Tax Effecting and the Valuation of Pass-Through Entities: Considering the Impact of the Tax Cuts and Jobs Act

By Tinkelman, Daniel | The CPA Journal, October 2018 | Go to article overview

Tax Effecting and the Valuation of Pass-Through Entities: Considering the Impact of the Tax Cuts and Jobs Act


Tinkelman, Daniel, The CPA Journal


One effect of the passage of the Tax Cuts and Jobs Act of 2017 (TCJA) may be to simplify the process for valuing certain pass-through entities. Under the new tax rates, there should be no valuation premium awarded to the pre-tax earnings of those pass-through entities whose shareholders cannot use the new 20% qualified business income (QBI) deduction for income from pass-through entities, as compared to C corporations. As a result, the procedure of tax effecting the earnings of these entities is now a logical step in the valuation process. These circumstances would pertain to many pass-through service companies, as well as those subject to limitations on the QBI deduction due to low wages. For those pass-through entities where the benefit of the new 20% QBI deduction is expected to be usable, the author believes that a procedure of partial tax effecting, at a rate less than the 21% corporate rate, would be appropriate. This article explores the situation under the new TCJA rates.

Nature of the Valuation Issue for Pass-through Entities

A common method of valuing companies is the income approach, which relies on estimating future income and then applying an appropriate discount rate to obtain a discounted present value. Valuation experts often look to public company data, such as that compiled by Duff & Phelps, for data on discount rates.

One issue with this procedure is that public company data comes primarily from C corporations and therefore measures returns that investors have obtained after corporate-level taxes but before personal taxes on corporate dividends and capital gains. The tax situation for pass-through entities (e.g., partner- ships, limited liability companies, subchapter S corporations) is different. According to IRS statistics, of the approximately 33.4 million business returns filed in 2013, only about 1.6 million were from C corporations (see IRS Integrated Business Data, Table 1: Selected financial data on businesses, http://bit.ly/2Q9u3o4). The other 95% were from sole proprietorships (72%), S corporations (13%), and partnerships (10%). Pass-through entities do not pay corporate income taxes, and their owners are taxed on the entities' income in their personal tax returns, whether that income is distributed or not. As a result, an adjustment to income or discount rates may be needed before a valuation analyst can apply discount rates based on public companies to pass-through entities.

Under the right set of tax rates, a simple and straightforward way to deal with the different tax situations of C corporations and pass-through entities in the valuation process is to impute a corporate-level tax on the pass-through entities' earnings and then apply a discount factor based on public company data. This is called "tax effecting." Tax effecting was for many years the normal process in valuation, and was accepted by courts and the IRS. Later, however, the IRS came to reject tax effecting; in the 1999 case of Walter L. Gross Jr., et al. v. Comm'r [78 TCM (CCH) 201 (1999)], the Tax Court upheld the IRS's position that a pass-through entity should be valued without imputing corporate taxes, the result of which is, clearly, an increase in the entities' estimated values.

Since Gross, the courts and the valuation community have held several differing positions regarding the valuation of pass-through entities. The IRS has consistently argued that there should be no tax effecting, and the Tax Court has upheld this position in several cases. Some valuation experts have continued to argue that tax effecting is appropriate, and this position has been upheld in some valuation cases in other courts. Still other experts have argued that passthrough entities' valuation should reflect a premium due to their different tax status, but that the premium implied by ignoring corporate taxes entirely is too large; they recommend measuring the premium by carefully considering the tax rates applicable to the case at hand. …

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