Bernier expert responds: Will the Tax Court get it right?
“The Massachusetts Supreme Judicial Court in Bernier and Judge Strine of the Delaware Chancery Court in Del. Radiology both got it right,” says Mark Leicester, CPA/ABV, JD, LLM (Director of Business Valuation and Litigation Services, RSM McGladrey, Inc.; Burlington, MA). Leicester testified on behalf of the wife in Bernier v. Bernier, the divorce case discussed in last week’s BVWire™. The debate on S corporation valuation lay at the heart of the case, as it did in Del. Open MRI Radiology Assocs. v. Kessler (Del. Chancery 2006).
“When I testified in Bernier in 2002,” Leicester explains, “the individual, marginal ordinary income tax rate and the dividend tax rate were the same. Therefore, the tax avoided was the federal corporate income tax, not the dividend tax, and so not tax affecting [the S corporation earnings] for federal corporate tax was the correct method at the time.”
Since then, the Feds lowered the tax rate on dividends to the capital gains rate. Because the combined federal/state corporate tax is now approximately the same as individual tax rates (about 40%), the tax avoided today is the dividend tax, Leicester says. The most accurate tax affecting methodology is to “apply the income tax to S corporation earnings and adjust that result to an equivalent, pre-dividend-tax, C corporation cash flow, and then value that cash flow stream.”
That’s essentially what the Court did in Del. Radiology—and what the Tax Court declined to do in Dallas v. Commissioner, decided in 2006 but concerning a pre-2003 valuation of an S Corp (i.e., before the change in tax rates). “The Tax Court could have (and should have) distinguished the situation on that basis alone,” Leicester says. “But…I don’t think the Tax Court got it then, and it still may not get it now.”
Getting S Corp values clearly, correctly
Leicester makes some excellent points, responds Nancy Fannon (Fannon Valuation Group). He is also making some critical assumptions (which Del. Radiology also made), including that:
- the S Corp benefits are perpetual;
- the retained net income is as valuable as distributed income (it’s not);
- there are no detriments to operating as an S Corp compared to a C Corp (there are many); and
- the same tax rates apply to capital gains as to ordinary income.
Moreover, the key issue is and always has been the avoidance of the dividend tax, Fannon says. “Many analysts have omitted a deduction for corporate income taxes when they value an S corporation. However, to do so treats the S corporation as if it (and its investors) avoids the tax on corporate income instead of the tax on dividends. This is simply not true, and has led to widespread misapplication of appropriate methodologies for valuing S corporations.”
This specific issue lies at the heart of the various conflicting court decisions—and forms the focus of the upcoming release, Fannon’s Guide to the Valuation of Subchapter S Corporations:
When we value an S corporation using the income approach, the only rate of return we have available comes from C corporations in the publicly traded stock markets. Immediately, we find that the rate of return does not match the cash flows. The public stock market investors set their rate of return requirements based on an expectation of having to pay a dividend tax when they receive their cash returns. We use this same rate of return to value the S corporation cash returns, yet investors pay no dividend tax. Thus, for the income approach, we have to account for this benefit.
In such clear, concise language, Fannon’s Guide strips away the complexity surrounding S Corp valuation and presents a Simplified Model, analytically accurate (including its treatment of key assumptions) and easily conveyable to clients as well as courts. To pre-order your copy, click here.
Another buy-sell gone bad for lack of appraisal method
Two partners in an educational marketing company tried to negotiate a buy-sell price for their respective ownership interests after one partner had already resigned. That was the first “bad” fact in Cardon v. Testout! Corp. (10th Cir., August 2007). Second: The company had suffered recent financial losses, further straining the partners’ relationship. Third, their partnership agreement provided a buy-sell price (percent ownership times a multiple of net income) for only three years after the inception in 1992, but their employment agreement required the departing owner to sell back his shares when he resigned in 2000. Finally, the ousted owner accepted a low-ball price for his shares, only to find out later that the company’s finances had improved. Litigation ensued in 2003—and given the 10th Circuit’s dismissal of certain state fraud claims without prejudice, the conflict and cost continue to this day.
