If you have a larger estate, asset valuation should be an important aspect of your estate plan. This is especially true if a closely held business is part of the estate. The valuation of your business for gift and estate tax purposes is critical to determining how much of your estate goes to your family and how much goes to the government.
“Tax-affecting” is a term you should become familiar with if your business is structured as a pass-through entity. A tax-affecting strategy can reduce the business’s value — which, in turn, can possibly reduce your estate tax liability.
Widely accepted, but often challenged
Tax-affecting — which involves discounting a pass-through entity’s projected earnings by an assumed corporate income tax rate — is widely accepted in the valuation community, but the IRS routinely challenges the practice. Historically, the U.S. Tax Court has sided with the IRS. In a recent estate tax case, however, the Tax Court accepted the use of tax-affecting by a valuation expert. Although the practice remains controversial (at least from the IRS’s perspective) the court’s decision may signal a greater willingness to accept it in future cases.
When valuing businesses or business interests, valuation professionals often rely on one of two types of methods. The income-based method projects the business’s future earnings or cash flow and discounts them to present value. The market-based method applies earnings multiples derived from public or private company market data. In either case, the subject company’s earnings are critical.
Pass-through entities and taxes
Pass-through businesses pay no entity-level taxes. Rather, as the name suggests, their profits and losses are passed through to the owners, who report their shares on their personal income tax returns. Nevertheless, valuation professionals often discount a pass-through entity’s earnings to reflect an assumed corporate income tax rate. Why? Because, despite the lack of entity-level taxes, owners still pay taxes on their shares of the entity’s profits at their individual rates, and pass-through entities commonly distribute sufficient earnings to cover those taxes.
Another rationale for tax-affecting is that it accounts for the risk that a pass-through entity will convert to a C corporation in the future. This conversion may happen, for example, if the pass-through entity loses its S corporation status or merges into a C corporation.
Although it’s important to recognize the real impact of taxes on a pass-through entity, applying an assumed corporate rate, without more, may undervalue the entity because it ignores the tax advantage such a structure provides. Because there’s no entity-level tax, pass-through entities avoid the double taxation experienced by traditional C corporations.
A C corporation’s earnings are taxed twice, once at the corporate level and again when they’re distributed to shareholders in the form of dividends. Thus, valuators often add a premium when valuing pass-through entities to reflect this tax advantage. But note that, since the Tax Cuts and Jobs Act cut corporate income tax rates, this advantage isn’t as significant as it once was.
Tax Court ruling
In a recent Tax Court case — Estate of Jones — the court approved tax-affecting in the valuation of two family-owned timber businesses. One was structured as an S corporation and the other as an LLC, for gift and estate tax purposes.
The court found that the estate’s valuation professional’s approach best accounted for the tax impact of pass-through status. He tax-affected the entities’ earnings, using a 38% rate for combined federal and state taxes, to arrive at an initial value, and then added back a premium to reflect the benefit of avoiding a tax on dividends. Tax-affecting was only one of several issues. But because the estate’s expert’s position prevailed, the family saved tens of millions of dollars in gift taxes.
Turn to a qualified professional
If your estate includes a closely held business, it’s worth your time to learn more about a valuation that incorporates tax-affecting. The key to a tax-affecting strategy is to work with a qualified valuation professional.