The Latest on S-Corps: Practical Lessons from Research and the Trenches. (and as we ll see, leave aside)

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1 Pass-through Entity Valuation Update Nancy Fannon, CPA, ASA, MCBA, ABV Meyers, Harrison & Pia Keith Sellers, CPA, CVA, ABV Daniels College of Business University of Denver Let s set aside (and as we ll see, leave aside) Control versus minority issues Whether or not distributions are made for taxes Percent of profits that are distributed WACC versus equity returns Applicability to methods other than income approach 2

2 Valuing pass-through entities (Prompted by the tax courts and the IRS ) Valuation analysts assume an S corp. is worth more than a C corp. As such, we add a premium to our valuation. 3 This raises some basic questions: On what evidentiary basis do we draw the conclusion that an S corp. is worth more? More compared to What? More based on what valuation method? 4

3 Basic issue that gives rise to premium Investors in public market pay dividend and capital gains tax Public market pricing is negatively affected by the fact that investors have to pay dividend and capital gains tax And if pricing is negatively affected, that means that the market return is higher because of it. Tax Penalty Pass-through entity investors avoid such taxes, therefore, the value of a pass-through entity should not be similarly penalized. 5 As Ayers et al. assert: The effect of shareholder-level taxes on stock prices is a fundamental issue for both tax policy and stock valuation. Shareholder-level taxes may affect share prices because these taxes are imposed on distributions of earnings (dividend taxes) and on the sale of shares through trades, share repurchases, and liquidating distributions (capital gains taxes), thus reducing the after-tax cash flows to investors. 6

4 Do shareholder taxes affect value? YES. Backed by a very substantive body of academic research. But wait: the Gross case said we should ignore shareholder taxes And made NO deduction for INCOME taxes (because they pass-through to the shareholder, and are therefore shareholder taxes ) Resulting in as much as a premium over the otherwise calculated value of 67% 7 IRS/Tax court model Passthrough C Corp. Pre tax income $ 1,000 $ 1,000 Income tax $ (400) Post tax income $ 600 $ 1,000 Capitalization rate 20.0% 20.0% Value $ 3,000 $ 5,000 Premium 67% 8

5 As a complete aside.. In fact, S corporations pay the highest income tax burden so if anything, income tax burden is a detriment to the pass-through entity. 9 Our (valuation community) reaction to tax court and IRS position? We created models that recognized income tax deduction (because, we said, they ARE paid, no matter who pays them) Then took into account the benefit of avoided shareholder taxes. 10

6 Valuation Community model Passthrough C Corp. Pre tax income $ 1,000 $ 1,000 Income tax $ (400) Post tax income $ 600 $ 1,000 Dividend tax $ (120) Pass through of income tax $ (400) Post shareholder tax income $ 480 $ 600 Capitalization rate 20.0% 20.0% Value $ 2,400 $ 3,000 Premium 25% Who is the C corp. in this example? 11 Otherwise identical investments Current models assume otherwise identical entities The models alternately follow: tax-exempt bond model, or capitalization of benefit model Is a public company otherwise identical to a pass-through entity? Legal Regulatory Access to capital Enterprise taxation Etc. etc. etc... What about variations from one private entity type to another? 12

7 PTE models Notwithstanding this, the PTE models assume an otherwise identical C and S corp (PUBLIC C corp.). Analysts are always tempted to fall back to comparing the S corp. to a private C corporation you do not value the S corp. by reference to a private C corp. in the income approach, so avoid this trap (even though the PTE models themselves fall into it at times). 13 How do they compare? IRS/Tax Court Valuation Models C Corp. Passthrough C Corp. Passthrough Pre tax income $ 1,000 $ 1,000 Pre tax income $ 1,000 $ 1,000 Income tax $ (400) Income tax $ (400) Post tax income $ 600 $ 1,000 Post tax income $ 600 $ 1,000 Dividend tax $ (120) Pass through of income tax $ (400) Post shareholder tax income $ 480 $ 600 Capitalization rate 20.0% 20.0% Capitalization rate 20.0% 20.0% Value $ 3,000 $ 5,000 Value $ 2,400 $ 3,000 Premium 67% Premium 25% 14

