S CORPORATIONS: A TAXING ANALYSIS
OF PROPER VALUATION
COURTNEY SPARKS WHITE*
Tax affecting1 S corporati ons, pass-through entit ies, for v aluation
purposes is appropriate under the proper methodology. Valuation of S
corporations h as been a contro versial issue for years, mainl y because of t he
tax benefits associated with S corporations.2 The decisions handed d own
by various court s regarding this issue have “emb oldened the IRS to take
positions relying solely on the tax court cas es, rath er than financial”
theory.3 The u nderlying fin ancial theories are important in the contex t of S
corporation valuation. Courts should consider the issue of tax affecting
using an appro priate methodo logy on a c ase-by-case basi s in order to
preserve the benefi ts of S corporati on status.
First, “ we mu st a cknowledge that the valuation of an S corp oration is
an inexact sci ence.”4 Berni er, the most recen t case co ncerning this issue,
was decided in Massachusetts in September of 2007. The Bernier cou rt
noted that “the difficulty in the cas e of an S corporation is the question
whether, and how, to accoun t fo r t ax consequences.” 5 Furt her, this court
Copyright © 2009, Courtn ey Sparks White.
* J.D. 2009. Thanks to my husband for always encouraging me, m y parents and sist er
for all their support, and Pro fessor Danshera Cords for all her time.
1 Because S corporations are not taxed at the corporate level, the term “tax affect”
relates to the application of an appropriate tax rate to th e S corpora tion’s e arnings fo r
valuation purposes. A tax rate may have a significant impact on value. Consider the
following comparison o f value between (1) no application of a tax affect and (2) application
of a tax affect, based o n a simple capitalization of earnings method: (1) earnings =
$100,000; capitalization rate = 20% (5x multip le); v alue o f entity = $100,000 / .20 =
$500,000; (2) earnings = $100,000; taxes = 40%; after tax earnings = $60,000;
capitalization rate = 20% (5x multiple); value of entity = $60,000 / .20 = $300,000
2 DAVID LARO & SHANNON P. PRATT, BUSINESS VALUATION S AND TAXES 79–80 (2005).
3 Nancy J. Fannon, S Corporations and Value: Simplifyi ng the Debate,
http://www.fannonval.com/pd f/S%20Corporations/S_Corporations_ and_Value—Simplify
_the_Debate.pdf (last visited Mar. 29, 2009).
4 Bernier v. Bernier, 873 N.E .2d 216, 225–26 (Mass. 2007).
5 Id. at 226.
1118 CAPITAL UNIV ERSITY LAW REVIEW [37:1117
observed that “[t]he m atter has bedevi led the prof essional appraisers’
community for so me time.”6
This comment wil l focus on the appropriate way to account for taxes in
valuing S corporations. The pri mary issue is whether or not to tax affect S
corporations, which are pass-through entiti es, fo r val uation purposes.7
Once th is is answered in the affirmative, the next issue is what the
appropriate tax affect should be. There is a lack of uniformity among
jurisdictions regarding these issues,8 but recent cases have shed some light
on (1) applyi ng a tax affect to S corporations and (2) th e proper tax affect.9
This Comment argues that application of a tax affect to S corporations i s
appropriate for valuation purp oses. A dis cussion of the differen ces
between S corporation s an d C corporations is neces sary t o start the
analysis, fol lowed by a discussi on of bus iness valuation and it s history an d
applicable approaches and methods. This comment focuses on four basic
areas of la w where v aluation issues arise, including estate, gift, divorce,
and shareholder di sputes.
This com ment then analyzes cases that have tou ched on this issue and
the progress co urts have mad e toward an ap propriate a nalysis. Final ly, this
comment concludes with an appropriat e analysis to apply in S corporation
valuations to deal with tax issues.
III. S CORPORATIONS VE RSUS C CORPORATIONS
A. S Corporati ons
Subchapter S corporations emerged in 1958.10 S corpo rations are
defined under § 1361 of the Internal Revenue Code.11 To become an S
corporation, a company must (1) be a domest ic corporati on; (2) h ave
shareholders who are individuals, estates, or certain trusts; (3) h ave
6 Id. (citing Gros s v. Comm’r, 272 F.3d 333, 355 (6th Cir. 2001) (Coh n, J., concurring
in part, dissenting in part) ).
7 For a simple exampl e and how the impact of a tax affect may impact v alue, see supra
8 See discussion infra Parts VI I–IX.
9 See, e.g., Bernie r, 873 N.E.2d at 22 4–31; Del. Open MRI Radiology Assocs., P.A. v.
Kessler, 898 A.2d 290, 328– 30 (Del. Ch. 2006).
10 Technical Amendments Act of 1 958, Pub . L. No. 85–866, § 1371, 72 Stat. 1606 ,
1650 (codified as amended at I.R.C. § 1361 (2006)).
11 I.R.C. § 1361.
2009] S CORPORATI ONS 1119
shareholders who are citizens or resident aliens; (4) have only one class of
stock;12 (5) have no more than 100 shareh olders; and (6 ) must not be an
ineligible corpo ration.13
The purposes of S corporation status include “(1) the prevention of
double taxati on of earnings received b y a ‘small business co rporation’; and
(2) the avoid ance of complex adjust ments made nec essary by in stances of
such double taxation.”14 The chief characteristi c for subchap ter S
corporations, as opposed to other corporations, is that inco me or los s is not
recognized at the corporate level but fl ows thro ugh to the individual
B. C Corporatio ns
On th e ot her h and, Subchapter C corporatio ns are defi ned under
§§ 301–385 of the Internal Rev enue Code.16 Becoming an S corporation
requires a § 1362 (a) election, and a C corporation is any “corporation
which is not an S corporation.”17 Thus, C corporations are the default
status. When valuing an S corporation and a C corporatio n with ident ical
earnings, each co mpany’s value can be signifi cantly different d epending on
the magnitu de of taxes applied to t he C corporation’s earnings.18 Whereas
S corporations are not taxed at the entity level, C corporati ons are taxed
both at the entit y level19 and at t he shar eholder level .20 An example of the
difference in tax t reatment follo ws:
12 If non-voting stock has all the characteristics of voting stock, except the voting rights,
it is not considered a secon d class of stock. Id. § 1361(c)(4).
13 Id. § 1361(b)(1).
14 Shores Realty Co. v. United State s, 468 F.2d 572, 575 (5th Cir. 1972).
15 SANFORD J. SCHLESI NGER, Estate Planning Update, in 38TH ANNUAL ESTATE
PLANNING INSTITUTE 11, 72 (Sanford J. S chlesinger chair 2007).
16 I.R.C. §§ 301–385.
17 Id. § 1361(a).
18 See supra note 1 for an examp le of the differ ence in tax treatmen t and the impact on
19 I.R.C. § 11.
20 Id. §§ 301(c)(1), 316.