Tax Pass-Through Entity Thought Leadership

S Corporation Valuation Analysis

Considerations
Andrew Duncan

This discussion addresses issues that the valuation analyst (“analyst”) may consider when
developing the business or stock valuation of an S corporation. These valuation issues
include (1) the appropriate level of value for the valuation, (2) the sources of empirical
data on which the analyst may rely, (3) the economic benefits associated with the S
corporation’s tax pass-through entity (“TPE”) income tax status, (4) the quantitative
models that analysts apply to account for the economic benefit associated with TPE tax
status, and (5) the judicial precedent related to TPE valuation adjustments. Specifically, this
discussion summarizes the so-called dividend income tax avoidance valuation adjustment
model that was applied in the Estate of Jones U.S. Tax Court judicial decision.

Introduction congressional intent was to mitigate the influence

of income tax considerations in the selection of
Historically businesses had two choices regard- business form—by providing certain corporate enti-
ing federal income taxation status—before the ties and shareholders with the option to be taxed
Department of Treasury proposed the concept of on a partnership basis. Therefore, S corporations
creating an entity that had both: achieved the advantageous corporate characteristics
1. a single layer of federal taxation and of limited liability—combined with the pass-through
2. limited liability protection. income attributes of a partnership.
Since the creation of subchapter S of the Internal
That is, a business could elect C corporation Revenue Code, S corporations have become the
federal income tax status that offered limited liabil- most common business taxation structure in the
ity but was subject to taxation both on corporate United States.1
income and shareholder distributions. Alternatively, According to the most recently published statis-
a business could elect to be taxed as a partnership tics of the Internal Revenue Service (the “Service”),
or sole proprietorship. While this structure shielded there were approximately 4.5 million S corporations
the business owners from double taxation, it offered operating in the United States as of 2015.2
no mitigation of liability.
Figure 1 illustrates the allocation of corporate
Neither of these alternative income tax status income tax returns filed by S and C corporations
elections were particularly advantageous to the typi- between 1980 and 2015. Specifically, S corporations
cal small business. accounted for 20.1 percent of corporate income tax
In 1958, Congress created the S corporation as returns filed by corporations during 1980. That fig-
part of a tax program to aid small businesses. The ure increased to 77.3 percent for the 2015 tax year.

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1

Figure 1
S Corporation and C Corporation
Income Tax Returns Filed between 1980 and 2015

7,000,000

6,000,000
Number of Returns

5,000,000

4,000,000

3,000,000

2,000,000

1,000,000

C Corporations S Corporations

Therefore, it is important for a valuation analyst and (3) do not increase the equity tax basis by
(“analyst”) to be cognizant of (1) issues that may retaining earnings.
arise when developing a business valuation of an According to Internal Revenue Code Section
S corporation and (2) relevant judicial precedent 1361 and the corresponding Treasury Regulations,
guidance to both taxpayers and analysts concerning a company may elect S corporation status if the fol-
such issues. lowing criteria are met:
n The corporation must be a domestic corpo-
Definition of an S Corporation ration.
The Internal Revenue Code defines S corpora- n The corporation must have only allowable
tions as “corporations that elect to pass corporate shareholders which include the following:
income, losses, deduction, and credits through to 1. Individuals
their shareholders for federal tax purposes.”
2. Certain trusts
S corporation shareholders (1) report their 3. Estates
pro rata share of pass-through income and losses
n Shareholders that do not meet the allowable
on their personal income tax returns and (2) pay
shareholder criteria are as follows:
federal income tax at their individual income tax
rates. Additionally, dividends paid to shareholders 1. Partnerships
(in excess of the amount of income tax due on the 2. Other corporations
shareholder’s pro rata share of S corporation taxable 3. Nonresident aliens
income) are received without the burden of federal
n The corporation must not have more than
income taxes.
100 shareholders.
Finally, the S corporation income that is not n The corporation must only maintain one
distributed will increase the equity tax basis of its class of stock. As such, distributions and
shareholders. liquidations to shareholders must be made
In contrast, C corporations (1) are subject to on a pro rata basis. However, the single
income taxes at the corporate level, (2) are subject class of stock can be differentiated with vot-
to dividend income taxes at the shareholder level, ing and nonvoting characteristics.

