As the benchmark against which S corporation minority interest values will be mea- sured, the value of an otherwise similar C corporation minority interest was first determined in Exhibit 8.14. Moving on to the S corporation examples in Exhibit 8.14, three scenarios are pre- sented. Note that the C corporation and personal tax rates (40 percent and 41 percent, re- spectively) differ. • Scenario A shows the valuation strategy for an S corporation distributing only enough of its income to satisfy the minority owner’s tax liability associated with entity income. • Scenario B represents the valuation of an S corporation minority ownership interest in an entity distributing 100 percent of net income to minority owners (facts similar to the Gross case). • Scenario C demonstrates the valuation strategy for an S corporation paying no distributions to the minority owner. General comments and observations for Exhibit 8.14: • Retained cash flow (line 15) differs for each of the four scenarios. • Net cash flows (line 10) for the three S corporation scenarios are identical but greater than the same measure for the C corporation scenario. If net cash flow is the basis for valuing the C corporation minority interest, the knowledgeable investor will always pre- fer the S corporation investment opportunities. Using the information previously pre- sented in this paper in combination with Exhibit 8.14, the folly of this position will be demonstrated. • Relative to the C corporation and other S corporations, larger S corporation distributions (lines 12 and 13, as well as 24, 25, and 35) favorably affect the value of the minority invest- ment (line 57). Conversely, smaller S corporation distributions adversely affect the value of a minority investment. If only net cash flow (line 10) is used as a basis in the valuation analysis, the conclusion will be wrong. • The three S corporation scenario entries on line 53—the present value of the tax-rate differential adjustments—are and always will be identical if the taxable incomes, line 1, are identical. C Corporation Scenario Because the C corporation pays no dividends (line 11) to its minority shareholders, its net cash flow (line 10) is the same as its retained cash flow (line 15). Particularly note that the present value of the cash to the investor is zero (line 55) because the investor receives no dividends. Additionally, because the entity is a C corporation, there are no double-taxation (line 43) or tax-rate differential (line 53) adjustments. Hence, the value of the benchmark C corporation minority interest is the value of its retained cash flow (line 22, which is identical to line 57). Logically, the traditional method of calculating the present value of a C corporation is consistent with determining the present value of net cash flow (line 10) because net cash flow and retained cash flow (line 15) are identical and there are no adjust- ments (lines 23 to 53) to this value. 112 S CORPORATIONS AND OTHER PASS-THROUGH TAX ENTITIES S Corporation Scenarios Scenario A: Distributions equal tax liability associated with entity income. If C corpora- tion and personal tax rates (lines 2 and 12, respectively) are identical, the present value components (lines 22, 32, 43, 53, and 57) of the C corporation and the Scenario A S corporation will be identical and the knowledgeable investor will be indifferent toward the two investments. However, if tax rates differ (as indicated in Treharne’s example), the investor will choose the C corporation minority investment since its Scenario A value (line 57) is slightly greater relative to the otherwise identical S corporation. Logically and all other factors identical, different tax rates (e.g., C corporation versus personal) affect an investor’s opinion of value. Scenario B: Distributions exceed the tax liability associated with entity income. The Sce- nario B conclusion indicates that this particular S corporation minority interest is worth more than an S corporation minority interest receiving no distributions and is worth more than a C corporation paying no dividends (line 57). Note that the pre- mium for the value of the S corporation minority interest versus the C corporation will vary with the amount of excess distributions and the likelihood of continued re- ceipt (the latter affecting the choice of a discount rate for the excess distribution). Contrary to Gross, also note that both premiums are much smaller than would be de- rived without tax-affecting S corporation income. Because Treharne’s example represents the extreme case of distributing all income (lines 12 and 13), the result is negative retained cash flow (line 15), which infers that the entity will be unable to fully generate or service the operating, investment, and fi- nancing activities on lines 1 to 8 and still pay owner distributions at the