We are not necessarily holding that tax affecting is always , or even more often than not , a proper consideration . a business is lower business values for pass-through entities and , therefore , a lower tax liability .
businessvaluation
BY JARED TONKS , CPA , ABV , CFF
Tax Affecting
The Debate Continues — Especially in California when the U . S . Tax Court published its most recent ruling addressing tax affecting S corporations , Cecil v . Commissioner ( TC Memo 2023-24 ), many business valuation publications and taxpayer advocates applauded the result . But was tax affecting S corporations even an issue in the case ? The short answer is no .
Remember , a court is a “ trier ” of fact , not a “ creator ” of fact . And if experts from both sides agree that tax affecting is appropriate , why would a court decide otherwise ? Why did the court in Cecil v . Commissioner even address the issue ? Well , that goes back to the U . S . Tax Court ’ s prior rulings when tax affecting was an issue before the court .
Due to those rulings , the U . S . Tax Court felt compelled to address it knowing the implications individuals would draw while reading between the lines .
The Court in Cecil stated , “… there is not a total bar against the use of tax affecting when the circumstances call for it .” The court later continues : “ We emphasize , however , that while we are applying tax affecting here , given the unique setting at hand , we are not necessarily holding that tax affecting is always , or even more often than not , a proper consideration for valuing an S corporation .”
So , why are taxpayer advocates celebrating the decision ? Because there are now two U . S . Tax Court cases that “ upheld ” tax affecting . The other case , Estate of Jones ( T . C . Memo . 2019-101 ), was similar to Cecil as both experts agreed that the business should be tax impacted .
The practitioners did this because the facts strongly indicated that the most logical purchaser of the business in Jones would have been a C corporation . And the result of tax affecting the earnings of
We are not necessarily holding that tax affecting is always , or even more often than not , a proper consideration . a business is lower business values for pass-through entities and , therefore , a lower tax liability .
But just because tax impacting the value of S corporations ( and other passthrough entities ) results in a lower tax bill , does it make tax affecting appropriate ? Let ’ s look at valuation when someone is buying and selling a business .
If you discuss tax impacting with professionals who are regularly involved in mergers and acquisitions , most will look at you puzzled at the thought of even having a debate on the issue . Of course they will tax impact the projected earnings of a business based on the purchaser ’ s actual tax rate . They also consider the rate of return the purchaser hopes to achieve , any cost savings measures they anticipate taking and their expected growth expectations .
What I have described above is an “ investment value ” standard of value or “ the value to a particular investor based on individual investment requirements and expectations .” Therefore , the reality is that in the real world , people tax affect the earnings stream based on the taxes that will actually be paid . The problem arises when we attempt to create hypothetical situations .
Working in the Hypothetical
For example , for estate and gift tax purposes , we must consider fair market value , or “ the price , expressed in terms of cash equivalents , at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller …”
Well , who is the hypothetical buyer and what tax rate should we use ? According to the most recent tax data published by the IRS from 2013 only , 4.6 percent of business entities are C corporations . Accordingly , a business appraiser must have specific evidence to suggest that the most logical buyer is a C corporation . The likely reality is the entity will retain some pass-through entity tax status . Therefore , if most businesses in the U . S . are pass-through entities , why would business appraisers tax impact the earnings stream under a fair market value scenario of “ a hypothetical willing and able buyer and a hypothetical willing and able seller ?”
As stated in Estate of Jackson v . Commissioner ( T . C . Memorandum . 2021- 48 ), proponents of tax affecting also www . calcpa . org MARCH / APRIL 2024 CALIFORNIA CPA 17