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 n The corporation must not be classified as beginning any analysis of the S corporation. If the
an ineligible corporation; ineligible corpora- valuation purpose is to estimate the value of an S
tions include the following: corporation controlling ownership interest for pur-
1. Certain financial institutions poses of buying, selling, or merging the company,
then the company’s income tax status should be
2. Insurance companies
considered in the valuation.
3. Domestic international sales corpora-
tions One example of when a C corporation acquirer
would pay a price premium for a TPE would be if
the transaction included an election under Internal
If the company meets the criteria listed above
Revenue Code Section 338(h)(10) (“Section 338
and elects S corporation status, the analyst should
election”). The Section 338 election may be made
be aware of (1) the potential economic bene-
when the shareholders of the acquired company sell
fits associated with the advantageous business tax
at least 80 percent of the equity.
structure and (2) the various empirical data that
may be applied in the course of developing the S The Section 338 election allows a stock equity
corporation business valuation. purchase to be treated as if it were an asset pur-
chase. This provides certain federal income tax
advantages to the acquirer.3
S Corporation Valuation It has been observed that “the positive income
tax benefits to the buyer—of the step-up in the basis
Considerations of the acquired assets available under the Section
When developing an S corporation business valua- 338 election—is often much greater than the nega-
tion, the analyst typically considers the following tive income tax attributes to the seller.”4
questions:
Not only does the seller pay higher income taxes
1. Is there incremental value attributable to under a Section 338 election, but the buyer enjoys
the income tax advantages of the company’s income tax advantages. A seller may use this as a
tax pass-through entity (“TPE”) status? If bargaining chip when negotiating the transaction
so, what is the most appropriate method to terms, effectively increasing the acquisition price in
account for this incremental value in the exchange for agreeing to the Section 338 election,
business valuation? which benefits the acquirer.5
2. Was the value of the S corporation derived This situation would be similar to the rea-
from comparison with valuation charac- son why acquirers pay control price premiums of
teristics of non-TPE entities? If so, what which a portion of the premium includes synergies.
adjustments are appropriate to apply to the Essentially, buyers and sellers share in the cost sav-
valuation of the subject S corporation? ings as part of the transaction consideration.
A specific example of this occurring is when
There is not a one-size-fits-all answer to these Marvin J. Herb sold his Chicago bottling com-
questions. The analyst should first consider the pany to Coca-Cola Enterprises Inc. in 2001. The
assignment purpose and objective before selecting Chicago bottling company was an S corporation.
the appropriate (1) business valuation approaches The transaction was structured as an equity sale
and methods or (2) TPE-related valuation adjust- under a Section 338 election, under which Coca-
ments. Cola Enterprises identified $125 million in income
The following sections outline specific valuation tax savings it would achieve under Section 338.
considerations that an analyst should be aware of A spokesman for Coca-Cola Enterprises Inc. con-
when developing a business valuation. A multitude firmed that it increased the price paid to Mr. Herb
of factors differentiate S corporations. Therefore, by $100 million due to these income tax benefits.6
the following sections do not encompass all of the
valuation issues an analyst may consider when Noncontrolling Equity Ownership Interest
developing an S corporation business valuation .
If the analyst is developing a noncontrolling owner-
ship interest valuation, then a direct comparison
Level of Value with values of other noncontrolling ownership inter-
ests may be an appropriate procedure in the busi-
Controlling Equity Ownership Interest ness valuation. However, there may be a lack of reli-
It is important that the analyst understand the able empirical data related to transactions involving
purpose and objective of the assignment before noncontrolling equity ownership in S corporations.