They could have used this free BVR download—and Mercer’s book. “The best time to think about what happens if the business…doesn’t work out is when the business is being formed and the…owners are happy,” writes John Stockdale, Jr., BVR editor, in “Recent Cases Highlight Problem Areas in Buy-Sell Agreements.” The article originally appeared in Value Matters™ (Mercer Capital) and is now available as a free download at BVResources. Business owners, their financial advisors and appraisers, will want to check out Mercer Capital’s Buy-Sell Agreements: Ticking Time Bomb or Reasonable Resolution?, available here.
New search tips now at BVLibrary
Let’s say you want to find out more about buy-sell agreements, from their treatment in the courts to their role in building a financial planning practice. You start at BVResources, where at the top of every page you’ll find a search button—providing access to the most comprehensive, cutting-edge, BV-specific search engine available to the legal, financial, and appraisal communities. If you’re new to the system, you might type in the term buy-sell agreements, without quotation marks. (This search returns 97 generalized results, from a case on a prenuptial agreement to another on a stock buy.) To help newcomers, we’ve added a new “search help” button, which appears on the same screen as the search-return results. The very first tip explains the use of quotation marks around phrases or groups of words—and sure enough: A search of “buy-sell agreements” returns 363 results, sorted by relevance, beginning with Mercer’s book and continuing with several on-point legal cases and teleconference materials addressing the planner’s and practitioner’s roles in buy-sell agreements. The search tips also provide instructions for more advanced BV research. It’s user-friendly and it’s free; check it out and let us know what you think.
The rest of the VC story…
Jim Rigby (Financial Valuation Group) commented on the item in last week’s ‘Wire on the “major” shakeout in the venture capital industry. In particular, he noted that the study by OVP Partners didn’t end with the cited quote, regarding the 50% drop in VC activity. The next paragraph states “the venture capital industry is healthier today than most people realize, given the magnitude of the shake-out already behind us.”
That’s true—but that also may be a way of saying that “pruning” has been good for the VC garden. A more recent article in Dow Jones’ Financial News cites the same OVP study to support the current “consolidation” in the VC industry, which has “learned its lesson from the bubble by investing less in more diverse technologies." Or as Rigby also observed, “The [OVP study] shows the maturity of the technology industry. VC systems depend on high-growth industries with a high need for cash and broad ‘people’ networks—technical, managerial, etc.” As more companies become established and growth slows, investors “are moving into alternative sources of energy such as bio-tech,” he says, “areas that can still achieve high growth rates.”
Finally, according to yesterday’s posting at VC Confidential, Google is entering the industry as another big, billion-dollar, strategic buyer, “boxing out” the boutique VC firms from making the start-up, high-growth investments. This is “yet another sign of where we are in the cycle,” says VCC. “Strategic activity tends to peak (along with angels') right before a market pull back.”
Should the BV community unite behind single standards?
“Taxation without representation is a well-known ‘no-no.’ The same should be, but is not, true of regulation in the [BV] profession,” writes Raymond C. Miles, CBA, ASA, Executive Director of the Institute of Business Appraisers, in the current issue of IBA News, now available at the IBA website. “There is a proliferation of institutions and organizations whose activities affect business valuation standards,” but, “the business valuation profession does not have effective input to standards established by the Appraisal Foundation, the Financial Accounting Standards Board, or the International Valuation Standards Committee. The BV profession needs to unite for the development of a single set of standards, written by BV appraisers, for BV appraisers and enforced by BV organizations,” Miles says. His article ends with a call to send a “teabag” of protest to the various BV membership organizations:
We call on the leaders of our BV organizations jointly to convene to draft these standards, putting aside organizational differences for the good of the profession and the public.
Do you agree? To register your vote on the proposal (and add any comments, revolutionary or not), please take a moment to answer our latest online poll.
Don’t miss the ‘$10 trillion’ opportunity
Exit-planning and related financial consulting is fast becoming a high-growth practice area for BV practitioners. The next issue (October 2007) of the Business Valuation Update™ will feature a presentation from the recent CICBV Eastern Regional Conference on how to “grow” a profitable succession-planning practice. Yet another sign of niche growth: The next Certified Exit Planning Advisor® course, sponsored by the Exit Planning Institute in Chicago, October 4th – 9th, is nearly sold-out. Check the website for more details and for future CEPA programs and events. “As the baby boomer generation begins to retire, one out of every two businesses is expected to change hands during the next 15 years. This represents a transfer of over $10 trillion in wealth,” says EPI founder Rich Jackim. “What role will you play?”