indicated level. Over the long term, distributions cannot exceed net cash flow (line 10). However, if the entity in Scenario B is in a mature industry with minimal growth prospects (i.e., has minimal demands for additional working capital, line 6), does not require investment in capital equipment (line 7) greater than its depreciation expense (line 5), and has no debt service requirements (line 8), net income (line 4) and net cash flow (line 10) will be similar. In such circumstances, the S corporation can afford to pay all of its income to its minority owners without jeopardizing the entity’s future. The preceding unusual circumstances are similar to the facts of Gross and do not rep- resent the facts of a typical S corporation valuation assignment. Scenario C: Distributions less than the tax liability associated with entity income. Be- cause the C corporation income taxes have been recognized in the C corporation sce- nario (line 2) and in Scenario A and Scenario B (line 12) cash flows, retained cash flow (line 15) does not need to be further adjusted to reflect the satisfaction of tax lia- bilities associated with entity income. However, the C corporation tax liability has not been recognized in Scenario C’s re- tained cash flow (line 15). As a result, for the purposes of a valuation analysis, a C corporation tax liability adjustment must be made on line 16 so that the discount rate and the cash flow streams are symmetric. If the C corporation tax liability is not rec- ognized and Ibbotson discount rates are used, the conclusion will be wrong. Because S corporation distributions (line 35) do not exceed C corporation taxes S Corporation Minority Interest Appraisals 113 (line 36), there is no double-taxation benefit (line 39). In general, when S corpora- tion distributions do not exceed C corporation taxes, no double-taxation benefit will be recognized. Conclusions The valuation conclusions are summarized on line 57 of Exhibit 8.14 and in Exhibit 8.15. Valuation Model Summary Consistent with the market’s expectations for evaluating tax-exempt investment opportunities, Treharne recommends identifying the incremental cash flow differences between C and S cor- poration minority interests and determining their present values using the following strategy: 1. Determine the present value of retained cash flow (Exhibit 8.14, line 22) by tax-affecting the S corporation’s cash flow at C corporation income tax rates (Exhibit 8.14, line 12). C corporation rates must be used to normalize the economic income stream to the same ba- sis as the Ibbotson derived discount rates (i.e., the tax liability associated with entity in- come has been paid). 2. Value attributed to investor’s cash flow (line 28) should be adjusted for the tax benefits as- sociated with the S corporation shareholder’s not having to pay a second level of taxes on excess distributions (i.e., S corporation distributions in excess of the equivalent C corpo- ration’s tax liability, Exhibit 8.14, line 38). When determining the present value of the S corporation minority shareholder’s tax benefit, the discount rate may be increased to re- flect greater uncertainty associated with receiving S corporation distributions. More specifically, the risk and discount rate associated with distributions may be greater than the risk and discount rate associated with the company’s net cash flow stream because dis- tributions are subordinate to, and dependent upon, net cash flow. Furthermore, distribu- tions are made at the discretion of the controlling owner. When the company’s history of distributions has been consistent, the additional premium will be minimal, maybe zero. Alternately, an inconsistent history of distributions may justify a larger discount rate. 3. The present value of the cash flow to the investor (line 28) should be adjusted for the in- come tax differences between C corporations and individuals (the latter being responsible for the tax liability associated with an S corporation’s income). 114 S CORPORATIONS AND OTHER PASS-THROUGH TAX ENTITIES Exhibit 8.15 Minority Interests’ Valuation Summary (Minority marketable basis) C Corporation S Corporation Scenario A Scenario B Scenario C Net cash flow for 2004 555 955 955 955 Present value (retained cash flow) 5,550 5,450 (450) 5,550 Present value (cash to investor) 0 (80) 6,976 (4,200) Value to investor 5,550 5,370 6,526 1,350 In addition to the preceding adjustments to a C corporation minority interest valuation analysis, Treharne recognizes that the ability of a buyer to build up S corporation basis (i.e., increase retained earnings) may have a favorable impact on the valuation conclusion. However, its impact is mitigated by one of the implicit, key assumptions of the multi- period discounting model used in Treharne’s example (Exhibit 8.14). More specifically, because the implicit