Academic journal article Journal of Accountancy

Converting from C to S Corp. May Be Costlier Than You Think: Where Gifting or Bequeathal Is Contemplated, Higher Gift and Estate Tax Could Be the Result

Academic journal article Journal of Accountancy

Converting from C to S Corp. May Be Costlier Than You Think: Where Gifting or Bequeathal Is Contemplated, Higher Gift and Estate Tax Could Be the Result

Article excerpt

In their article "Now Is the Time: Converting a C Corporation to an S Corporation or LLC" (The Tax Adviser, Aug. 2012, page 534), authors Michael Lynch, David Casten, and David Beause-jour present a compelling argument in favor of electing flowthrough-entity status for existing C corporations. However, before "pulling the trigger" and converting to a flowthrough entity, taxpayers and their advisers should consider at least one additional issue: the appraised fair market value (FMV) of the entity for gift, estate, and income tax purposes. If business owners' succession planning involves the gift or bequest of all or part of their stock in the business entity, they should be aware that a change from a C corporation to an S corporation or other flowthrough entity could increase the appraised FMV of the entity by 50% or more.

While FMV appraisals may combine multiple valuation techniques (e.g., income-based approach, market-based guideline company approach, and cost-based approach), the Tax Court has held that the discounted cash flow (DCF) method is sufficient to properly value the stock of closely held business entities. Under the DCF valuation method, a higher appraised FMV for a closely held business will result if it is a flowthrough entity than if it is a C corporation, because a flowthrough entity does not pay income tax and a C corporation does, and thus the business's cash flow will be greater as a flowthrough entity.

Recognizing that the benefits of reduced entity taxes are at least partially offset by higher shareholder taxes, many business valuation analysts mitigate the increase in appraised FMV by "tax-affecting" the cash flow of the flowthrough entity. Tax-affecting refers to the practice of reducing the earnings stream of a business for hypothetical corporate-level or owner income taxes.

While this issue is not new, it is still relevant, as illustrated in the ongoing case of Estate of Giustina, T.C. Memo. 2011-141, rev'd and remanded, 586 Fed. Appx. 417 (9th Cir. 2014), where the appraised FMV of a noncontrolling partnership interest was increased by the Tax Court when it disallowed an adjustment to predicted cash flows to account for the income taxes that would be owed by the owner of the partnership interest.

Similarly, on Oct. 29,2014, the IRS stated in an internal document, "A Job Aid for IRS Valuation Analysts":

   With respect to the question of pass-through
   taxation, no entity level tax should be applied
   in the valuation analysis of a non-controlling
   interest in an electing S Corporation, absent
   a compelling demonstration that independent
   third parties dealing at arms-length would do
   so as part of a purchase price negotiation.

Given the positions of the IRS and the Tax Court, shareholders contemplating making gifts of stock should obtain an appraisal of their C corporation and make gifts of all or part of the stock in the business entity before making an S corporation election. This action may reduce both the amount of gift tax imposed and complications if the gift tax return is audited. Due to the income tax adjustment in DCF valuations of flowthrough entities, these appraisals may face greater scrutiny and risk of challenge by the IRS. If litigation is required to defend a taxpayer's valuation, the taxpayer is at additional risk. Indeed, these cases often come down to a battle of expert witnesses.

Tax advisers should be fully aware of the magnitude of potential valuation changes when converting from a C corporation to a flowthrough entity and understand the increased level of uncertainty in the appraised valuation of S corporations (resulting not only from an IRS examination but, more importantly, from any judicial resolution of the FMV of the transferred interest), and should incorporate this information when advising clients who are considering a change in the type of entity.

The purpose of this article is to alert taxpayers and tax advisers that the Tax Court's refusal to recognize any form of tax-affecting when valuing a flowthrough entity has the effect of treating two otherwise identical business interests as having significantly different FMVs. …

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