Understanding and valuing S Corporations

On the Money

Are S Corporations valued at a premium?

Until 2001, S Corps were generally valued just like C Corporations. S Corps were valued using discounted cash flows that incorporated C Corp tax rates and multiples from public company guidelines. The rationale for using C Corp tax rates to value an S Corp was that the most likely buyer would be a C Corp and the C Corp tax rate would apply in a hypothetical transaction.

Several tax court cases decided between 2001 and 2006 changed how courts viewed the valuations of minority interests in S Corps. In 2001, Gross vs. Commissioner held that S Corps have a tax rate of zero. Previously, it was assumed the S Corp used the C Corp tax rate and there was no material difference between entities. By holding a zero tax rate, the court essentially said an S Corp is 67 percent more valuable than a C Corp.

Valuation professionals continue to debate the relative valuation benefit of an S Corp compared to a C Corp. While a C Corp may pay as much as a 40 percent corporate tax, an S Corp faces taxes on earnings, whether distributed or not. A consideration of these incremental taxes leads to a premium closer to 25 percent for an S Corp, not the 67 percent implied in the Gross case.

Considerations in valuing S Corporations

Are S Corps worth more than C Corps? The answer is circumstantial. Every S Corp valuation depends on the relevant shareholder agreements. The level of dividends paid to shareholders is also important. If distributions are only enough to cover taxes, there is no added value in the S Corp structure. Other factors include the holding period of the transferred interest, the ability to raise or borrow equity, investor level taxation, cost of capital, and sub-S restrictions.

The general consensus of empirical studies shows there is no significant premium paid for a controlling interest in an S Corp, but there could be a premium paid in the case of a minority interest. In VRC’s experience, we have not seen clear evidence that S Corps are valued at more than a 25 percent premium compared to C Corps, and depending on the facts and circumstances, many do not have any premium.

Bryan Browning is managing director of Valuation Research Corp. in Milwaukee.

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