Michael Gregory Michael Gregory Consulting, LLC

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1 Michael Gregory Michael Gregory Consulting, LLC

2 DISCLAIMER All rights reserved. No part of this work covered by the copyrights herein may be reproduced or copied in any form or by any means graphically, electronically, or mechanically, including photocopying, audio/video recording, or information storage and retrieval of any kind without the express written permission of the Consultants Training Institute (CTI ), the National Association of Certified Valuators and Analysts (NACVA ), the Institute of Business Appraisers (IBA ), and the presenter. The information contained in this presentation is only intended for general purposes. It is designed to provide authoritative and accurate information about the subject covered. It is sold with the understanding that the copyright holder is not engaged in rendering legal, accounting, or other professional service or advice. If legal or other expert advice is required, the services of an appropriate professional person should be sought. The material may not be applicable or suitable for the reader s specific needs or circumstances. Readers/viewers may not use this information as a substitute for consultation with qualified professionals in the subject matter presented here. Although information contained in this publication has been carefully compiled from sources believed to be reliable, the accuracy of the information is not guaranteed. It is neither intended nor should it be construed as either legal, accounting, and/or tax advice, nor as an opinion provided by the Consultants Training Institute (CTI), the National Association of Certified Valuators and Analysts (NACVA), the Institute of Business Appraisers (IBA), the presenter, or the presenter s firm. The authors specifically disclaim any personal liability, loss, or risk incurred as a consequence of the use, either directly or indirectly, of any information or advice given in these materials. The instructor s opinion may not reflect those of the CTI, NACVA, IBA, their policies, other instructors, or materials. Each occurrence and the facts of each occurrence are different. Changes in facts and/or policy terms may result in conclusions different than those stated herein. It is not intended to reflect the opinions or positions of the authors and instructors in relation to any specific case, but, rather, to be illustrative for educational purposes. The user is cautioned that this course is not all inclusive National Association of Certified Valuators and Analysts (NACVA). All rights reserved South State Street, Suite 400, SLC, UT, The Consultants' Training Institute (CTI) is registered with the National Association of State Boards of Accountancy (NASBA) as a sponsor of continuing professional education on the National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be submitted through its web site: learningmarket.org National Association of Certified Valuators and Analysts (NACVA) 2

3 How the IRS Values Non-Controlling Interests in S Corps with Commentary by Original IRS Champion How the IRS Determines Reasonable Compensation with Commentary by Original IRS Champion Michael Gregory Consulting, LLC

4 Michael Gregory, Chief Manager Michael Gregory Consulting LLC since September 12, 2011 Formerly IRS: 28 Years as Engineer and Valuer, Manager, Operations Team Lead, Controller, Acting Assistant District Director, Territory Manager Was Champion of IRS Original Job Aids CVA, ASA, MBA, and Mediator MN Supreme Court Michael Gregory Consulting, LLC

5 Mediation and Negotiation Business Valuation Review Developing Leaders managingresolutions.org Nine Books and Fourteen Videos on Tax Topics and Leadership Topics Michael Gregory Consulting, LLC

6 The opinions presented here are those of Michael Gregory. Michael Gregory does not represent the IRS. Any opinions presented in this seminar are those of the author and do not represent an official position of current or previous employers. This material is offered for educational purposes only. The author and his employer expressly disclaim any liability, including incidental or consequential damages, arising from the use of this material or any errors or omissions that may be contained in it. Michael Gregory Consulting, LLC

7 Michael Gregory Michael Gregory Consulting LLC

8 Note New Nancy Fannon Keith Sellers Book: Taxes and Value: The Ongoing Research and Analysis Relating to the S Corporation Valuation Puzzle Background on S Corps and Job Aid Job Aid Revealed Commentary for Your Consideration Overview Personal Observations The Job Aid is 32 Pages Michael Gregory Consulting, LLC

9 Valuation of Non-Controlling Interests in Business Entities Electing To Be Treated as S Corporations for Federal Tax Purposes: A Job Aid for IRS Valuation Analysts October 29, 2014 This job aid is not Official IRS position and was prepared for reference purposes only, it may not be used or cited as authority for setting any legal position. Michael Gregory Consulting, LLC

10 Background on S Corps Revenue Ruling Additional Data C Corps Shareholder Agreements Appropriate Tax Rates Generally Not Maximum Statutory Rate Even if C Corp Likely Hypothetical Buyer Look at the Universe of All Hypothetical Buyers Michael Gregory Consulting, LLC

