Tuesday, October 2, 2012

Tax Affecting S Corp Earnings, Bernier II; Implications on Business Value

Bernier Heading Back to Trial Regarding How Tax Affecting S Corp Earnings Can Substantially Reduce Value

Unlike traditional corporations (C corporations), subchapter S corporations do not pay federal or state income taxes.  However the earnings of S corporations are taxed to the shareholders at the full ordinary rate, instead of the 15% corporate dividend rate (preferred rate) enjoyed by shareholders of C corporations.  To account for this difference, some valuation professionals feel the S corp earnings should be ‘tax affected,’ presuming that a rational investor would prefer C corp earnings to S corp earnings, all else being equal.

The adjustments can be substantial.  In Delaware Open MRI Radiology v. Kessler, the court settled on a 29.4% adjustment.  However, very convincing arguments can be made for both applying and not applying the adjustment, and courts have ruled in both directions (Gross, Gallagher, Giustina, Bernier, Kessler).  The IRS (see Gross) has historically taken the position that tax affecting is inappropriate.  Now, Bernier v. Bernier – a key divorce case supporting tax affecting - is headed back to trial.

The impact of tax affecting the S corp earnings will, in most cases, cause a reduction in value near or equivalent to the discount percentage.

Regardless of whether tax affecting S corp earnings will benefit your client’s position or not, your valuation expert should address their logic for applying or not applying the discount in their valuation report.  Failure to do so may result in the court discounting or disregarding your expert’s testimony (see judicial commentary in Bernier I and Kessler).

Brian Murray CPA/ABV, CVA specializes in business valuations and merger and acquisition consulting, and has served as an expert witness in court.  Please call Murray & Roberts CPA Firm SC at (920) 225-6436 to find out more or visit our website www.murrayrobertscpa.com, and click on the BUSINESS VALUATION link.  Go to www.mycompanyvalue.com now for a fast and affordable business valuation report prepared by Brian Murray.

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