8 BTW, this is essentially the same thing as Taxable vs. Tax-Exempt Bonds 15 We just assume a constant yield. Substitute the word taxable with C corp, and non-taxable with S corp, and this is Van Vleet s model. 16

9 ANY% Payout Which is the same as Public Private Van Vleet s method C Corp S Corp Income before corporate income taxes 100, ,000 Corporate income taxes 40% (40,000) - Net income 60, ,000 Dividends Dividends paid to S corporation dividend payout rate Federal rate = individual rate, cap. gains rate 20%, dividend rate 20% 75% - 75,000 Income tax due by S corporation shareholders 40% - (40,000) Net cash flow benefit to S corporation shareholders - 35,000 Dividends paid to C corporation dividend payout rate 75% 45,000 - Dividend tax due by C corporation shareholders 20% (9,000) - Net cash flow benefit to C corporation shareholders 36,000 - Capital Appreciation Net income 60, ,000 Dividends paid to shareholders 75% (45,000) (75,000) Retained earnings (i.e., net capital appreciation) 15,000 25,000 Effect of retained earnings on the income tax basis of the shares - Net taxable capital appreciation 15,000 Capital gains tax liability 20% (3,000) Net capital appreciation benefit to shareholders 12,000 25,000 Net economic benefit to shareholders Net cash flow benefit to shareholders 36,000 35,000 Net capital appreciation benefit to shareholders 12,000 25,000 Total net economic benefit to shareholders 48,000 60,000 ROR 20% NEBc NEBs C corp value ($60,000./. 20%) $ 300, Times NEBs over NEBc 1.25 S corp value $ 375, Which is the same as the Delaware Chancery Method C Corp S Corp S Corp Valuation "Premium" Income before tax $ $ $ Corporate income tax rate 40% 0% 25.00% Available Earnings $ $ $ % Dividend or Personal Income tax rate 20% 40% 20% Available After Dividend $ $ $ % "Premium" 25.00% 18

10 Which is basically the same as the Grabowski model 19 We make these adjustments because: 1. We recognize that public market investors pay dividend and capital gains taxes, and investors in pass-through entities avoid these taxes. We recognize the fact that investors pay such taxes has an effect on value. 20

11 Therefore, the following assumptions MUST be true (to use these methods) 1. All investors in the public market fully bear dividend and capital gains tax 2. The fact that they pay such taxes directly correlates with value. Neither of these assumptions are true. 21 To the extent that shareholder-level taxes impact the stock prices of publicly traded companies, they are also impounded in the cost of capital estimates derived from public company returns. 22

12 These underlying assumptions need to be examined: 1. To what extent do investors in the public market pay dividend and capital gains taxes, and 2. To what extent does the fact of their paying such taxes actually affect value And therefore the market return we use 23 What are we really doing here? We re removing the effect of the tax penalty from the public market return. But we only need to do this to the extent that it actually exists! Otherwise, we re over-stating the magnitude. This is a market return issue. 24

13 This should be familiar: we already adjust the market return for issues that don t match the private company we re valuing: Size Liquidity SCRP 25 Compare the hypothesis that leads to the conclusion that a small company is worth less than a public C corporation: We use public market returns to value small companies Small companies earn high returns Large companies earn lower returns So there must be a detriment to owning a smaller company 26

14 Let s put these side-by-side: Small company detriment compared to public return 1. We use public market returns to value small companies 2. Small companies earn high returns 3. Large companies earn lower returns 4. So there must be a relative detriment to owning a smaller company PTE benefit compared to public return 1. We use public market returns to value PTEs 2. Public market investors pay dividend and capital gains tax 3. PTE investors don t 4. So there must be a relative benefit to owning a PTE 27 How do you know how much tax penalty is in the market return? Let s start with a primer on market returns. 28