11 The Hypothetical Seller Hypothetical Sale Identify the Most Important Factors Evidence-Based Valuation Analysis A View from the Tax Court A View from Academia Theory Based Valuation Analysis Michael Gregory Consulting, LLC

12 Weighting of Factors and Approaches: Limit on the Number of Interest Holders Limit on the Type of Interest Holders Limit on the Number of Classes of Stock Limit on What Constitutes Straight Debt Absence of an Entity-Level Federal Income Tax Interests of a Hypothetical Buyer Interests of a Hypothetical Seller Michael Gregory Consulting, LLC

13 Assessment and Synthesis Example 1: The Tax Status of the Electing S Corporation Series of Questions to be Asked in Seven Broad Areas Consider These in Application of the Gross Case Michael Gregory Consulting, LLC

14 Example 1: Six Broad Questions: Are Electing S Corps Common in Business and Industry? How has the Business Changed and What is Expected in the Future? What is the Economic Outlook? What is the Market Like for Potential Buyers? Is Maintaining the S Corp Status the Most Productive Use? What are the Interests of the Seller? Gross Case Met This Criteria Don t Tax Affect Michael Gregory Consulting, LLC

15 Example 2: Cost of Capital and DLOM Greater Risk in Limited Ability to Raise Capital Shareholder Agreement Restrictions Increase DLOM and Increase Cost of Capital Taking into Account Pool of Likely Buyers Possibly no Adjustment Here Depending on the Facts of the Case Michael Gregory Consulting, LLC

16 Summarizing Factors to Consider The Size and Composition of the Pool of Hypothetical Buyers The Economic Interests of the Hypothetical Seller The Actual Revenues Available to and the Actual Expenses to be Paid by the Entity that has Elected to Be Taxed as an S Corp The Availability at the Entity Level of Equity and Debt The Likely Holding Period of the Transferred Interest Michael Gregory Consulting, LLC

17 With respect to the question of pass-through taxation, no entity level tax should be applied in the valuation analysis of a non-controlling interest in an electing S Corporation, absent a compelling demonstration that independent third parties dealing at arms-length would do so as part of purchase price negotiation. Personal income taxes of a potential interest buyer are not relevant. Michael Gregory Consulting, LLC

18 Appendix A Rev Rul Appendix B A View from the U.S. Tax Court (Six Estate and Gift Tax Cases and One Limited Partnership Case) Appendix C A View from the Academic Community (Erickson and Wang Paper) Michael Gregory Consulting, LLC

19 Appendix B: Gross T.C. Memo , aff d. 272 F.3d 333 (6th Circuit) 2001, cert denied 537 US 827 (2002) (Corp) Wall TC Memo (Corp) Heck T.C. Memo (Corp) Adams T.C. Memo (Corp) Dallas T.C. Memo (Corp) Guistina TC Memo (Limited Partnership) Gallagher TC Memo (LLC) Michael Gregory Consulting, LLC

20 Appendix C: Merle M. Erickson and Shiing-wu Wang, Tax Benefits as a Source of Merger Premiums in Acquisitions of Private Corporations, The Accounting Review, Vol. 82, No 2, pp (2007) Code Section 338(h)10 77 purchases of large privately held S Corps compared with 77 C Corp purchases without 338(h)10 Elections as Stock Purchases Merle Erickson and Shiing-wu Wang of the University of Chicago differences in S vs C, but less than Gross Case Note Controlling Interests 338(h)10 Large Entities The Erickson and Wang study did show a small difference (approximately 12% to 17%) between sales of S and C Corporations. However, the transactions in the study were very large and drawn from the reporting of the acquisition of privately-held businesses by publicly-traded corporations. Michael Gregory Consulting, LLC

21 Consider Benefits of an S Corp Consider Risks of an S Corp Inconsistency at the IRS (Division, Geography, Personnel) Leading Models (Fannon-Sellers, Grabowski, Mercer, Treharne, Van Vleet) Comments on Erickson and Wang Study for Controlling S Corp Valuation Michael Gregory Consulting, LLC