holding period in the example is perpetuity, the present value of any benefit associated with S corporation basis increases is negligible. From a more practical perspective, the analyst may choose to recognize that a holding pe- riod of 10 years may approximate perpetuity at a 25 percent equity discount rate and a long-term growth rate of 5 percent. More specifically, the tax benefit attributed to basis buildup is only 0.83 percent at 10 years, assuming a 20 percent capital gain tax rate (fed- eral plus state). In general, the longer the investment holding period, the larger the dis- count rate, and/or the lower the growth rate, the smaller the impact of basis changes on value. Unless one of these variables is at an opposite extreme to those identified in the preceding sentence, Treharne believes the impact of basis buildup is negligible when valuing a minority S corporation interest. Because Treharne’s model produces a marketable minority interest value, one final adjust- ment, a discount for lack of marketability (DLOM), also should be considered if the ob- jective is a nonmarketable minority interest value. Many analysts recognize the contribution of C corporation dividends by adjusting the benchmark-DLOM averages (e.g., the pre-IPO or restricted stock studies’ averages) downward. Because Treharne’s S corporation valuation model quantifies similar adjustments in terms of dollars (instead of a percentage), the analyst needs to be wary of and avoid double counting the favorable impact of an S corporation’s excess distributions. Van Vleet’s Model 35 Introduction The S corporation economic adjustment model developed by Daniel R. Van Vleet contem- plates the following: (1) the economic characteristics of generally accepted business valuation approaches; (2) the disparate income tax attributes of S corporations, C corporations, and their respective shareholders; and (3) the net economic benefits derived by S corporation and C corporation shareholders. This model should be used only when the following conditions are present: (1) the assignment is to value a non-controlling equity interest in an S corporation and (2) empirical market data of publicly traded C corporation equity securities is used to es- timate the value of the subject S corporation equity securities. There are two basic premises that are relevant to a discussion of the Van Vleet model. The first premise is that there are significant differences in the income tax treatment of S Corporation Minority Interest Appraisals 115 35 Daniel R. Van Vleet, ASA, CBA, “The S Corporation Economic Adjustment Model,” Chapter 4, The Handbook of Business Valuation and Intellectual Property Analysis (New York: McGraw-Hill, 2004). S corporations, C corporations, and their respective shareholders. These differences are briefly described as follows: • C corporations are subject to corporate income taxes at the entity level. Conversely, the shareholders of S corporations recognize a pro rata share of the net income 36 of the S corpo- ration on their personal income tax returns. • Dividends from C corporations are subject to dividend income tax rates at the shareholder level. 37 Conversely, dividends received by shareholders of S corporations are not subject to income taxes. • The undistributed income of an S corporation increases the income tax basis of its equity securities. Conversely, the undistributed income of a C corporation does not change the in- come tax basis of its equity securities. The second premise is that capital markets are efficient, at least over the long term. Con- sequently, equity investment rates of return, equity security prices, and price/earnings multi- ples of publicly traded C corporations inherently reflect the income tax treatment of C corporations and their respective shareholders. Based on these two premises, there is a theoretical mismatch between (1) the economic characteristics of the empirical market data of publicly traded C corporations and (2) the eco- nomic attributes of noncontrolling equity interests in S corporations. This mismatch may dis- tort the appraised value of S corporation equity securities when empirical studies of C corporations are used to estimate such value. These potential distortions may occur when pub- licly traded C corporation data is used to (1) estimate the capitalization rate or present value discount rate used in the income approach, (2) estimate the price/earnings multiples used in the market approach, or (3) estimate the discount for lack of control used in the income ap- proach, market approach, or asset-based approach. Currently, there is a lack of good empirical data related to transactions involving minor- ity equity interests in S corporations. Consequently, Van Vleet argues the need for a mathe- matical framework that conceptually addresses the relevant income