15 Public market returns. Public market returns are a changing mix of: Investors Dividend returns (income returns) v. Capital gains (change in value of market) Tax rates Holding periods All of which change over time (and may vary between different companies during the same time period.) Because we use historical returns, the returns we use are an amalgam of all these factors and behaviors 29 Ex-post total return Arithmetic average of income returns + Arithmetic average of capital gain returns (changes in the value of the stock market) + reinvestment return =Total return -Arithmetic average of income portion of long-term government bond returns =Equity risk premium +Current long term government bond return =Total return 30

16 Arithmetic Average + change in value of stockmarket -Income portion of LT govt bond returns + current LT govt bond return = Total return (large cap stock) +Reinvestmen = Total S&P 500 Dividends t Return Return =ERP % 5.7% 0.5% 3.7% x% x% x% x% x% x% x% x% % 0.0% 0.2% 3.8% Average, % 7.4% 0.2% 11.7% 5.2% 6.6% 2.5% 9.0% Supply-side removes the effect of P/E 31 Arithmetic Average + change in value of stockmarket -Income portion of LT govt bond returns + current LT govt bond return = Total return (large cap stock) +Reinvestmen = Total S&P 500 Dividends t Return Return =ERP % 18.9% 0.3% 3.9% x% x% x% x% x% x% x% x% % 0.0% 0.2% 3.8% Average, % 7.7% 0.2% 11.1% 6.8% 4.3% 2.5% 6.8% 32

17 Arithmetic Average + change in value of stockmarket -Income portion of LT govt bond returns + current LT govt bond return = Total return (large cap stock) +Reinvestmen = Total S&P 500 Dividends t Return Return =ERP Average, % 7.4% 0.2% 11.7% 5.2% 6.6% 2.5% 9.0% Average, % 7.7% 0.2% 11.1% 6.8% 4.3% 2.5% 6.8% The S corp models assume that a shareholder tax penalty is baked into market returns i.e., that investors penalize the prices of stocks in the public market because they have to pay dividend and capital gains tax. This penalty causes stock prices to be lower than they would otherwise be which increases market returns. 33 Remember we said: Public market returns are a changing mix of: Dividend returns (income returns) v. Capital gains (change in value of market) Tax rates Holding periods Investors All of which change over time The returns we use are an amalgam of all these behaviors. 34

18 Income Returns 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Market Value $14,000,000 $12,000,000 $10,000,000 $8,000,000 $6,000,000 $4,000,000 $2,000,000 $

19 Total Return 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% 2.0% % 6.0% Arithmetic Average Income Return Arithmetic Average Cap Gain return 37 Arithmetic Averages Total Market Return 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Total return Total return

20 Arithmetic Averages Long term government bond income returns 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% LT govt. bond LT govt. bond Equity Risk Premium 1926 v to % 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% % ERP ERP

21 Over this time period, much has changed Effective tax rates have dropped dramatically Holding periods have varied greatly over time The make-up of the market has changed significantly 41 Investors (& the effect of clienteles ) 60% % share of market, institutional investment 50% 40% 30% 20% 10% 0% % share of market, institutional investment 42

22 Characteristics of institutional investors (relevant to this discussion) Favor dividend paying stocks May have board representation Look at holding periods Favor large stocks, lesser representation in small cap stocks Some research suggests that the entire market has been driven up by the marginal investor Other research suggests the disappearance of a small stock premium for a period of time that corresponded with the surge in institutional investment However, these studies focused on a narrow time frame Disappearance of small stock premium, using Ibbotson data 2011 Total Return Large Cap Stocks (CAPM) 2011 Total Return Small Cap Stocks (CAPM) % 17.88% 70 year 9.37% 17.56% 60 year 7.99% 13.02% 50 Year 6.23% 12.20% % 12.78% 40 Year 6.51% 11.03% 30 Year 7.80% 10.14% Inst. Investor study 10.97% 10.22% 20 year 6.42% 13.83% 10 year 2.86% 15.01% 44

