Valuation of Pass-Through Entities: Looking at the Bigger Picture

Abstract

A critical and ongoing controversy in the valuation of closely held companies relates to the relative value of pass-through entities vis-a-vis traditional corporations which are subject to double taxation. This issue gained significant recognition in 1999 with the Tax Court's decision in Gross v. Commissioner. In that case, the Tax Court first examined and then rejected the concept of "tax affecting" the earnings of a Subchapter S corporation when using the income approach to estimate the fair market value of a firm. Absent tax affecting, the appraised fair market value of a typical closely-held corporation increases by more than 50 percent when it elects to be taxed under Subchapter S, since that is how much its "after-tax" income increases. This is a conclusion that has been rejected outright by the majority of private equity analysts, creating significant controversy and uncertainty for valuation analysts and the IRS. This paper documents a wealth of empirical research that demonstrates that the Tax Court, the IRS and indeed the valuation profession are missing the larger issue. Cost of capital estimates based on publicly traded markets impound shareholder-level taxes, but at varying rates across firms and over time. Fortunately, research may also provide a means of removing the effects of shareholder-level taxes, yielding an untainted and defensible cost of equity capital appropriate for the valuation of closely held companies.

Keywords: valuation, business valuation, tax affecting, cost of capital