22 Besides Erickson and Wang Consider The Moderating Effects of Acquisition Premiums in Private Corporations: An Empirical Investigation of Relative S Corporation and C Corporation Valuations. By James A. DiGabriele Multiple Regression Analysis Indeed S Corp Premium Exists The premium depends positively on net sales The premium is higher for the cases in which the transaction is done through Asset sales (rather than Stock sales) The premium is higher for the cases in which firms are bought by Private Buyers (rather than Public buyers) Michael Gregory Consulting, LLC

23 S Corps are Growing Maximum Effective tax rate on corporations is 35% Wall Street Journal reported 69% of U.S. corporations as nontaxable in 2008, compared to 24% in ,500 of the largest 4,500 corporations pay less than 5% Federal Income Tax The Average corporate tax rate in 2011 was 12.1% Think about this in terms of the hypothetical buyer and seller What are the facts in your case? Michael Gregory Consulting, LLC

24 Look at subject Look at industry Look at hypothetical buyers and sellers To tax affect or not to tax affect Consider alternatives Consider risks Make a professional determination Michael Gregory Consulting, LLC

25 See the new Fannon Sellers Book (April 2015) Treharne Fannon Sellers Paper Reconcile Use at Federal and local Levels Michael Gregory Consulting, LLC

26 Michael Gregory Michael Gregory Consulting LLC

27 Introduction Reasonable Compensation Job Aid for IRS Valuation Professionals Overview Commentary for Your Consideration Michael Gregory Consulting, LLC

28 Reasonable Compensation Job Aid for IRS Valuation Professionals October 29, 2014 This Job Aid is not Official IRS position and was prepared for reference purposes only; it may not be used or cited as authority for setting any legal position. 54 Pages Michael Gregory Consulting, LLC

29 Section I: Purpose, Background, and Case Coordination Section II: Identifying a Reasonable Compensation Issue Section III: Developing Reasonable Compensation Issues Section IV: Taxpayer Arguments for Reasonable Compensation Issues Section V: Consideration of Penalties Section VI: Focusing Specifically on Not-For-Profits Michael Gregory Consulting, LLC

30 Appendices A: Suggested readings on Reasonable Compensation B: Data Sources for Compensation Issues C: Information Document Requests D: Financial Analysis Example E: Market Approach Example F: Income Approach Example Michael Gregory Consulting, LLC

31 Appendices Continued G: Court Cases Relating to Prior Years Under- Compensation H: Court Cases Relating to Multiple Jobs I: Example of a Not-For-Profit Analysis (University Sector) Michael Gregory Consulting, LLC

32 Section I: Purpose, Background, and Case Coordination Purpose for IRS Valuation Professionals Background Code Section 162 reasonable compensation deduction Section 4958 Taxes on Excess Benefit Transactions for Not for Profits Case Coordination: Valuation Analyst, Team Coordinator, Account Coordinator, Principal Revenue Agent, Employment Tax Specialist, Counsel, the Compensation and Benefits IPG Subject Matter Experts (SME s) Appendix A provides a list of suggested readings Michael Gregory Consulting, LLC

33 Financial Valuation: Applications and Models, James Hitchner, John Wiley & Co. (2006) Reasonable Compensation: Do You Know Where Your Circuit Stands?, Melanie McCoskey, 109 Journal of Taxation, (October 2008) Valuing a Business, Shannon Pratt, Irwin Press, 5th Edition (2010) Reasonable Compensation: Application and Analysis for Appraisal, Tax and Management Purposes, Ron Seigneur and Kevin Yeanoplos, Business Valuation Resources, LLC, Portland, OR (2010) Reasonable Compensation, BNA portfolio 390, 5th Ed., Tax Management (2011) Michael Gregory Consulting, LLC

34 Section II: Identifying Reasonable Comp Issue Six Cautions This is a Sensitive Issue Focusing on Reasonable Compensation Be Careful to Protect Information The Amount is Interpretive Comparisons with the Right Parties is Often Key A Thorough Interview is Important See Appendix C Information Documents Requests Michael Gregory Consulting, LLC

35 Section II: Identifying Reasonable Comp Issue C: Information Document Requests Five Broad IDR s Example 1 to Explore the Role of the Various Officers Example 2 to Determine the Character and Condition of the Enterprise Example 3 To Gather Compensation Information Example 4 Independence of Process Example 5 Relationship of Compensation Paid to Others in Entity Michael Gregory Consulting, LLC

