Valuing Pass-Through Entities
Pass-through entities are very popular entity types, especially for small, privately held companies. Pass-through entities include Subchapter S corporations, partnerships, limited liability companies and even sole proprietorships.
One of the primary benefits of pass-through entities is the avoidance of the ”double taxation” on corporate profits that are typically paid when a C corporation first pays tax on its taxable income and then the shareholders pay a tax on dividend distributions of corporate earnings.
Pass-through entities are sometimes referred to as non-taxed entities, but this is inaccurate, because the company’s income is being taxed, albeit at the shareholder level rather than at the company level.
Business appraisers using the income approach1 have traditionally tax affected pass-through entities as though they were C corporations because, typically, the empirical data that was used in the valuation analysis was drawn from the public stock markets, which consisted almost exclusively of C corporations. Thus, failure to tax affect a pass-through entity would lead to a result that was not an apples-to-apples comparison.
In 1999 the Gross v Commissioner case (T.C. Memo. 1999-254) was issued, wherein the Tax Court agreed with the IRS that, in the case of the non-controlling interest in the business in question, tax affecting was inappropriate.
However, the business valuation profession has always believed that the economic reality which cannot be ignored is that the tax on corporate earnings for a pass-through entity is always paid, whether out of company assets or out of shareholder assets. However, the Gross case caused the valuation profession to revisit the analysis of pass-through entities and to acknowledge that the previous analytical models, while properly tax affecting the earnings, did not adequately consider the benefits of the avoidance of the dividends tax.
In the wake of Gross, five analytical models were developed and published, each of which provided alternative ways to incorporate the benefits of pass-through status into the valuation analysis of a non-controlling interest in a pass-through entity. The models all have the same objective, and go about it in somewhat different ways, but the component they all share is that they take into account the specific facts and circumstances of the subject company, and do not rely on a one-size-fits-all approach.
Proper use of any of the models results in a more thorough analysis of the specific facts regarding the subject company, and thus a more meaningful valuation conclusion.
1This article does not address issues related to use of the market approach to value a pass-through entity.