www.willamette.com INSIGHTS • SUMMER 2021 15

 Examples of situations in which the analyst may n Distribution (i.e., dividend) payout ratio of
rely on empirical market data of publicly traded C 50 percent of net income
corporations include the following: n C corporation corporate income tax rate of
n The analyst may apply an income approach 35 percent
method (i.e., the direct capitalization meth- n Individual ordinary income tax rate of 35
od or the discounted cash flow method). In percent
the application of these income approach
methods, the direct capitalization rate or n Dividend income tax rate of 15 percent
the present value discount rate may be n Capital gains income tax rate of 15 percent
derived from empirical studies of invest- n Capital gains tax liability is economically
ment rates of return on noncontrolling recognized when incurred
equity ownership interests in publicly trad-
ed C corporations. n Capital appreciation of equity is derived
from increases in retained earnings on a
n The analyst may apply a market approach dollar-for-dollar basis
method (i.e., the guideline publicly traded
company method) to estimate the value n No adjustment was made for qualified busi-
of the S corporation equity interest. When ness income or the operations of the subject
applying the guideline publicly traded com- company
pany method, pricing multiples applied to
the subject S corporation are derived from As presented in Exhibit 1, the net economic ben-
empirical studies of (1) stock prices and (2) efit differs between S corporation shareholders and
financial fundamentals of publicly traded C C corporation shareholders. The primary economic
corporations. benefit to the shareholders of an S corporation is the
n The analyst may apply (1) the market avoidance of double taxation on dividend income.
approach guideline merged and acquired As such, analysts have developed and applied
company method or (2) an asset-based several models to measure the economic benefit to
approach business valuation method to esti- shareholders associated with the S corporation TPE
mate the value of the S corporation equity taxation status.
interest. However, these valuation methods
develop indications of value on a control- Some of the economic generally accepted applied
ling interest level of value basis. In order models that quantify this benefit include (1) the Van
to develop an opinion on a noncontrolling Vleet (S corporation economic adjustment multiple
interest level of value basis, the analyst typ- or “SEAM”) model, (2) the Treharne model, (3)
ically applies a discount for lack of control the Mercer model, (4) the Grabowski model, (5)
(“DLOC”). Such a DLOC may be derived the Fannon model, (6) the Sellers model, and (7)
from empirical studies of acquisitions price the adjustment for dividend income tax avoidance
premiums paid for the equity securities of model.
publicly traded C corporations. This discussion focuses on one of these math-
ematical frameworks that quantify the adjustment
If the analyst relies on empirical market data of that may be applied to the unadjusted equity value
publicly traded C corporations, all three generally of an S corporation to account for differences in
accepted business valuation approaches can yield taxation status: the adjustment for dividend income
the equivalent value of a noncontrolling interest in tax avoidance model.
a C corporation for a noncontrolling interest in an
S corporation.
Adjustment for Dividend Income Tax
There are differences in the tax treatment of cor-
porate income, dividends, and capital gains between
Avoidance Model
S corporations, C corporations, and their respective As presented in Exhibit 1, a primary economic ben-
shareholders. Those disparities in the income tax efit to the S corporation shareholder is the avoid-
treatment of S corporations and C corporations may ance of the C corporation dividend income tax on
result in differing economic benefits attributable to earnings that have already been taxed at the corpo-
the shareholders of each respective entity. rate level. The adjustment for dividend income tax
avoidance model measures the economic benefit to
Exhibit 1 illustrates an example of those eco-
S corporation shareholders through the application
nomic benefits. Exhibit 1 was developed using the
of an income approach valuation method (e.g., the
following assumptions:
direct capitalization method).

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 1

Exhibit 1
C Corporation versus S Corporation Income Tax Status
Comparison of the Net Economic Benefit to the Corporation Shareholders

Financial Fundamental C Corporation S Corporation

Pretax Income $ 100,000 $ 100,000

Provision for Corporate Income Taxes 35% $ (35,000) NM

Net Income $ 65,000 $ 100,000

Dividends:
Distributions to S Corporation Shareholders 50% NM $ 50,000
Income Taxes Due by S Corporation Shareholders 35% NM $ (35,000)

Net Cash Flow Benefit to S Corporation Shareholders NM $ 15,000

Dividends to C Corporation Shareholders 50% $ 32,500 NM

Dividend Tax Due by C Corporation Shareholders 15% $ (4,875) NM

Net Cash Flow Benefit to C Corporation Shareholders $ 27,625 NM

Capital Gain:
Net Income $ 65,000 $ 100,000
Distributions/Dividends $ (32,500) $ (50,000)