23 What if the individual tax rate of the individual investor is different? 45 What if tax rate of investor increases? The marginal investor is the price setting investor setting price and yield Nontaxable Tax exempt bonds Taxable Taxable Yield (Return) 6.0% 6.0% 4.8% Face Value (Investment) $ 1,000 $ 1,000 $ 1,000 Income $ 60 $ 60 $ 48 Personal tax rate 15% 20% Personal tax $ (9) $ (12) $ Cash flow to individual $ 51 $ 48 $ 48 Effect of clienteles: net cash to lower taxed individual 6% Tax exempt bonds Taxable Taxable Taxable Nontaxable Yield (Return) 6.0% 6.0% 6.0% 4.8% Face Value (Investment) $ 1,000 $ 1,000 $ 1,000 $ 1,000 Income $ 60 $ 60 $ 60 $ 48 Personal tax rate 15% 20% 25% Personal tax $ (9) $ (12) $ (15) $ Cash flow to individual $ 51 $ 48 $ 45 $ 48 46

24 Clienteles Who makes up institutional investors? Pension funds (non-taxed) Corporations (insurance companies) (tax-favored) Mutual funds (taxed) 47 Let s revisit the hypothesis again. We use public market returns to value PTEs Public market investors pay dividend and capital gains tax PTE investors don t So there must be a benefit to owning a PTE 48

25 How much dividend and capital gain tax do investors pay? A corporate investor only pays tax on a fraction of dividends received, but institutional investors primarily pension funds and endowments that traditionally hold the largest stake in the public markets pay no tax at all. 49 The effect of taxes on market returns... higher levels of dividend taxes versus capital gain taxes increase the implied equity premium and that the magnitude of the dividend tax premium, in general, varies predictably with the magnitude of the dividend tax penalty (and) aggregate institutional ownership mitigates the dividend tax premium. Dan Dhaliwal, Linda Krull, Oliver Zhen Li, and William Moser, December 2005, Dividend Taxes and the Implied Cost of Equity Capital, Journal of Accounting Research, Vol. 43 No. 5 p

26 In the academic literature, this is known as Tax Capitalization Theory The market prices of securities reflect future taxes that must be paid by investors Journal of the American Taxation Association, Winter 2002, The effect of the expected holding period on the market reaction to a decline in the capital gains tax rate. This concept is easily seen in the lower returns paid by taxable versus tax-exempt municipal bonds (which experience pricing based on personal taxes) In fact, it is this model upon which the S corp models are built. And, it has been the subject of extensive academic research 51 How have academic studies tested this? This issue has been extensively studied in the public markets Changes in shareholder dividend and capital gains taxes have been studied to examine value implications Other factors that affect value at the same time as a tax affect are identified Tax affects do not operate in a vacuum 52

27 (1) Shareholder taxes & (2) other factors that affect value Once these factors are known, it is possible to (1) calculate the amount of taxes embedded in market returns, and then, to (2) calculate the effect they had on value. Academic researchers have done this for varying time horizons Different calculations of market returns and time horizons necessarily have different tax affects embedded in them With the most recent studies going on to calculate the relationship of such taxes to value in the marketplace 53 Now let s talk about how much penalty is actually in market returns Because this is the effect we are trying to remove when we value an S corporation. 54

28 Let s start with the tax avoidance that EVERYONE engages in (not just S corp. investors) Shareholders and investors have been avoiding taxes since taxes were invented Regardless of form Public or Private C Private pass-through (S, LLC, partnership, sole proprietorships) Some analysts treatment of S corporations is as if this form of entity and their investors are the only ones successfully avoiding taxes. 55 Tax policy causes the behavior of firm managers to shift How do taxes affect corporate decisions? Corporations want individuals to invest; so what could they do in their payout policy to entice them? react to changes in tax law, changing their payout strategies from dividends to repurchases and back to dividends depending on the tax regime, so as to minimize the tax consequences to their investors. 56