tax–related differences between S corporations, C corporations, and their respective shareholders. This mathemati- cal framework should permit the adjustment of estimated values of noncontrolling equity in- terests in S corporations when empirical market data of publicly traded C corporations is used in the valuation analysis. This mathematical framework should be generally applicable to each of the generally accepted approaches and methods to business valuation, not just the income approach. Business Valuation Approaches There are three basic approaches to the valuation of an equity interest in a business enterprise: (1) the income approach, (2) the market approach, and (3) the asset-based approach. In order to assess whether the S corporation organization form has an impact on any of these business 116 S CORPORATIONS AND OTHER PASS-THROUGH TAX ENTITIES 36 S corporation net income is defined as net income prior to the payment of federal and state income tax at the shareholder level. 37 The term shareholder level refers to a noncontrolling equity interest in the subject business enterprise. valuation approaches, it is necessary to understand (1) the general economic nature of corpo- rate transactions and (2) how empirical studies of these transactions are reflected within the various business valuation approaches. In order to simplify the following explanations, the three business valuation approaches are grouped into two categories: (1) income-based ap- proaches and (2) asset-based approaches. For purposes of this discussion, the income approach and market approach are both clas- sified as income-based approaches. The indicated value of equity provided by each of these approaches is based on (1) a measurement of income and (2) the application of a capitaliza- tion factor. The capitalization factor is a percentage—or multiple—used to convert a measure- ment of income into an indication of value. Capitalization factors used in the income approach may take the form of a single-period capitalization rate or a multiperiod present value dis- count rate. Capitalization factors used in the market approach may take the form of a price/earnings multiple. Income Approach The two most commonly used income approach methods are (1) the discounted cash flow method and (2) the single-period direct capitalization method. 38 These methods use either a capitalization rate or present value discount rate—both of which are typically derived from empirical studies of investment rates of return on noncontrolling equity interests in publicly traded C corporations—to estimate the value of the subject S corporation equity securities. A fundamental business valuation principle is that the economic attributes of income and the capitalization rate or present value discount rate should be conceptually consistent. In or- der to assess whether this consistency is present in a valuation analysis, it is necessary to un- derstand how investment rates of return on publicly traded C corporation equity securities are calculated. Public market equity investors expect to receive an investment rate of return that is com- prised of some combination of income (i.e., cash dividends) and capital gains or losses. The following formula is the mathematical representation of this relationship: where: k 1 = Investment rate of return during period 1 S 1 = Stock price at end of period 1 S 0 = Stock price at beginning of period 1 d 1 = Dividends paid during period 1 The formula illustrates the principle that investment rates of return on equity securities— and, therefore, the capitalization rates and present value discount rates used in the income k SS d S 1 10 = −+() 1 0 S Corporation Minority Interest Appraisals 117 38 Either of these methods can be constructed to provide either a controlling interest or a noncontrolling interest in- dication of value. However, for purposes of our discussion, the income approach methods discussed in this portion of the chapter are assumed to provide a noncontrolling indication of value. approach—are derived from a combination of capital appreciation of the security (S 1 – S 0 ) and dividend payments (d 1 ). Theoretically, capital appreciation and dividend payments are derived from the net in- come of the corporation. In other words, net income is either (1) paid to the shareholders in the form of dividends or (2) retained by the company (resulting in the capital appreciation 39 of equity). Consequently, equity investment rates of return inherently reflect (1) corporate in- come taxes at the entity level and (2) capital gains taxes and dividend income taxes at the shareholder level. When the income approach uses capitalization rates or present value dis- count rates derived from publicly traded equity securities, and when the projected net income of the subject S corporation is tax-affected using an