Retained Earnings (net capital gain) $ 32,500 $ 50,000

Effect of Increase in Income Tax Basis of Shares NM $ (50,000)

Taxable Capital Gain $ 32,500 $ -

Capital Gain Tax Liability 15% $ (4,875) $ -

Net Capital Gain to Shareholders $ 27,625 $ 50,000

Total Net Economic Benefit to Shareholders:

Net Cash Flow Benefit to Shareholders $ 27,625 $ 15,000
Net Capital Gain to Shareholders $ 27,625 $ 50,000

Total Net Economic Benefit to Shareholders $ 55,250 $ 65,000

Specifically, the analyst (1) estimates a normal- tionment of corporate income—whether or not that
ized level of distributions (in excess of S corporation income is distributed.
shareholder income tax liabilities), (2) estimates Any S corporation income distributed to the
dividend income tax savings associated with those shareholders in excess of their individual income
previously calculated excess distributions, and (3) tax liability is passed through tax free to the share-
capitalizes that level of savings into perpetuity in holder. Therefore, the analyst may estimate a nor-
order to estimate the economic benefit attributable malized level of excess shareholder distributions to
to the S corporation shareholders. quantify the income tax savings.
The analyst may consider multiple factors when
Normalized Level of Distributions estimating a normalized level of distributions for the
In applying the adjustment for the dividend income S corporation. Those factors may include, but are
tax avoidance model, the analyst estimates a nor- not limited to, the following:
malized level of income distributions in excess of 1. The level of historical income distributions
shareholder income tax liabilities. Shareholders of made to shareholders by the S corporation.
an S corporation are taxed based on their appor- If the S corporation has a specific policy

www.willamette.com INSIGHTS • SUMMER 2021 17

 regarding the level of historical distribu- standard income tax rate. However, qualified divi-
tions, this policy may inform the future dends are dividends that are subject to the 0 per-
distribution expectations. cent, 15 percent, or 20 percent maximum tax rate
2. The level of income distributions projected that applies to capital gains.7
to be paid by the S corporation. As a part The net investment income tax is imposed by
of the due diligence process in the valua- Section 1411. The net investment income applies
tion engagement, the analyst should con- at a rate of 3.8 percent to certain net investment
duct a management interview. Information income earned by individuals, estates, and trusts
obtained from this management interview that have income above statutory thresholds.8
may help the analyst select a normalized After calculating the normalized benefit for
level of distributions. income tax avoidance, the analyst should divide
3. The stage in the business life cycle the sub- that figure by the applicable direct capitalization
ject S corporation occupies. For example, rate in order to estimate the present value of the
a start-up or growth-stage company may benefit of dividend income tax avoidance.
allocate substantially all of its cash flow to
invest in business opportunities instead of Direct Capitalization Rate
shareholder distributions.
The direct capitalization rate is equal to the pres-
4. The current performance and outlook of the ent value discount rate (typically the “WACC”) less
industry in which the S corporation oper- the expected long-term growth rate. The WACC
ates. Strong industry performance may lead represents the weighted average cost of each of the
to excess cash flow generation by industry components in the S corporation’s capital structure.
operators, which may then be distributed to In this scenario, the analyst develops an opinion
shareholders. of value on a noncontrolling level of value basis.
5. The availability of investment opportuni- Therefore, the WACC is based on the actual capital
ties with strong anticipated returns. The S structure of the S corporation.
corporation may be more likely to allocate The basic formula for calculating an after-tax
funds to profitable investment opportuni- WACC and the implied direct capitalization rate is
ties than distributions if it can generate a as follows:
strong return on that investment.
Direct Capitalization Rate = WACC - g
After estimating a normalized level of income
distribution in excess of shareholder income tax WACC = (Ke × We) + (Kd [1-t] × Wd)
liabilities, the analyst calculates the normalized
benefit associated with dividend income tax avoid- where:
ance, as compared to a C corporation.
g = Expected long-term growth rate
Ke = Cost of equity capital
Normalized Benefit for Dividend Income Kd = Pretax cost of debt capital
Tax Avoidance We = Percentage of equity capital in the
The normalized benefit for dividend income tax capital structure
avoidance is calculated by multiplying the normal- Wd = Percentage of debt capital in the capital
ized level of distributions (in excess of shareholder structure
income tax liabilities) by the estimated income tax
rate on dividend income. t = Effective C corporation income tax rate
The estimated income tax rate on dividend
income has three components: The analyst divides the normalized benefit for
1. The federal dividend income tax rate income tax avoidance by the direct capitalization
rate in order to estimate the present value of the
2. The state dividend income tax rate benefit of dividend income tax avoidance associated
3. The net investment income tax rate with the S corporation status.

