# The Economic Impact of Taxes on S Corporation Values By C. Donald Wiggins, D.B.A., ASA S. Mark Hand, CPA Laura L. Coogan

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3 The calculation of the tax burden for the example company is shown in Table 3. Reinvesting \$35 in the company in the form of retained earnings will, of course, require that more than \$35 of pretax income be earned to net the required amount after tax. Assuming that equityholders have an average personal tax rate of 30%, the amount of pre-tax income can be calculated by dividing the required reinvestment by (1-personal tax rate of equityholders). 4 In this case, it would be: The tax burden on \$50 would be: \$35/(1-0.30) = \$50 \$50 X 0.30 = \$15 The tax burden assigned to the company to develop its economic income statement and to determine its cash flows for valuation purposes would be \$15, regardless of how much income it earns. The restated economic income statement is shown in Table 4. Maximum Implies Internal Growth There is also an implied maximum growth level in any one year that can be funded internally without equityholders having to pay taxes out of their own personal funds. This maximum is the total net income of the S corp reduced for the total taxes that equityholders will have to pay on the income. In the above example, this maximum would be: \$70 X (1-0.30) = \$49 At this level of growth, the company would be able to pass \$21 through to owners to pay personal taxes on the \$70 of total corporate net income. Any growth in assets net of debt increases and issue of common stock greater that \$49 (i.e., funded internally) would require equityholders to pay at least part of the tax burden from the S corp s earnings out of their own pockets. The S corp would not have sufficient cash to pass through to its equityholders to cover their personal taxes from the S corp s earnings. The Effect on Value The resulting effects on value of the three methods of treating taxes are shown in Table 5. Free cash flow to equityholders is calculated for the projected year using (1) a full C corp tax burden, (2) no corporate taxes, and (3) the economic tax burden described above. The resulting free cash flows to equityholders are \$7, \$35, and \$20, respectively. Using a 20% capitalization rate, the resulting values for the equity ownership in the three cases are \$35, \$175, and \$ If the extreme conditions of either a full tax burden or no taxes are used to value the tax advantage of the S corp, the difference is \$175 less \$35, or \$140. However, this large difference is overstated because the tax advantage of the S is recognized, but no provision is made for the personal taxes that owners will have to pay to fund internal growth as shown above. The true value of the tax advantage of the S corp over the C corp in this example is \$100 less \$35, or \$65, and this result has an intuitive appeal. S corps were specifically created to have a tax advantage. Depending on the situation, a specific s corp may be valued as if it is going to be an S or a C in the future. If the company is being valued as an S corp and all other factors are the same, this advantage should result in greater value.

4 However, owners generally recognize (and often complain) that they do not receive and are not free to use all of the income from S corps on which they are taxed. This condition has a negative impact on value. The methodology described above addresses and appropriately accounts for both of these effects in the valuation process. The Effect on Value There has long been a debate in the appraisal profession over the treatment of taxes in S corporations and C corporations, primarily centering around whether to include a full income tax burden on the company being appraised or to include no taxes at all. The real answer is that neither of these choices is usually correct and the appropriate tax burden lies somewhere between the extremes. The true economic tax burden of the S corporation is the tax that must be paid by owners personally that will net sufficient internally generated cash flow to support growth not financed by other means. Using this tax burden in projecting cash flows yields a more economically sound and rational value that realistically reflects the true economic tax advantage of the S corporation.

6 Table 1 S vs. C Tax Example Projected- Year 1 C Corporation S Corporation Revenue \$ Revenue \$ Expenses: Expenses: Cash Expenses \$ Cash Expenses \$ Depreciation Depreciation Taxable Income \$70.00 Taxable Income \$70.00 Taxes (40%) Taxes (0%) 0.00 Net Income \$42.00 Net Income \$70.00 Personal Taxes of Equityholders: Dividends \$7.00* Income \$70.00 Personal Taxes on Income to Shareholders (30%) 2.10 Personal Taxes (30%) Total Taxes Paid: Corporate \$28.00 Corporate \$0.00 Personal 2.10 Personal Total \$30.10 Total \$21.00 Corporate Tax Rate 40% Corporate Tax Rate 0% Individual Tax Rate 30% Individual Tax Rate 30% *\$7.00 is the actual dividend payment the c corp stockholders receive. See Table 5 below.

7 Table 2 Current and Projected Balance Sheets Current Year Projected Growth Projected Year 1 Cash \$20.00 \$10.00 \$30.00 Accounts Receivable Inventory Total Current Assets \$ \$ Fixed Assets: Property & Equipment \$ \$35.00 \$ Less: Accumulated Depreciation (20.00) (10.00) (30.00) Net Fixed Assets \$80.00 \$ Total Assets \$ \$70.00 \$ Current Debt \$50.00 \$15.00 \$65.00 Long Term Debt Total Debt \$ \$ Common Stock \$ \$0.00 \$ Retained Earnings Total Equity Total Debt & Equity \$ \$70.00 \$ Table 3 Economic Tax Calculation Net Income Necessary to Fund Increased Retained Earnings \$50.00 Taxes on Income Net Income Added to Retained Earnings \$35.00

8 Table 4 S Corporation Income Restated with Economic Taxes Revenue \$ Expenses: Cash Expenses \$ Depreciation Taxable Income \$70.00 Economic Taxes Net Income \$55.00 Table 5 Value Comparisons for Different Tax Burdens (1) C Corp with Full Taxes (2) S Corp with No Taxes (3) S Corp with Economic Taxes Net Income \$42.00 \$70.00 \$ Depreciation Total \$52.00 \$80.00 \$65.00 Change in Current Assets (45.00) (45.00) (45.00) Change in Current Debt Operating Cash Flow \$22.00 \$50.00 \$35.00 Change in Fixed Assets (35.00) (35.00) (35.00) Change in Long Term Debt \$20.00 Cash Flow to Equity \$7.00 \$35.00 \$20.00 Value with 20% Capitalization Rate \$35.00 \$ \$100.00

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