Academic journal article Stanford Journal of Law, Business & Finance

The Sale of the Washington Redskins: Discounted Cash Flow Valuation of S-Corporations, Treatment of Personal Taxes, and Implications for Litigation

Academic journal article Stanford Journal of Law, Business & Finance

The Sale of the Washington Redskins: Discounted Cash Flow Valuation of S-Corporations, Treatment of Personal Taxes, and Implications for Litigation

Article excerpt

This paper presents an economic argument for how a discounted cash flow (DCF) analysis should properly account for taxes when valuing an S corporation. Through a simple numerical example, we demonstrate that ignoring taxes in a DCF analysis when valuing an S corporation potentially leads to an overestimation of value. To produce more meaningful valuation estimates, we propose that any DCF analysis used to value an S corporation should adjust cash flows to reflect its owners' personal tax burdens. Our approach has the possibility to affect litigation outcomes irrespective of whether the valuation estimates are used independently or in comparison to market prices. The advantage of our approach is that it results in claimants being "made whole" and nothing more.

Introduction

The discounted cash flow (DCF) method for valuing an asset takes the expected future cash flows that the asset will generate, and discounts them back to the present at an appropriate cost of capital to produce an estimate of current value. While the use of the DCF method has become increasingly common in U.S. courts, certain aspects of how the valuation technique is implemented are still being debated.89 For example, questions still remain about the treatment of taxes when valuing a partnership or S corporation using the DCF method.90 Partnerships and S corporations are not taxed at the corporate level.91 Instead, income for these entities is passed through to owners and taxed at the individual level in the year that it is earned. Is it appropriate, therefore, to ignore taxes when valuing a partnership or S corporation using the DCF method because, strictly speaking, these entities do not pay taxes? Alternatively, should a DCF analysis account for taxes when valuing a partnership or S corporation because the price a rational economic agent would be willing to pay for such an enterprise reflects its ultimate tax burden, regardless of where taxes are actually paid?

The U.S. Court of Appeals for the Sixth Circuit touched upon these questions in Gross v. Commissioner, an appeal of a 1999 United States Tax Court decision.92 The case involved a dispute between taxpayers and the Internal Revenue Service (IRS) over the fair market value of shares of stock in an S corporation for gift tax purposes. Valuation experts for both taxpayers and the IRS used the DCF method to estimate the value of the S corporation stake. In doing so, the taxpayers' expert applied a fictitious tax burden to the S corporation cash flows. The expert for the IRS did not. The taxpayers' expert justified his use of tax-affected cash flows by arguing primarily that such an adjustment compensated for certain difficult-to-quamify costs of S corporation status. As additional support for their position, taxpayers pointed to mentions in two internal IRS documents of making adjustments for taxes in the context of valuing S corporations. However, the tax court was not sufficiently persuaded by these arguments and ruled in favor of the IRS.

The appeals court affirmed the ruling of the tax court, but the judges' opinions highlighted continued disagreement over how taxes should be treated with respect to the valuation of pass-through entities.93 Senior Judge Avern Cohn wrote for the majority,

Valuation is a fact specific task exercise; tax affecting is but one tool to accomplish that task. The goal of valuation is to create a fictional sale at the time the gift was made, taking into account the facts and circumstances of the particular transaction. The Tax Court did that and determined that tax affecting was not appropriate in this case. I do not find its conclusions clearly erroneous.94 Judge Eric clay responded in a dissenting opinion,

Although the majority of the factors the tax court used in calculating the valuation amount were proper, I take issue with the court's use of a 0% tax affect and would therefore hold that to the extent the valuation was based upon the use of a 0% tax affect, the court's ultimate finding that the G&J stock was worth $10,190 per share was clearly erroneous. …

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