For federal income tax purposes, dividends Implied TPE Benefit

can be categorized as either ordinary or qualified. The economic benefit associated with dividend
Ordinary dividends are taxed at the shareholder’s income tax avoidance is often presented as a

18 INSIGHTS • SUMMER 2021 www.willamette.com

percentage premium that applies to the indicated Court agreed with the Willamette valuation inputs
value of equity of the S corporation. In order to and assumptions in all material respects.10
calculate that percentage premium, the analyst There were a variety of issues considered in
divides the present value of dividend income tax the Jones decision. But this discussion focuses on
avoidance by the indicated C corporation equivalent the issue of applying income tax to the valuation
value of equity. of a TPE. The Willamette analyst stated that it was
Exhibit 2 illustrates the calculation of the implied appropriate (1) to treat the subject TPEs as C cor-
TPE benefit based on the adjustment for dividend porations from an income tax perspective and (2)
income tax avoidance model. to apply a premium to account for the economic
Exhibit 2 was developed using the following benefit associated with dividend income tax avoid-
assumptions: ance.
n Normal level of shareholder distributions The Willamette analyst provided the following
(in excess of tax liabilities) of $20,000 reasons to substantiate his income tax valuation
variables:
n C corporation dividend income tax rate of
30 percent 1. The present value discount rate applied was
based on empirical data derived from pub-
n Direct capitalization rate of 12 percent
licly traded C corporations.
n Indicated value of equity (C corporation
2. The pool of hypothetical willing buyers of
equivalent value) of $1,000,000
a subject TPE often consists of C corpora-
tions that may not pay a premium for TPE
The model, illustrated by the figure presented income tax status.
in Exhibit 2, concludes a 5 percent premium to 3. The subject TPEs incurred income taxes
indicated C corporation equivalent equity value at the shareholder level. Therefore, the
attributable to the TPE status of the S corporation. subject TPEs incurred income tax expenses
The following sections summarize a recent judi- in the form of shareholder distributions for
cial opinion of the U.S. Tax Court related to tax their respective income tax liabilities.
affecting and subsequent adjustments when valuing
an S corporation.
In the Jones case, the Willamette Management
Associates analyst applied the adjustment for
The Estate of Aaron U. Jones9 dividend income tax avoidance model to quantify
The ongoing debate regarding the appropriate appli- the premium associated with subject entities’ TPE
cation of income tax in a valuation of a TPE has status.
frequently made its way to the U.S. Tax Court. The The analyst provided the following support for
Service has consistently opposed applying income this position on a premium for the TPE tax status:
taxes on TPEs (i.e., partnerships and S corpora-
tions) when conducting a 1

business valuation. Exhibit 2

However, the judicial Illustrative Example of the TPE Valuation Adjustment
decision in the Estate Dividend Income Tax Avoidance Model
of Aaron U. Jones v.
Commissioner of Internal Value
Revenue (“Jones”) repre-
sents a landmark decision Normal Level of Shareholder Distributions (excess of income tax liabilities) $ 20,000
which confirms that the Multiplied by: C Corporation Dividend Income Tax Rate (%) 30.0
federal court system may Equals: Normalized Benefit for Dividend Income Tax Avoidance $ 6,000
consider the application of Divided by: Direct Capitalization Rate (%) 12.0
income taxes when valuing
a TPE. Equals: Present Value of the Benefit of Dividend Income Tax Avoidance $ 50,000
Divided by: Indicated Value of Equity (C corporation equivalent value) $ 1,000,000
In the Jones case,
Willamette Management Equals: Implied TPE Benefit (%) 5.0
Associates (“Willamette”)
was retained by the estate’s Selected TPE Benefit Based on the Adjustment for Dividend Income Tax
counsel to provide valua- 5.0%
Avoidance Model (rounded)
tion analysis and testifying
expert services. The Tax