29 Tax minimization & clienteles As early as 1961, Miller and Modigliani argued that firms have an incentive to provide stocks that minimize the taxes of each clientele (i.e., representative investor group). When taxes on dividends are higher than those on capital gains, the optimum policy is not to pay dividends. Dynamic models have demonstrated that when investors can trade over time (and defer capital gains tax), they can further reduce tax liabilities. 57 Tax minimization of public market firms and investors In 1999, the dividend tax rate was the same as the ordinary income tax rate and was high relative to the capital gains tax rate. One study found that when dividend rates are high, companies substitute stock buy-back programs and liquidations (resulting in capital gains tax to investors). High dividend rates greatly discourage the payment of dividends; in fact, payments of dividends in the public markets declined starting in In 2003, however, when the dividend tax rate declined with the passing of the Revenue Reconciliation Act, dividends rose accordingly. Raj Chetty and Emmanual Saez, Dividend Taxes and Corporate Behavior: Evidence from the 2003 Dividend Tax Cut, NBER Working Paper No (September 27, 2004). 58

30 By treating S versus C corps as the equivalent of taxable versus tax-exempt bonds: Our treatment of S corps has assumed none of this goes on. That is, we act as if investors in the public market fully pay dividend and capital gains taxes, and that such investors and public companies engage in NO tax avoidance strategies. This is just not true. 59 What does all this mean about how much dividend and capital gain tax is embedded in market returns? 1. In any setting, investors seek to avoid or minimize investor-level taxes. Public market returns reflect strategies by investors and managers of public companies that minimize the impact of personal taxes. 2. If tax is minimized, then the effect on value is also minimized. 3. If other factors shift when tax policies shift such that taxes are less important to the investor, then the effect on value is further minimized. 60

31 Foundation for S corp. valuation models Adjusting for the benefit of avoided dividend and capital gains taxes that pass-through entity investors theoretically avoid, compared to investors in the public market who (1) theoretically paid those taxes, and (2) the payment of such taxes actually affected value We have likely over-estimated (1) Simply put: public market firms and investors minimize shareholder taxes too We have heretofore not considered (2) nearly to the extent it deserves (or not considered it at all) Correlations of shareholder tax affects to value are relatively low in the academic research, indicating at the very least that other considerations serve to offset the impact of tax affects to some degree. 61 Removal of tax penalty If the tax penalty in the public market return can be calculated (it can), then it can be removed. Then consider any further tax penalty or advantage of a private company, whatever its form of entity. Social security taxes, for example, can be a penalty. What about private C corps what relationship do they have to the public market? Just as we discussed at the beginning, each form of entity has different circumstances, including tax motivations. 62

32 Because this is a cost of capital issue It only affects the income approach (and possibly guideline company, but in a different way; It affects both control and minority valuations. 63 What am I doing? For now: lowering the magnitude of any premium I apply in an S corporation valuation By a direct modification to where it emanates from to begin with the total return. That is, I decrease my build-up of the cost of capital to remove the tax penalty usually so a modest premium results to the value conclusion. This doesn t mean you can t continue to employ S corp. models (which accomplish the same thing as adjusting the cost of capital, they just go about it in a different way) but if you do, consider the mitigating factors against the magnitude of the tax penalty (and hence, any premium you ascribe to a pass-through entity.) 64

33 For example, if you use the Delaware Chancery Method C Corp S Corp S Corp Valuation "Premium" Income before tax $ $ $ Corporate income tax rate 40% 0% 33.33% Available Earnings $ $ $ % Dividend or Personal Income tax rate 10% 40% 10% Available After Dividend $ $ $ % "Premium" 11.11% 65