appropriate C corporation equivalent in- come tax rate, the resulting indication of value of equity is a C corporation publicly traded equivalent value. Market Approach Within the market approach, there are a variety of valuation methods. The two most com- monly used methods are (1) the guideline publicly traded company method and (2) the guide- line merger and acquisition method. The guideline publicly traded company method estimates the value of equity based on the application of price/earnings multiples derived from empirical studies of stock prices and earnings fundamentals of comparative publicly traded companies. Investment theory tells us that these price/earnings multiples are based on the same fundamental prin- ciples as the equity investment rates of return used to estimate the capitalization rates and present value discount rates used in the income approach. The indication of value provided by the guideline publicly traded company method is a C corporation publicly traded equiv- alent value. The guideline merger and acquisition method estimates the value of the subject company based on the application of market-derived pricing multiples extracted from transaction prices and earnings fundamentals of target companies involved in merger or acquisition transactions. The guideline merger and acquisition method initially provides a controlling interest indica- tion of value. When using this method to value an equity interest that lacks control, a discount for lack of control (DLOC) is typically estimated and applied. The DLOC is typically esti- mated using empirical studies of acquisition price premiums paid for the equity securities of publicly traded companies in control-event merger or acquisition transactions. The inverse of this premium is generally considered a reasonable proxy for the DLOC. When the DLOC is estimated and applied, the analyst has essentially adjusted the indication of value provided by the guideline merger and acquisition method from a controlling interest value to a C corpora- tion publicly traded equivalent value. 118 S CORPORATIONS AND OTHER PASS-THROUGH TAX ENTITIES 39 There are many economic factors that contribute to the capital appreciation (or depreciation) of an equity secu- rity. It is not feasible to mathematically model all of the components that either contribute to or detract from the capital appreciation of an equity security. Consequently, the most reasonable assumption is that, over the long term, capital appreciation is derived from retained earnings. The discussion contained in this portion of the chapter is consistent with this assumption. Asset-Based Approaches The asset-based approach is not commonly used to value a noncontrolling equity interest of a profitable going-concern business enterprise. Typically, the asset-based approach provides an indication of equity value on a controlling interest basis. As such, the indication of value is typically adjusted with a DLOC when valuing a noncontrolling equity interest. When this dis- count is estimated using empirical studies of acquisition price premiums paid for the equity securities of publicly traded companies in control event merger or acquisition transactions, the analyst has effectively adjusted the indication of value to a C corporation publicly traded equivalent value. Summary The income approach, market approach, and asset-based approach can be used to estimate the C corporation publicly traded equivalent value of a noncontrolling equity interest in a C cor- poration or an S corporation. Exhibit 8.16 illustrates this concept. The C corporation publicly traded equivalent value assumes that the equity interest being valued is (1) a noncontrolling equity interest, (2) readily marketable, and (3) subject to C corporation entity-level income taxation, and (4) subject to dividend and capital gains in- come tax treatment at the shareholder level. Also, the indication of value assumes that in- vestors are indifferent between dividends and capital gains, since both forms of investment returns are (1) readily liquid and (2) subject to identical federal income tax rates. Since there are significant differences among the income, dividend, and capital gains in- come tax treatment of S corporations, C corporations and their respective shareholders, the C corporation publicly traded equivalent indication of value may not be appropriate when valu- ing a noncontrolling equity interest in an S corporation. Also, the S corporation shareholders may or may not be indifferent between investment returns in the form of distributions (i.e., dividends) or capital gains. Conceptual Mismatch between S Corporations and C Corporations There are income tax differences between S corporations, C corporations and their respective shareholders. These income tax differences result in differing economic benefits