Tax Issues and Valuation

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1 Tax Issues and Valuation Roger Grabowski, FASA Duff & Phelps LLC Daniel R. Van Vleet, ASA Stout Risius Ross, Inc. October 20, 2015

2 Overview Fundamental Principles Market Studies of Pass Through Entities Tax Transaction Structuring Tax Rate by Entity Type Entity Taxation and Solvency Built In Capital Gains Taxes 2

3 FUNDAMENTAL PRINCIPLES

4 Fundamental Investment Return Equation k 1 = Equity investment rate of return during period 1 S 1 = Stock price at end of period 1 S 0 = Stock price at beginning of period 1 d 1 = Dividends paid during period 1 EBT x (1 T) = Net Income (Ni) Ni x D P = Dividends (d 1 ) Ni x (1 D P ) = Capital Appreciation (S 1 S 0 ) 4

5 Net Shareholder Investment Return 5

6 Efficient Market Hypothesis Fundamental Principles Equity security pricing reflects known and knowable information Both corporate and shareholder taxes affect equity security pricing and investment rates of return Substantial academic research supports this finding Academic studies fail to estimate impact with precision Relationship between statutory tax rates and effective tax rates is not known with precision Substantial noise in the historical data 6

7 Fundamental Principles Evidence that tax advantaged institutional investors reduce impact of shareholder taxes on equity pricing Magnitude and relationship to statutory tax rates is uncertain Corporate dividend policy will change as tax rates on capital gains and dividends differs Inconsistent use of effective and statutory tax rates may distort values Actual effective tax rates on PTE shareholders will likely never be known due to privacy issues 7

8 Fundamental Principles Questionable deferred capital gains tax analysis Stock Price Period 0 $ 1,000 Stock Price Period 10% Growth $ 1,100 Capital Gain $ 100 Capital Gain Tax Rate 25.0% Capital Gain Taxes $ 25 Present Value Discount Factor Present Value of Capital Gains Taxes $ 20 Effective Capital Gains Tax Rate 20.0% Capital Gains Tax Savings $ 5 8

9 Fundamental Principles Equity security pricing reflects capital gains taxes Effective tax rate is not known with certainty Discretionary aspect of capital gains tax is both a benefit and a detriment Benefit requires a holding period and is subject to equity risk Capital gain tax liability is not subject to realization risk Put option analysis Cost of a put option to quantify holding period cost would generally exceed the capital gains tax benefit 9

10 Summary Corporate and shareholder taxes affect equity pricing Difficult to estimate impact with precision When tax affecting C corps or using S corp models, use best available and most supportable evidence Academic evidence is generally weak Cash effective tax rates of public comps and market based evidence on shareholder taxes may be helpful Consideration of statutory tax rates may be useful Consider pool of likely willing (hypothetical) buyers/sellers for the subject interest Benefit of deferred capital gains taxes is questionable Ignores holding period risk Taxation is not subject to equity risk 10

11 MARKET STUDIES OF PASS- THROUGH ENTITIES 11

12 Market Studies of Pass-Through Entities Publicly Traded PTEs REITs Conversion to REITs Master Limited Partnerships Yields on Taxable and Tax Free Bonds Studies of C vs S Acquisitions Erickson/Wang Effect of Organizational Form on Acquisition Price 12

13 Market Studies of Pass-Through Entities Canada income trusts before change in Canadian tax law Hybrid structures did not pay corp-level income taxes Distributed taxable income to unit holders, which was fully taxed as ordinary income Corporate level tax avoided only if income was distributed each year Distributions in excess of taxable income were treated as tax-free return of capital Diverse operating companies organized or converted to income trusts 13

14 Market Studies of Pass-Through Entities Klassen and Mescall found earnings for Canadian income trusts were valued higher than matched businesses operating as corporations Consistent with marginal investors in income trusts being low-tax-rate investors. Income trusts were valued about 18.75% greater per dollar of pretax income than the otherwise identical corporations. See: Kenneth J. Klassen and Devan Mescall, Valuation of Income Trusts: An Exploration of Clienteles and Implicit Taxes, Working paper, April

15 Market Studies of Pass-Through Entities In 2006, tax treatment of Canadian income trusts was changed to tax trusts at regular corporate tax rates Public unit prices on most trusts declined 25% to 35%, due primarily to proposed tax law change. Trust returns represent returns to owners of the trusts, assuming continued operation of business as organized. See Richard M. Wise, Valuation of Taxed Trust Units: Real-World Considerations, Adapting to Income Trusts Taxation, The Canadian Institute, Calgary, May