www.willamette.com INSIGHTS • SUMMER 2021 19

 1. Excess shareholder distributions above Therefore, it may be appropriate for the analyst
income tax liabilities are not subject to to tax affect the subject S corporation. Since the
taxes at the capital gains rate. subject S corporation maintains TPE tax status and
2. An acquiring company would pay an acqui- avoids double taxation, it may be necessary to apply
sition price premium for the subject enti- a price premium to offset the value decrease associ-
ties’ TPE tax status. ated with the tax affecting procedure.
One method to quantify this price premium
In contrast, the Service argued that a 0 percent is the application of the adjustment for dividend
income tax rate was appropriate for the valuation of income tax avoidance model. The procedures of
the subject TPE given the lack of income tax bur- (1) tax affecting and (2) applying a price premium
den incurred by the subject entities at the company (specifically the adjustment for dividend income tax
level. avoidance model) were accepted in the judicial deci-
sion of the Estate of Jones case.
In the published judicial decision, the Tax Court
concurred with the Willamette analyst’s application Given the history of federal court decisions
of income taxes and the premium associated with regarding these issues, the analyst should prepare a
dividend income tax avoidance. thorough analysis when developing an S corporation
business valuation.
Specifically, the Tax Court stated:
We find on the record before us that Mr.
Reilly has more accurately taken into Notes:
account the tax consequences of SJTC’s 1. Shannon P. Pratt, Valuing a Business: The
flow-through status for purposes of estimat- Analysis and Appraisal of Closely Held
ing what a willing buyer and willing seller Companies, 5th ed. (New York: McGraw-Hill,
might conclude regarding its value. His 2008).
adjustments include a reduction in the total 2. https://www.irs.gov/statistics/soi-tax-stats-inte-
tax burden by imputing the burden of the grated-business-data
current tax that an owner might owe on the 3. Robert P Schweihs, “S Corporation Buyers and
entity’s earnings and the benefit of a future Sellers Should Consider Making a Section 338
dividend tax avoided that an owner might Election,” Willamette Management Associates
enjoy. Insights (Winter 2016): 73.
4. Ibid.

Summary and Conclusion 5. Ibid.: 76.

6. Mark Hendricks, “The S-Corp Windfall,” Crains
The S corporation federal income tax election pro-
Chicago Business (May 7, 2005).
vides its shareholders with the unique benefit of:
7. https://www.irs.gov/pub/irs-pdf/p550.pdf
1. limited liability protection and
2. TPE income tax status. 8. https://www.irs.gov/newsroom/questions-and-
answers-on-the-net-investment-income-tax
9. Estate of Aaron U. Jones, v. Commissions, T.C.
Since its inception in 1958, the S corporation Memo 2019-101 (Aug. 19, 2019).
has become one of the most common business
structures utilized in the United States. Analysts 10. Scott R. Miller and Curtis R. Kimball, “Estate
of Aaron U. Jones v. Commissioner of Internal
are frequently asked to value S corporation equity
Revenue: Increasing Acceptance of Tax-
interests. Therefore, analyst should be aware of the
Affecting,” Willamette Management Associates
issues that may arise in these valuations—as well as Insights (Winter 2020).
the judicial precedent guidance regarding S corpora-
tion valuation.
Specifically, analysts may consider whether
(1) there is incremental value attributable to the
income tax advantages associated with TPE tax
status and (2) the value of the S corporation was
derived from comparisons with valuation character- Andrew Duncan is an associate in
istics of non-TPEs. our Atlanta practice office. He can
be reached at (404) 475-2317 or at
In the S corporation valuation, many inputs are [email protected].
selected based on empirical data from non-TPEs.

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