‘Just say no’ to tax-affecting: Analysts respond
In last week’s BVWire, we quoted an IRS attorney as saying that he stood firm on the legal as well as IRS precedent that absolutely rejects tax-affecting the value of pass-through entities. As you might imagine, the remarks (the opinion of the speaker, not the IRS) generated some feedback from fellow panelists at the ASA LA Symposium:
“I have not heard the IRS take this position before,” [implying that not tax-affecting S corporation income is formal IRS policy] said Chris Treharne (Gibraltar Business Appraisals, Inc.). “It’s also important to be aware of the models that strongly recommend adjusting for S Corp differences,” he added—referring to his own model as well as those by analysts Chris Mercer, Dan Van Vleet, Roger Grabowski, and Nancy Fannon.
You need to be able to go to court and persuade the judge that tax-affecting is justified. Remember, the 6th Circuit in the Gross appeal said: ‘All you did was give us a choice between 0% and 40% [for the pass-through income tax rate]. That’s not the same as saying ‘don’t tax-affect.’ Also, recognize that there may be adjustments for dividend tax avoidance and basis build-up benefits.
Continuing, Treharne said, “I’m aware of one of the authors of one of the models who has done subsequent work for the Gross family. He has always tax-affected the S corporation’s income. To my knowledge, he has never been challenged. I also tax-affect income and have successfully defended my position to the IRS.” Treharne later added (after the ASA LA panel) that he has only been challenged once on the issue in the 12 years since the Gross decision.
Treharne also indicated that he’s spoken off the record with an IRS manager who agreed that tax-affecting S corporation income typically is appropriate. “The bottom line is that is our professional obligation to prove to the judge that tax-affecting is appropriate. Judge Halpern of the U.S. Tax Court repeatedly made the point that he writes the ending to the story we tell. We have to tell a good story.”
”Historically, the court cases say no to tax-affecting,” said Mel Abraham (www.valuationeducation.com). But the situation may be analogous to built-in capital gains, in which the courts and cases started off by saying no but have recently start to come around (at least in the 5th and 11th Circuits; the 9th and others have yet to rule). “So we do need to look at the [S Corp] valuation models and question whether the conclusion in any one case is supported by the facts. You shouldn’t blindly follow any mechanical approach, not without this kind of factual analysis,” he observed. “The relevance and reliability of any analysis are even more important these days, in light of Daubert.”
Finally, Judge Halpern weighed in, with more of a Socratic question for the analysts than an answer. “If I own proprietorship and transfer all of my assets to [my own] S corporation, then have I lowered my value?”
Time was running out for the ASA panelists, though Treharne noted, “If you use discount rates derived from publicly traded companies [inferring that the Ibbotson and Duff & Phelps data is derived from public C corporations], you should tax-affect the valuation of proprietorships, too, and partnerships,” and promised to ponder the question on his way to the LA airport. Perhaps, after pondering what one court called this “bedeviling” topic, you’ll email your thoughts to the BVWire editor.
The call to be the third appraiser can be problematic
Chris Mercer (Mercer Capital) posted these insights on his Valuation Speak blog last week:
Over the last several years, I’ve been involved in several multiple appraiser valuation processes as the third appraiser. These experiences provide the basis for a few ideas to “fix” a process that is already underway and headed for almost certain trouble for one or more of the following reasons:
- In some cases, when the call comes, there have already been two appraisals that are not close together in their conclusions.
- In other cases, there has been a failure to negotiate a value and two appraisers have been selected (one by the selling shareholder and one by the company) for the purpose of picking a third appraiser.
- Often, no information is provided in the buy-sell agreement regarding required qualifications for the appraisers. The first two appraisers often differ in terms of background, qualifications, and independent valuation experience. At this point, they have to agree, regardless of prior instructions or lack thereof.
- In some cases, even though the first two appraisers are supposed to select the third appraiser, the buy-sell agreement is not clear on what party(ies) will pay the third appraiser’s fees. This must be resolved.
- And so on…
Mercer also provides steps to help address the problems with appraisals by third appraisers. Read the article here.