attributable S Corporation Minority Interest Appraisals 119 Exhibit 8.16 Business Valuation Approaches Derived from Tender Offer Premiums Paid for Publicly Traded Companies Guideline Publicly Traded Company Method Asset-Based Approaches Discounted Cash Flow Method Controlling Interest Value Discount for Lack of Control C Corporation Publicly Traded Equivalent Value Guideline Merger & Acquisition Method to the shareholders of S corporations and C corporations. Exhibit 8.17 illustrates these differ- ences and was created using the following assumptions: • Distribution (i.e., dividend) payout ratio of 50 percent of net income • C corporation corporate income tax rate of 35 percent • Individual ordinary income tax rate of 35 percent • Dividend income tax rate of 15 percent • Capital gains income tax rate of 15 percent • Capital gains tax liability is economically recognized when incurred. • Capital appreciation of equity is derived from increases in retained earnings on a dollar-for- dollar basis. As demonstrated in Exhibit 8.17, the total net economic benefit of $65,000 derived by S cor- poration shareholders is different from the total net economic benefit of $55,250 derived by C corporation shareholders. Historically, business valuation analysts have attempted to correct for these differences by estimating income taxes and subtracting this amount from the net in- come of the subject S corporation. Unfortunately, this adjustment does not properly resolve the economic mismatch. 120 S CORPORATIONS AND OTHER PASS-THROUGH TAX ENTITIES Exhibit 8.17 Net Economic Benefits to Shareholders C Corp. S Corp. ($) ($) Income before Corporate Income Taxes 100,000 100,000 Corporate Income Taxes (35,000) NM Net Income 65,000 100,000 Dividends Distributions to S Corporation Shareholders NM 50,000 Income Tax Due by S Corporation Shareholders NM (35,000) Net Cash Flow Benefit to S Corporation Shareholders NM 15,000 Dividends to C Corporation Shareholders 32,500 NM Dividend Tax Due by C Corporation Shareholders (4,875) NM Net Cash Flow Benefit to C Corporation Shareholders 27,625 NM Capital Appreciation Net Income 65,000 100,000 Dividends and Distributions (32,500) (50,000) Retained Earnings (i.e., Net Capital Appreciation) 32,500 50,000 Effect of Increase in Income Tax Basis of Shares NM (50,000) Taxable Capital Appreciation 32,500 0 Capital Gains Tax Liability (4,875) 0 Net Capital Appreciation Benefit to Shareholders 27,625 50,000 Net Cash Flow Benefit to Shareholders 27,625 15,000 Net Capital Appreciation Benefit to Shareholders 27,625 50,000 Total Net Economic Benefit to Shareholders 55,250 65,000 The S Corporation Economic Adjustment Van Vleet developed the S corporation economic adjustment (SEA) as a means to address the differences in net economic benefits between S corporation and C corporation share- holders. The SEA contemplates the differing income tax treatments of S corporations, C corpo- rations, and their respective shareholders. As such, the SEA is the first step in creating a mathematical framework that may be used to adjust the indicated value of noncontrolling equity interests in S corporations. The SEA is based on equations that model the net eco- nomic benefits to (1) C corporation shareholders (NEB C ) and (2) S corporation sharehold- ers (NEB S ). The NEB C equation is comprised of two principle components: (1) net cash received by shareholders from dividends after the payment of income taxes at the entity level and income taxes on dividends at the shareholder level and (2) net capital appreciation of the equity secu- rity after recognition of capital gains taxes at the shareholder level. The equation for the first component of the NEB C equation is: Net Cash from dividends = I p × (1 – t c ) × D p × (1 – t d ) where: I p = Income prior to federal and state income tax (I p > 0) t c = C corporation effective income tax rate D p = Dividend payout ratio T d = Income tax rate on dividends The equation for the second component of the NEB C equation is: Net capital appreciation = I p × (1 – t c ) × (1 – D p ) × (1 – t cg ) where: I p = Reported income prior to federal and state income tax (I p > 0) t c = C corporation effective income tax rate D p = Dividend payout ratio t cg = Capital gains tax rate Adding together the first and second components of the NEB C equation results in an equa- tion that models the total net economic benefit to the C corporation shareholder. The NEB C equation follows in its entirety: NEB C = [I p × (1 – t c ) × D p × (1 – t d )] + [I p × (1 – t c ) × (1 – D p ) × (1 – t cg )] The NEB S equation is less complex. 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If C corpora- tion and personal tax rates (lines 2 and 12, respectively) are identical, the present value components (lines 22, 32, 43 , 53, and 57) of the C corporation and the Scenario A S