

We are pleased to recognize the employmentanniversaries of several or our professionals. Theseanniversaries were recognized at our firms annualprofessional development retreat, held this year in

Portland, Oregon, in November 2002.

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These anniversaries represent significant careermilestones for our dedicated, tenured colleagues.

Each of these employees personifies the WillametteManagement Associates standard of excellence in

experience, creativity, and responsiveness.

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Jeff is member of the financial advisory services practice of our Chicago office.

Jeff holds a BA degree in finance from theUniversity of Kentucky

and an MBA in finance from the Joseph M. KatzGraduate School of Business at the

University of Pittsburgh.

Prior to joining Willamette ManagementAssociates, Jeff was a member of the

PricewaterhouseCoopers corporate valuation con-sulting practice.

As recognized by this promotion, Jeff exemplifies the Willamette Management Associates

standard of excellence in client service, professional integrity, and technical expertise.


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has redeemed a minority interest from

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The undersigned acted as financial advisor tothe Board of Directors of

Advanced Drainage Systems, Inc.in this transaction.

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purchased a 100 perent interest in

RRoobbeerrtt BBoowwddeenn,, IInncc..

The undersigned acted as financial advisor to theTrustee of Robert Bowden, Inc.

Employee Stock Ownership Plan.and rendered a fairness opinion in this transaction.


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INTRODUCTION

Recently, there has been much controversy regarding the busi-ness valuation of Subchapter S closely held corporations in thelegal, taxation, estate planning, and valuation communities.This controversy has arisen from several recent United StatesTax Court decisions1 including Gross v. Commissioner,2 Heck v.Commissioner,3 and Adams v. Commissioner.4

In this controversy, most commentators have primarilyfocused on the differences in legalattributes, cash flows, and profit distri-butions of C corporations versus S cor-porations. While these are importantconsiderations, the current discussionhas failed to address (1) the economiccharacteristics of investment rates ofreturns of publicly traded C corpora-tions and (2) whether these rate ofreturn characteristics match well withthe economic benefits derived by Scorporation shareholders.

This discussion will (1) demonstratethe differing economic benefits attrib-utable to the income tax treatment of S corporation share-holders as opposed to C corporation shareholders5 and (2)provide a mathematical framework to adjust the indicatedequity value of an S corporation6 in order to account for theseeconomic differences.

PREAMBLE

First, the value of a business enterprise primarily depends on its(1) operational (e.g., management, workforce, productionprocesses, etc.), (2) financial (e.g., revenue growth, earningsvolatility, profit margins, etc.), (3) macro-economic (e.g., U.S.and regional economic conditions, etc.), and (4) micro-eco-nomic (e.g., cost of capital, industry conditions, etc.) charac-teristics. However, recent research7 has demonstrated that theelection to be treated as a C corporation or as an S corporationfor income tax purposes may have an impact on the value of abusiness enterprise on a controlling ownership interest basis.

Second, it is possible that the income tax attributes of Scorporations versus C corporations may result in value at theshareholder level. This is due to the following: (1) C corpora-tions are subject to corporate income tax rates at the entity

level, (2) dividends from C corporations are subject to ordinaryincome tax rates at the shareholder level, (3) the undistributedincome from an S corporation changes the income tax basis ofthe shareholders ownership interest, and (4) S corporationshareholders are required to recognize a pro rata share of thereported net income of the S corporation on their personalincome tax returns. All other factors being equal, these differ-ences may ultimately affect the economic value of S corpora-tion shares when compared to otherwise identical C corpora-

tion shares.

Third, lets consider the premisethat capital markets are efficient (atleast over the long term).Consequently, investment rates ofreturn (and price/earnings multiples)of C corporations contemplate theincome tax attributes discussed above.Based on this premise, there is a con-ceptual mismatch between (1) theempirical market-derived data (i.e.,rates of return, price/earnings multi-ples, etc.) of publicly traded C corpo-rations and (2) the economic charac-

teristics of the earnings reported by closely held S corpora-tions.

Fourth, analysts currently do not have the ability to specif-ically isolate and quantify value differences solely attributableto the income tax characteristics of S corporations versus Ccorporations in empirical studies of actual transactions. This isbecause of the nearly infinite variety of corporate transactionstructures. This is true in both the public and private transac-tion markets. Consequently, valuation analysts need to devel-op a mathematical model that conceptually addresses the dif-ferences in economic benefit between S corporation and Ccorporation shareholders.

This discussion will demonstrate the conceptual mismatchbetween (1) the economic characteristics of the empirical mar-ket data of publicly traded C corporations and (2) the eco-nomic characteristics of the earnings of S corporations. Also, amathematical model that may be used to adjust the indicatedvalue of equity of an S corporationwhere such value is esti-mated using empirical studies and analyses of C corpora-tionsis provided. It is noteworthy that the analysis containedin this article is only applicable to the valuation of equity inter-ests that lack ownership control (i.e., that are valued on a non-controlling ownership interest basis).

THE VALUATION OF S CORPORATION STOCK:THE EQUITY ADJUSTMENT MULTIPLE

Daniel R. Van Vleet

It is noteworthy that the analysis contained in this article

is only applicable to the valuation of equity interests thatlack ownership control (i.e., thatare valued on a noncontrolling

ownership interest basis).