16 Market Studies of Pass-Through Entities Companies traditionally organized as C corps have elected to convert to REITs Mitigate double taxation or enhance shareholder returns REITs technically not PTEs but negate double taxation American Tower Cellular towers Weyerhaeuser Reduced entity level income tax cost by converting 16

17 Transaction Evidence Are the prices paid in acquisitions of PTEs than for the otherwise identical C corps Why should there be a difference in value Erickson and Wang reported on multiples paid for matched pairs of (comparable) S and C corporations Median acquisition multiple paid for S corporations exceeded that paid for C corporations by 31% Erickson/Wang, The Effect of Organizational Form on Acquisition Price, Working paper, May 16,

18 Transaction Evidence Some studies indicate no difference, except for larger corps DiGabriele found S corp premium in certain circumstances Premium was larger in asset sales rather than stock sales C corps can create synthetic S with excess compensation Added compensation subject to employment taxes and IRS scrutiny Sellers of C corps can mirror proceeds they would receive as if they were selling assets of S corp Payments under employment agreements and noncompetition agreements that are tax deductible to the buyer 18

19 TAX TRANSACTION STRUCTURING 19

20 Stock purchase Tax Transaction Structuring Stock is acquired by buyer and seller recognizes gain based on purchase price and tax basis No step up in asset values Asset purchase Assets are acquired and subject company is liquidated C corp gain on sale is recognized at corporate level and proceeds are subject to dividend taxes at shareholder level Potential recognition of depreciation tax recapture 338(h)(10) S corp stock deal treated like asset sale and seller recognizes gain like stock deal Assets stepped up to FMV Potential recognition of depreciation tax recapture 20

21 (A) (B) (C) (D) (E) Tax Stock FMV Asset Asset C Corporation Basis Purchase Adjustment Purchase Purchase (1) Current Assets $ 400,000 $ 400,000 $ - $ 400,000 $ 400,000 (2) Land 300, , , , ,000 (3) Depreciable Assets 300, , , , ,000 (4) Intangibles , ,000 1,523,529 (5) Total Assets 1,000,000 1,000,000 1,000,000 2,000,000 2,823,529 (6) Liabilities 500, , , ,000 (7) Equity $ 500,000 $ 1,500,000 $ 1,000,000 $ 1,500,000 $ 2,323,529 (8) Corporate Gain on Sale of Assets NM 1,000,000 1,823,529 (9) Corporate Taxes on 40% NM 400, ,412 (10) Shareholder Taxes on 15% NM 90, ,118 (11) Capital Gain on Sale of Stock 1,000,000 NM NM (12) Personal Capital Gains 15% 150,000 NM NM (13) Depreciation Recapture NM 200, ,000 (14) Depreciation Recapture 40% NM 80,000 80,000 (15) Net Proceeds to Seller 1,350, ,000 1,350,000 (16) Buyers Gross Equity Cost 1,500,000 1,500,000 2,323,529 (17) Less Step Up Tax Benefit [a] - 182, ,581 (18) Buyers Adjusted Equity Cost $ 1,500,000 $ 1,317,454 $ 1,973,948 [a] Based on 15 year amortization period, corporate tax rate of 40%, and discount rate of 10%. 21

22 (A) (B) (C) (D) (E) Tax Stock FMV Asset S Corporation Basis Purchase Adjustment Purchase 338(h)(10) (1) Current Assets $ 400,000 $ 400,000 $ - $ 400,000 $ 400,000 (2) Land 300, , , , ,000 (3) Depreciable Assets 300, , , , ,000 (4) Intangibles , , ,992 (5) Total Assets 1,000,000 1,000,000 1,000,000 2,000,000 2,228,992 (6) Liabilities 500, , , ,000 (7) Equity $ 500,000 $ 1,500,000 $ 1,000,000 $ 1,500,000 $ 1,728,992 (8) Corporate Gain on Sale of Assets NM 1,000,000 NM (9) Shareholder Taxes on 40% NM 400,000 NM (10) Shareholder Taxes on 15% NM - NM (11) Capital Gain on Sale of Stock 1,000,000 NM 1,228,992 (12) Personal Capital Gains 15% 150,000 NM 184,349 (13) Depreciation Recapture NM 200, ,000 (14) Depreciation Recapture 40% NM 80,000 80,000 (15) Net Proceeds to Seller 1,350,000 1,020,000 1,464,643 (16) Buyers Gross Cost 1,500,000 1,500,000 1,728,992 (17) Less Step Up Tax Benefit [a] - 182, ,992 (18) Buyers Adjusted Cost $ 1,500,000 $ 1,317,454 $ 1,500,000 [a] Based on 15 year amortization period, corporate tax rate of 40%, and discount rate of 10%. 22