36 Section III: Developing Reasonable Compensation Issues What is Reasonable Compensation? Treasury Regulation Section (b)(3) as the amount that would ordinarily be paid for like services by like organizations in like circumstances Two Prong Test: Amount Test Purpose Test Michael Gregory Consulting, LLC

37 Section III: Developing Reasonable Compensation Issues Evaluating Requirements for Section criteria Factors Relating to the Employee Factors Relating to the Organization Factors Relating to Compensation Itself Factual Development is Key Factors to Consider Michael Gregory Consulting, LLC

38 Section III: Developing Reasonable Compensation Issues Financial Analysis Detailed Explanation is Beyond this Guide Easy to Manipulate Return on Equity as Discussed Later in Section IV Appendix D Provides an Example of Financial Analysis for a Reasonable Compensation Issue by Year Ending Income Statement with Percentages Balance Sheet with Percentages Calculations of Ratios Comparison with RMA Data by Quartile as Favorable or Unfavorable Michael Gregory Consulting, LLC

39 Section III: Developing Reasonable Compensation Issues Valuation Approaches Market Approach General Industry Surveys by SIC, NAICS See Appendix B Salary Surveys within the Industry Trade Associations, Trade Journals, or Analysts Proxy Statements and Annual Reports for Publicly Traded Companies Private Company Compensation Information such as Dunn & Bradstreet or RMA Appendix E Contains an Example of a Market Approach Michael Gregory Consulting, LLC

40 Section III: Developing Reasonable Compensation Issues Income Approach Requires Fair Market Value of the Company Each Year with Consideration for Appreciation and Distributions Independent Investor Test A Series of Key Court Cases Calculate Return on Equity Compared with Required Rate of Return Appendix F Contains an Example of the Income Approach for Determining Reasonable Compensation Michael Gregory Consulting, LLC

41 Section III: Developing Reasonable Compensation Issues Cost Approach Many Jobs How Much Time Appropriate Compensation for Each Finally, Reconcile Approaches Market Approach Generally Given the Most Weight Refine Methods Given Results Michael Gregory Consulting, LLC

42 Section IV: Taxpayer Arguments for Reasonable Compensation Issues Five Major Areas: 1. Some of the Compensation is for Prior Years Under-Compensation 2. Employee Performs Multiple Jobs 3. Hypothetical Independent Investor Test was Satisfied 4. Employee Personally Guarantees Company Debt may result in higher compensation 5. Employee is the Key Person at the Company or is a Superior Employee that Deserves Extraordinary Compensation Michael Gregory Consulting, LLC

43 Appendices A: Suggested readings on Reasonable Compensation B: Data Sources for Compensation Issues C: Information Document Requests D: Financial Analysis Example E: Market Approach Example F: Income Approach Example Michael Gregory Consulting, LLC

44 B: Data Sources for Compensation Issues: IRS Purchases: Watson-Wyatt, RMA Annual Statement Studies and ERI Free Sources at Library: Top Executive Compensation by National Industrial Conference Board, Executive Compensation and Taxation Coordinator by RIA; Almanac of Business & Industrial Financial Ratios by Leo Troy; General financial analysis of companies by Industry organized by SIC ; Industry Norms and Key Business Ratios, by Dun & Bradstreet Credit Services Michael Gregory Consulting, LLC

45 ERI Comments It is suggested that ERI data be used with caution and mainly for risk analysis and planning purposes, that is, use it to determine whether or not a reasonable compensation issue might exist. Michael Gregory Consulting, LLC

46 According to Regulation (a), The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services." Many Court Cases on Point Egregious for Enforcement When Working with Client Reasonable in the Eyes of an Investor or a Third Party, Not the Client. What Would the Client Pay a Third Party Michael Gregory Consulting, LLC

47 Documentation is Key Expertise of Analyst is Key Key Elements Employees Role External Comparison Character and Condition of the Company Conflict of Interest Internal Consistency Courts Have Documented Approximately 20 Additional Factors Michael Gregory Consulting, LLC

48 If There is a Wide Range Determine Why Based on Strengths and Weaknesses The Market Approach is Typically Weighed the Most If an Approach is Not Applicable, Indicate Why or Why it Should be Weighed Less Michael Gregory Consulting, LLC

49 The Reasonable Compensation Job Aid for IRS Valuation Professionals Provides Real Insight Into How Business Valuers at the IRS Address This Issue. Key Points Were Presented by the Original IRS Issue Champion You May Apply This Information on Your Cases Michael Gregory Consulting, LLC

