IRS Finally Acknowledges Reality: The Legal Structure of a Business Does Not Affect Value

The market value of a business is determined by its expected profitability and the risk of profit meeting those expectations. Seems simple enough, but several factors drive the estimation of future profit and the risk of a business – its leadership, competitive advantage, market growth, specialization, customer base, capital structure, and the industry’s barriers to entry, just to name of few.

The market considers these variables - and more - when determining value, but an element that makes no difference to market value is the legal structure of a business. However, until a U.S. Tax Court ruling in 2023, the IRS refused to accept this fact when comparing pass-through entities and C-corporations.

A C-corporation is a structure where the business pays taxes on profit, and distributions made to shareholders are taxed again. A pass-through entity, such as a limited liability company (LLC) or an S-corporation, is not taxed; rather, the tax liability is passed through to the shareholder. Before the 2023 ruling in subject case Cecil v. Commissioner, the position of the IRS was that pass-through entities are valued on pre-tax profit rather than after-tax profit, resulting in pass-through entities having higher values, all other things being equal. The tax court ruled that “tax affecting” the earnings of a pass-through entity to ascertain fair market value was appropriate.

Valuation professionals have long protested that the position taken by the IRS inflates the fair market value of pass-through entities because “real world” buyers and sellers do not pay premiums for pass-through entities. Taxes must be paid regardless if they are paid at the company level or the shareholder level. Additionally, many transactions occur as asset sales, rather than stock sales, where the assets are purchased and transferred to a new entity. This demonstrates that the value of the operating assets drives the value of the equity of the business, and it makes no difference if the equity is in the form of company stock (corporation) or membership interest (LLC).  

This tax court ruling has practical implications for business owners when implementing various tax and estate planning strategies. Thanks to the tax court’s ruling, valuation professionals may be allowed to value pass-through entities based on after-tax earnings, thus producing a relatively lower value, and making it possible for a greater amount of ownership interest to be transferred.

But like so many things in life, and many things with the IRS, the issue is not black and white. The opinion of the court included language that left open the possibility that it may not be appropriate to tax-affect an S corporation in a business valuation, stating, “We emphasize, however, that while we are applying tax affecting here, given the unique setting at hand, we are not necessarily holding that tax affecting is always, or even more often than not, a proper consideration for valuing an S-corporation.” There has been no guidance as to when it is appropriate and when it is not, in the view of the IRS.

Value will continue to be driven by expected after-tax returns to business owners because business owners will continue to pay taxes on business profit. It is a significant breakthrough in the valuation community that the IRS has come to acknowledge this reality.

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