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BUSINESS VALUATION APPROACHES

One of the more interesting aspects of the current controversyis that it has focused on the income approach to business val-uation. The impact that S corporation status has on both themarket approach and asset-based approach to business valua-tion has been conspicuously absent from the discourse.

There is no conceptual reason as to why the valuationimpact of S corporation tax status is limited to the incomeapproach. If S corporation shares have an inherent economicbenefit over C corporation shares, then this economic benefitshould be reflected in all business valuation approaches.9

The market approach and the income approach share twofundamental valuation components: (1) a measurement ofeconomic income and (2) a capitalization rate,10 present valuediscount rate,11 or market-derived pricing multiple12 (i.e.,price/earnings pricing multiple). Most of the current discussionregarding S corporations has focusedon the income tax attributes of theeconomic income and ignored theeconomic characteristics of the capi-talization rates, present value dis-count rates, and market-derived pric-ing multiples (collectively referred toas capitalization rates).

INVESTMENT RATES OF RETURN

In order to conceptually match theeconomic characteristics of economic income to the capital-ization rates, it is necessary to understand how investmentrates of return are calculated. The following formula presentsthe mathematical calculation of the equity rate of return.

where:

k1 = Rate of return on equity during period 1

S1 = Stock price at beginning of period 1

S0 = Stock price at end of period 1

d1 = Dividends paid during period 1

The above formula illustrates that investment rates ofreturn on equity securities are derived from a combination ofcapital appreciation and dividend/distribution payments.

Empirical studies on equity rates of return provided in pub-lications like Stocks Bonds Bills and Inflation or the Cost ofCapital Quarterly (both published by Ibbotson Associates) are

based on the capital appreciation and dividends of publiclytraded C corporations. Also, market-derived pricing multiples(i.e., price/earnings multiples based on EBITDA, net income,etc.) are conceptually the mathematical inverse of the invest-ment rate of return.

For purposes of this discussion, lets assume that equityinvestment rates of return on C corporations are derivedentirely from net income. In other words, lets assume that netincome is either paid to the shareholder in the form of divi-dends or that the retained portion of net income results in thecapital appreciation of the stockholders interest.13

Consequently, empirical studies of C corporation invest-ment rates of returnat the shareholder levelinherentlyreflect the income tax treatment of (1) C corporations at theentity level and (2) capital appreciation and dividends of C cor-poration shares at the shareholder level.

As will be demonstrated below,there are significant differences inthe income tax treatment of C cor-poration shares and S corporationshares. Consequently, when using Ccorporation (1) empirical studies and(2) pricing evidence to value S cor-poration equity ownership interests,it is necessary to adjust the indicatedequity value of the S corporation.

S CORPORATIONS VERSUS C CORPORATIONS: THECONCEPTUAL MISMATCH

There are a variety of differencesboth tax and non-taxbetween S corporations and C Corporations. There is substan-tial literature that describes these differences. This discussionwill not address the vast majority of these differences. Instead,this discussion will focus solely on the valuation implicationsattributable to the income tax and capital gains tax differencesbetween S corporations and C corporations at the shareholderlevel.

The following Table 1 illustrates the effect of these incometax differences. The analysis in Table 1 is based on the follow-ing assumptions:

The C corporation is publicly traded and is identical inevery respect to the S corporation (other than the incometax status of each corporation).

The investment rates of return and market derived pricingmultiples of the C corporation are used to value the S cor-poration.

The shares of the C corporation and the S corporation areowned on a noncontrolling ownership interest basis.

0

1011

)(S

dSSk +=

In order to conceptually matchthe economic characteristics of

economic income to the capitalization rate, it is necessary

to understand how investmentrates of return are calculated.


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The distribution (i.e., dividend) scenarios are as follows: (1)zero distributions, (2) a distribution of 40 percent of netincome, and (3) a distribution of 100 percent of netincome.

The corporate income tax rate is 40 percent. The ordinary income tax rate applicable to individuals is 40

percent.

The applicable capital gains tax rate is 20 percent. The capital gains tax liability is economically recognized

when incurred.

Capital appreciation in the shares of each company isderived solely from increases in retained earnings.

The retained earnings of the C corporation are necessaryfor businesses purposes. Consequently, the C corporationwould not be subject to the accumulated earnings taxunder Internal Revenue Code Section 531.

THE DIVIDEND PAYMENT RATIO

The analysis of Table 1 leads to the following three importantconclusions:

1. the net economic benefit to the S corporation shareholder(NEBS) is greater than the net economic benefit to the Ccorporation shareholder (NEBC)regardless of earningsdistribution (i.e., dividend payout ratio) scenario,

2. the NEBC declines as the dividend payout ratio increases,and

3. the NEBS remains the same regardless of dividend payoutratio.

Each of these three conclusions is discussed below.

The NEBS is greater than the NEBC regardless of dividendpayout ratio. This is due to the fact that S corporationshareholders have two distinct income tax advantages: (1)dividends are not taxable at the shareholder level and (2)undistributed earnings of the S corporation increase the taxbasis of the S corporation shares. Shareholders in C corpo-rations do not enjoy either of these income tax benefits.