Claywell: Do not project historical data forward when your valuation date is a “stub year”
J. Richard Claywell, CPA recently wrote in NACVA’s Ambassadors’ QuickRead:
Valuators commonly need to perform a valuation using a “stub year,” or a date other than the company’s year end. This requires forecasting projected future company operations. It’s critical when performing this forecast that valuators not project historical data forward, and instead perform a new assessment for the new year.
In his article “Tips for Valuators,” Claywell provides a real-world example of “a misperformed valuation showing how dramatically this kind of error effects a calculation of net present value.”
Questions to answer when drafting shareholder agreements
In a case study of three close friends who started a business, Don Bays (Henry & Horne) demonstrates the need for a well-written shareholder agreement—including the following:
- Valuation date: What is the date of the valuation of the departing (or deceased’s stock)? Is it the date of termination? The date of death (as may be required for estate tax purposes)? Or the date of the end of the latest fiscal year?
- Value to be used: Will it be book value (possibly useful for companies with a high concentration of liquid receivables and inventory assets as compared to fixed assets); or, adjusted net asset value (the fair market value of tangible assets less liabilities, plus the value of intangibles such as goodwill, patents, and copyrights); or, a fair market value based on the economic earnings of the company, or the ratio of selling price to revenues of similar companies (a direct market data method of business valuation)?
- Discounts: Will minority and marketability discounts be applied to the shares or will they be redeemed at one-third of the 100% of the value of the company, however value is determined?
- Annual valuations: Will the stock be valued on an annual basis so that the changing economics of the company are considered on a somewhat timely basis?
- Appraisers: Will a competent business appraiser be engaged to value the stock? (For estate tax purposes the Internal Revenue Services requires an independent opinion of value rendered by a qualified business appraiser)? Or will the value of the stock be negotiated by the remaining owners of the company?
- Life insurance: Will the purchase of the stock be funded by life insurance?
- Unwanted owners: Does the shareholder agreement stipulate that the departing or deceased shareholder cannot sell its shares to anyone other than the remaining stockholder?
Click here to read the complete article on the firm’s blog.
Randy Biernat shares valuation checklist
In last week’s BVR webinar “Valuing Management Services Contracts Between Physicians and Hospitals” Randy Biernat (Katz, Sapper & Miller) shared with listeners the checklist he uses when starting these types of valuation engagements:
- Determine FMV requirements
- Document jurisdictional exceptions to FMV
- Identify parties to agreement
- Document purpose of arrangement
- Identify method of compensation
- Consider and Select Valuation Methodology
- Evaluate transaction from management services company perspective
- Evaluate transaction from hospital perspective
- Reconcile FMV findings
- Provide conclusion of FMV range of compensation
Biernat and his colleagues document the first five points in the engagement letter and process points 6 -10 after they receive the information from the client. “The availability of information may limit the appraiser’s ability to complete each of the above steps,” he warns. “If we can’t assess some of these points we will work with counsel to identify those issues and come up with a reasonable course of action to account for information we can’t get access to.” Biernat recognizes that appraisers frequently get bad data from hospitals and/or physicians.
The webinar training pack, filled with Biernat’s expertise on valuing physician management services contracts, will be available in mid-June.
Valuing life insurance policies can be problematic
In a recent Trusts and Estates blog post Melvin A. Warshaw (Financial Architects Partners) says “antiquated gift tax regulations create ambiguity in valuing certain types of newer policies that are sold today.” One example is in the case of gift taxes. Warshaw explains:
The estate and gift tax regulations indicate that the value of a policy is based on the cost of a hypothetical “comparable contract.” For newly issued policies, the value is the cost of the policy (that is, premiums paid). For one-time, single premium policies that are “paid up,” the value is the carrier’s current cost for an identical policy. For policies in force for some time on which additional premiums are due, the regulations say that the FMV of the policy can be “approximated” by using the ITR [interpolated terminal reserve] amount plus unearned premiums unless this method isn’t reasonably close to full value (for example, the insured is terminally ill).
“ITR is at the heart of the current dilemma on how to value policies,” says Warshaw. Find out more by reading his article “Life Insurance Policy Valuation.”
