Tax-affecting the earnings of pass-through entities can have a profound effect upon valuation. Understand this specialized subject for better practice.
By Barry Sziklay, Valuator
What is a Pass-through Entity?
A pass-through entity is a legal entity under state law that generally, with certain limited exceptions applicable to S corporations, does not pay entity-level taxes, but instead reports its taxable income, expenses, gains and losses to its owners, who then directly report such amounts in their personal income tax returns.
Regular and Subchapter S Corporations
Regular corporations are taxed pursuant to IRC Subchapter C; partnerships are taxed pursuant to Subchapter K and S corporations are taxed pursuant to Subchapter S of Chapter 1 of the Code. Regular C corporations are taxed as a separate entity. Therefore, only after-corporate-tax net cash flows are available to distribute to shareholders in the form of dividends (technically, a distribution of accumulated earnings and profits (“AE&P”). The dividend is then subject to tax at the recipient’s tax rate.
Partnerships and Limited Liability Companies
A general partner has unlimited personal liability for the debts of the partnership. A limited partner’s liability for partnership debt is limited to his/her/its capital account, plus whatever amount of partnership debt separately guaranteed by the partner. There is no limitation on the type of entity that can be a partner. A partnership does not pay an entity-level tax.
Pass-through Entity: Outside Basis
Partners pay tax on the entity’s income, expense, gains and losses regardless of cash distributions to the partners. Cash distributions are not taxable to the extent of the partner’s outside adjusted basis in the partnership. Outside adjusted basis cannot go below zero, but a partner’s capital account can become negative as a result of partnership debt that provides additional basis. Partners can increase their adjusted outside basis by the amount of partnership debt for which they are directly liable, their personal guaranty of entity debt, and qualified nonrecourse financing (generally real property indebtedness). Upon a sale of a partner’s interest in a partnership in which their capital account is negative, either as a result of having deducted losses in excess of their adjusted capital contributions (using outside basis from debt to deduct losses), or as a result of the distribution of partnership debt proceeds, that negative capital account may be “recaptured,” resulting in the recognition of ordinary income.
This is a huge issue in divorce, particularly for folks involved in the real estate industry, because, prior to the most recent financial crisis, many of these people leveraged their properties as values rose, and took out cash for a variety of purposes. Leveraging properties to withdraw cash oftentimes resulted in creating negative capital account balances. Eventually, these negative capital account balances will be recaptured as ordinary income; thus, creating embedded deferred tax liabilities that have to be addressed from a valuation standpoint. If and when such deferred tax liabilities will have to be recognized are points of negotiation between the parties.
Distributions of cash or property to partners in excess of outside adjusted basis are taxable to the transferee partner. See §731(a)(1). When an ownership interest in the partnership is purchased by a contribution of appreciated property, the adjusted basis of that property carries over to the partnership and oftentimes results in a difference between the fair market value of the property contributed to the partnership in excess of the adjusted basis of that contributed property (“Excess”). A partnership can elect pursuant to IRC §754 to adjust the inside basis of partnership property to the extent of that Excess. That Excess might be goodwill in a business valuation context. The amortization/depreciation of the Excess is then specially allocated to the contributing partner. This is a very valuable advantage that partnerships have over other business entity forms such as S corporations. In fact, only partnerships, whether general or limited, and inclusive of limited liability companies that are taxed as partnerships, have the ability to make special allocations of income, expenses, gains and losses.
S corporations offer shareholders pass-through taxation somewhat similar to partnerships, as well as limited personal liability with respect to entity-level debt. Shareholders get outside basis for direct loans that they make to the S corporation; however, unlike partnerships, an S corporation shareholder cannot get an increase in outside adjusted basis for entity-level debt. Partners do get an outside adjusted basis “step-up” for entity-level debt that the partner guarantees. The sale of stock in an S corporation is generally subject to capital gains tax rates. A sale of assets of the S corporation may generate ordinary income as well as capital gains.
IRC §338(h)(10) Election
The law provides that the shareholders of an S corporation can unanimously elect pursuant to Code §338(h)(1) to create a tax fiction in which they sell their stock in the corporation, but the transaction is re-characterized as a sale of assets followed by a complete redemption by the corporation of all the stock of the selling shareholders. This creates a greater tax burden for the selling shareholder. Since the buyer is gaining the “step-up” in depreciable outside basis, all other things being equal, the buyer should be willing to increase his/her/its purchase price. The amount of that increase is generally negotiated and bargained for by both buyers and the sellers. While the availability of an IRC §338(h)(10) election somewhat “levels the playing field” as between partnerships and S corporations, that election is not as powerful as a §754 election.
Notwithstanding that there a lot of other technical differences between regular C corporations, S corporations and partnerships, what is the valuation controversy associated with these differences? The academic literature strongly suggests that shareholder-level taxes are manifested in the Equity Risk Premium that valuation analysts employ (either in their build-up models or capital asset pricing models) in determining value using an Income Approach. Valuation analysts and academics have been unable to develop a truly comprehensive financial model to quantify the impact. Accordingly, there are a handful of models being employed in practice, and the valuation impact can be enormous.
Effect on Equity Risk Premium
To the extent that the ERP increases as shareholder-level taxes increase, reducing the expected net cash flow stream by some imputed entity-level tax rate benefit for the presumed advantage of partnership tax status may result in an overstatement of value. That is because the valuation analyst cannot determine with certainty whether the increase in expected net cash flow that s/he calculates by decreasing the expected net cash flow stream by the imputed tax amount is offset, in whole or in part, by an increase in the discount rate. All of this controversy is superimposed upon sometimes conflicting U.S. Tax Court decisions that have dealt with this issue.
Tax-Affecting Pass-through Entity: The Standard of Value
In a divorce context, if the standard of value is pure fair market value, the issues enumerated herein above have to be carefully considered. What if the standard of value is fair value or some iteration of investment value or value to the holder or divorce value, does the above analysis really matter? If the valuation analyst does not assume the hypothetical disposition of the business, then the issue of differences in business entity may not make a difference. If the business has a history of making tax distributions to owners, it may be appropriate to impute an entity-level tax at the expected combined federal and state effective rate of tax when valuing a controlling interest. If valuing a minority ownership interest, the valuation analyst has to review the company’s historical cash distribution policy relative to the control and minority owners, as well as any specific provisions in the company’s shareholder, partnership or operating agreement related to any required tax distributions.
 All references to IRC and Code refer to the Internal Revenue Code of 1986, as amended.
 Excluding liquidating distributions.
 However, if the partner/LLC member dies, there will be a “step-up” to fair market value of the decedent’s partnership/membership interest; thus, avoiding the recapture. See IRC §2031 and Treas. Reg. §20.2031-1(b).
*This article has been abridged. To read the full, original article visit: https://familylawyermagazine.com//articles/pass-through-entity-earnings
Barry Sziklay is the partner-in-charge of the Forensic Accounting, Litigation Support and Valuation Services practice of Friedman, LLP, a certified public accounting and advisory firm, with offices located throughout New Jersey, New York City, Long Island and Beijing, PRC. www.FriedmanLLP.com