50 Know Who Your Working with at the IRS Request a Valuator if this is an Issue and a Subject Matter Expert if Issues are Not Being Resolved Understand the Role of Participants Seek to Understand Interests Do Not be Afraid to Ask Questions Consider Options First Ask for a Valuator Ask to Elevate in Management as a Neutral Party Given Ownership of the Issue by the Revenue Agent or an Estate Tax Attorney Michael Gregory Consulting, LLC

51 Michael Gregory Consulting, LLC

52 Part 1 Overview of S Corps Key Court Cases Key Models Recommendations to Help with IRS Issues on Topic Part 2 IRS Job Aid on Valuing Non-Controlling Interests on S Corps on the right side Comments for Your Consideration Tying into Part 1 to Clarify and Assist the Business Valuer on the left side Michael Gregory Consulting, LLC

54 Part 1 Overview of Reasonable Compensation Key Factors and Sources of Information The Three Approaches Key Issues Recommendations Part 2 IRS Job Aid on Reasonable Compensation with Commentary IRS Job Aid on Valuing Non-Controlling Interests on S Corps on the right side Comments for Your Consideration Tying into Part 1 to Clarify and to Assist the Business Valuer on the left side Michael Gregory Consulting, LLC

56 1. How My Experiences at the IRS and as a Consultant Can Help You 2. Understand the IRS Official Organization and the Unofficial Rules of Engagement 3. Use the IRS Official Organization to Your Advantage 4. Classification in General and Estate and Gift in Particular 5. Working with Technical Specialists 6. Discover the Issue Resolution and Mediation Process at the IRS 7. Using the IRS Evaluation Process to Your Advantage 8. How to Work with Expert Witnesses 9. Applying Strategic Thinking to Your Firm 10. Follow These Golden Rules When Working with the IRS Michael Gregory Consulting, LLC

58 1. Overview of Chapter Contents 2. Classification in General, and in Estate and Gift Tax in Particular 3. Writing a Business Valuation Report for IRS Tax Purposes 4. Potential Penalties on Appraisers 5. Considerations in Valuing Interests in Subchapter S Corporations 6. How to Address Reasonable Compensation in Corporations 7. Code Section 409A and Valuators 8. Discount for Lack of Marketability and How to Approach the Issue 9. Most Common Errors in Valuations and How to Avoid Them 10. Potential Growth Areas for Business Valuation Appraisers 11. How to Work with the IRS to Resolve Differences in Valuation 12. Key Take-Away Items for Business Valuation Appraisers Michael Gregory Consulting, LLC

60 From Chapter five in Business Appraisals and the IRS Pulled this Chapter from the Book Given Customer Feedback Covers the Material in this Presentation with two Example Comparisons 63 Pages in Length Michael Gregory Consulting, LLC

62 Uses the Discount for Lack of Marketability Job Aid for IRS Valuation Professionals Published August 2011 Supplemented with Commentary from Modelers Critiqued in the Original Job Aid Michael Gregory s Commentary Based on IRS and Private Sector Reviews of Scores of Reports for Expert Witnesses Specific Recommendations Michael Gregory Consulting, LLC

64 Download for free at This Book Has Gone Viral On reddit 7,500 up votes, 3,500 comments and a million reads Commentary from Current and Former IRS Employees at All Levels Testimony Before Congress IRS Statistics Bottom Line, the IRS is in Serious Trouble Michael Gregory Consulting, LLC

66 Based on 11 Years Teaching Managers Feedback from 30 of the Glassdoor s 50 Best Places to Work in America Best Practices with Interactive Commentaries Organized into 16 Chapters Value Added Service to Increase Productivity, Enhance Customer Satisfaction, Improve Employee Satisfaction Michael Gregory Consulting, LLC

68 The Art of Communication The Art of Conversation The Art of Listening The Art of Discussion The Art of Negotiation The Art of Mediation The Art of Compromise Virtual Approaches Keys Listening Understanding: Facts, Issues, Emotions, Interests Love Thy Neighbor Show Respect Michael Gregory Consulting, LLC

69 Michael Gregory Consulting, LLC Sharondale Ave. Roseville, MN Contact me with any questions or concerns Michael Gregory Consulting, LLC