Two reports just out on 1Q11 M&A activity
- Middle market deal volume slowed in the first quarter, according to GF Data’s Q1 Middle Market Update. However, valuation and debt multiples remained unchanged, and average pricing “held steady at 6.1x trailing twelve months adjusted EBITDA for the third consecutive quarter.” For more information on the report contact Bob Wegbreit at firstname.lastname@example.org
- PCE Investment Bankers released their quarterly State of the M&A Markets report. The author George Steinbarger reports:
Transaction activity during the first quarter of 2011 increased across all segments when compared to the first quarter of 2010. Acquisitions greater than $250 million lead the way, growing at a striking 83% versus 1Q10. While transactions less than $50 million command all segments in total volume, its growth compared to 1Q10 was a more modest 31%, hardly a disappointment.
The report also indicates that valuation multiples, based on CapitalIQ data, showed a slight decreased during the same period. Based on current deal momentum, Steinbarger is cautiously optimistic that the deal markets will continue to improve throughout 2011. Read the full report here.
Must-have books for your divorce valuation library
At the AICPA Family Law Conference in Las Vegas last week, Brenda Clarke (Seigneur Gustafson) and Stacey Udell (Gold Gocial Gerstein) recommended the following books for the valuation practitioner:
- Family Law Services Handbook: The Role of the Financial Expert (Donald Glenn, Thomas Burrage, Donald DeGrazia, and William Stewart
- Litigation Services Handbook: The Role of the Financial Expert, 4th ed. (Roman Weil., Peter Frank, Christian Hughes, and Michael Wagner)
- The Handbook for Divorce Valuations (Robert Kleeman Jr., R. James Alerding, and Benjamin Miller)
- Reasonable Compensation: Application and Analysis (Ronald L. Seigneur and Kevin Yeanoplos)
- Standards of Value; Theory and Applications (Jay E. Fishman, Shannon Pratt and William Morrison)
- A CPA’s Guide to Family Law Services(AICPA Business Valuation and Forensic & Litigation Services Section)
- BVR’s Guide to Personal v. Enterprise Goodwill, 2011 edition (articles from leading experts)
- BVR’s Business Valuation in Divorce Case Law Compendium. The soon-to-be-released 2011/2012 edition contains court case digests, summary tables and a fully indexed and hyperlinked CD to the actual cases. Download an excerpt from the Compendium.
Help those in need in Joplin, Missouri
BVR wishes our friends in Missouri well during the recovery from the tornadoes in Joplin and surrounding areas. Our thoughts are with you and your families and all of those impacted by this destructive event. Larry Ellison (Kirkpatrick Phillips Miller, Springfield, MO) recommends the local organization for donations: Convoy of Hope at www.convoyofhope.org
Upcoming CPE opportunities:
June 7th: The New Minority Share Exchanges: What do they Mean for Private Company Value and Strategy.” FREE!
This free webinar will address what impact recent SEC rule changes and emerging private company share exchanges mean for the valuation and operations of private companies. Featured on this expert panel will be appraiser Neil Beaton (Grant Thornton), banker Susan Casey (Square 1 Bank), venture capitalist Lawrence Lennihan (FirstMark Capital), attorney Chip Lion (Morrison Foerster), and Jeff Thomas, Senior Vice President of SecondMarket, one such exchange of private company shares.
June 14th: Valuing Clinical Co-Management Agreements
Part 6 of BVR’s Online Symposium on Healthcare Valuation continues features Gregory Anderson (Horne LLP) and Ann Brandt (HealthCare Appraisers). The two experts will focus on what has become perhaps the greatest change to the American healthcare system: the increased use of clinical co-management agreements, many of which are often so unique and new that some valuation techniques are insufficient to assess their value. Presentation topics will include operational characteristics of co-management agreements and methods of valuation, including income-, incentive-, and cost-based approaches.
June 16th: Valuing Alternative Investment Management Companies: Private Equity and Hedge Funds
Proliferating in good times while seeking to mitigate risks, alternative investments are an increasingly popular vehicle in the world economy. Given the complexity of their strategies, it should be no surprise that the management strategies of these firms can also seem confusing, resulting, in turn, with complications and pitfalls for the appraiser tasked with their valuation. This program, featuring expert appraisers Jay Fishman ( Financial Research Associates) and Scott Nammacher (Empire Valuation Consultants) examines the valuation challenges inherent in this growing sector of our economy.
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