The NEBC declines as the dividend payout ratio increases.This is attributable to a greater proportion of the total eco-nomic benefit of the C corporation shareholder beingtaxed at the higher ordinary income tax rate of 40 percent(as opposed to the lower capital gains tax rate of 20 per-cent).

The NEBS remains the same regardless of the dividend pay-out ratio. This is due to the fact that the S corporationshareholder receives either (1) cash or (2) tax-free capitalappreciation in the value of the stock.

The mix of economic benefit of cash or tax-free capitalappreciation changes as the dividend payout ratiochanges. However, the NEBS remains the same regardlessof the dividend payout ratio. Consequently, an increase in

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No Distribution 40% Distribution 100% Distributionof Earnings of Earnings of Earnings

C Corp. $ S Corp. $ C Corp. $ S Corp. $ C Corp. $ S Corp. $

Income Before Income Taxes 100,000 100,000 100,000 100,000 100,000 100,000Corporate Income Taxes (40,000) NM (40,000) NM (40,000) NMNet Income 60,000 100,000 60,000 100,000 60,000 100,000

Dividends to Shareholders 0 0 24,000 40,000 60,000 100,000Income Tax Due by Shareholders 0 (40,000) (9,600) (40,000) (24,000) (40,000)Net Cash Flow to Shareholders 0 (40,000) 14,400 0 36,000 60,000

Net Income 60,000 100,000 60,000 100,000 60,000 100,000Dividends to Shareholders 0 0 (24,000) (40,000) (60,000) (100,000)Net Capital Gains 60,000 100,000 36,000 60,000 0 0Increase in Income Tax Basis 0 (100,000) 0 (60,000) 0 0Net Taxable Capital Gains 60,000 0 36,000 0 0 0Capital Gains Tax Liability (12,000) 0 (7,200) 0 0 0Net Capital Gains Benefit to Shareholder 48,000 100,000 28,800 60,000 0 0

Net Cash Flow to Shareholders 0 (40,000) 14,400 0 36,000 60,000Net Capital Gains Benefit to Shareholder 48,000 100,000 28,800 60,000 0 0Net Economic Benefit to Shareholder 48,000 60,000 43,200 60,000 36,000 60,000

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the dividend payout ratio serves to increase the differencein the net economic benefit between C corporation share-holders and S corporation shareholders.

The primary conclusion derived from Table 1 is that the div-idend payout ratio of the C corporation is the most importantaspect of the difference in the net economic benefit betweenC corporations and S corporations at the shareholder level.

As indicated by this analysis, there is a conceptual mis-match between (1) the information derived from empiricalstudies of transactions involving C corporation shares and (2)the net economic benefit enjoyed by S corporation sharehold-ers. Further, this mismatch is not properly corrected by (1) taxeffecting the S corporation reported net income12 at somecombination of federal and state income tax rates or (2) usingpretax measurements of rates of return or pretax market-derived pricing multiples (i.e., price/earnings pricing multiplesbased on EBIT, EBITDA, etc.) derived from C corporations.

Also, the application of C corporation after-tax rates ofreturn or after-tax market derived pricing multiples (i.e.,price/earnings pricing multiples based on net income or debt-free net income) to S corporation reported net income isequally incorrect.

As previously mentioned, empirical studies are unable toisolate the economic differences solely attributable to the dif-fering income tax treatments of C corporation and S corpora-tion shares. Consequently, it is necessary to develop a mathe-matical model that conceptually adjusts the indicated value ofequity of an S corporation when empirical studies of C corpo-rations are used to estimate value.

This mathematical model should contemplate the differ-ences in the NEBC and the NEBS. To this end, the next sectionwill present a mathematical formula referred to as the S cor-poration economic adjustment.

THE S CORPORATION ECONOMIC ADJUSTMENT

The income tax-related differences in economic benefitbetween C corporations and S corporations essentially includethe following:

The income tax rates applicable to S corporation netincome are based on ordinary income tax rates for individ-ual shareholders. The income tax rates applicable to C cor-poration pretax income are based on corporate tax rates asdefined in the various federal and state tax codes.

These two income tax rates are rarely equivalent.

The dividend payout ratio has a material impact on thecomparability of the economic benefit derived by C corpo-ration shareholders as compared to S corporation share-holders.

Dividends paid by C corporations are taxed at theshareholder level at ordinary income tax rates. Dividendspaid by S corporations typically are not subject to incometaxes.

Undistributed earnings of S corporations increase the taxbasis of S corporation shares and therefore affect thepotential capital gains tax liability attributable to thoseshares. This is not the case with respect to the undistrib-uted earnings of C corporations.

SEA EQUATIONSIn order to create a mathematical model to address the eco-nomic differences attributable to the income tax characteristicsdiscussed above, we begin with equations that model theNEBC and the NEBS. These two equations are then set equal toeach other and an X factor is included to represent the cor-rection to the inequality between these two equations. In thisdiscus

2003 Winter - Valuation Discounts & Premium S Corp Valuations

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