New Research into the Pass-Through Entity Adjustment

The issuance of the case of Gross v Commissioner in 1999 provided the Internal Revenue Service with ammunition to deny tax effecting of earnings in the valuation of pass-through entities (i.e., Subchapter S corporations, partnerships, limited liability companies). Since most valuators tax affect a pass through entity’s earnings at 40%, this has the effect of increasing value by 67%, other things being equal.

While it is widely acknowledged that frequently there are benefits to owning a pass through entity as compared to a C corporation, the increase in value is far, far below an amount of 67%. On the heels of the Gross case, leaders in the business valuation profession developed several mathematical models to better quantify the change in value that accrues by virtue of pass through entity status. These models all focus on the present value of future tax savings, given the specific circumstances of the subject company. That is, these cash flow oriented models estimate the future tax savings, then compute the present value of those savings at the entity’s capitalization or discount rate of return. In our experience, these models measured the increase in value to be generally between 10% and 15%.

New research has been released that seeks to quantify the pass through entity adjustment by focusing instead on the capitalization rate used to value the company’s cash flows. In this rate of return oriented methodology, it is the entity level rate of return that is adjusted, rather than the cash flow.

This new research has only recently been published, so we have not yet assessed its results as compared to the previous, cash-flow oriented models. However, we always welcome the opportunity to explore new developments in the business valuation community.