23 Summary All shareholders must agree to the 338(h)(10) election S corp shareholders not always better off making election Every transaction must be analyzed on its particular facts using analysis of previous slide Election tends to be less advantageous when tax bases of assets are high and bases of stock is low Buyer may insist on an asset deal due to liability issues 23

24 TAX RATE BY ENTITY TYPE 24

25 Tax Rate by Entity Type Business in the U.S.: Who Owns it and How Much Tax They Pay Authored by 8 economists from U.S. Treasury and NBER faculty.booth.edu (September 20, 2015) Use of administrative tax data from 2011 to identify pass-through owners and estimate tax payments Average federal income tax rate on pass-through business income is 19% and C corp income is 31.6% 25

26 Tax Rate by Entity Type 26

27 Tax Rate by Entity Type Study uses 2011 filings and tax rules Misses the sharp rate hike in 2013 Use of more recent data would raise resulting effective rates Study finds S corps pay highest tax on income 25% vs. 22% for C corps prior to factoring shareholder taxes Study assumes shareholder-level taxes add another 9% to C corp average rate Assumption based on economic literature from 2004 rather than tax collections from Study makes heroic assumptions about composition of corporate distributions. 27

28 Tax Rate by Entity Type For partnerships, study fails to differentiate between active business income and investment income 70% of partnerships are finance and holding companies investing in C corps Income is already taxed at entity level Tax rate expected to be lower than top statutory rate Should partnership income be included in C corp bucket? Study attributes 20% of partnership income to unidentified TIN and EIN Assumes unidentified income was taxed at a blend of two lowest applicable rates resulting in lower average rate for partnerships Study needs more work 28

29 ENTITY TAXATION AND SOLVENCY 29

30 Entity Taxation and Solvency Federal definition of insolvency: Insolvent defined as a financial condition such that the sum of [the] entity s debts is greater than all of [the] entity s property, at a fair valuation Fair valuation is not defined in the bankruptcy code Fair valuation is process sensitive and not result sensitive Initially requires determination of premise going concern or failed concern If going concern, range of values should account for goodwill of business If failed concern, likely nominal or negative goodwill 30

31 Entity Taxation and Solvency How should entity level taxation be handled for the solvency determination of a PTE 7th circuit, no precedent for subtracting entity-level taxes when assessing solvency of a pass-through debtor Entity is not required to make tax distributions to shareholders Balance sheet test Should the DCF method be tax affected in determination of value Meeting obligations as they become due Should fictitious entity level taxes be included in the analysis when making the determination Depending on treatment of entity taxation, the two tests could conclude different indications of solvency 31

32 ENTITY TAXATION DIFFERENCES 32

33 Taxation of S Corporations Most rules governing relationship between S corps and its shareholders differ from a partnership and its partners. S corps are subject to most subchapter C rules, with a few exceptions. S corps do not pay entity income taxes and income and losses pass through to the shareholders Basis adjustment to S corp stock attributable to AAA account for income, losses, and distributions Source: Tax Lawyer, Vol. 67, No. 2 When Subchapter S Meets Subchapter C, by Martin J. McMahon, Jr. & Daniel L. Simmons 33

34 Taxation of Partnerships (Including LLCs) LLCs almost always elect to be taxed as partnerships No limit on number of partners in a partnership. No restrictions on types of entities that may be partners. Partnerships can allocate income, deductions, gains and losses among partners in any manner desired. S corps can t Shareholder s bases in S corp stock or debt is limited to the shareholder s investment plus adjustments by the AAA Partners include their shares of partnership debt in the bases of their partnership interests Partners deduct partnership losses attributable to debt. 34

35 Technically, REITs are not pass-through entities Taxation of REITs Taxed first at entity level and then at shareholder level Permitted to deduct dividends from corporate taxable income Required to distribute at least 90 percent of taxable income Effectively, pay very little, if any, corporate income tax Subject to corp-level tax on what is left over after distributions Some states follow federal rules, whereas other states (e.g., New Hampshire) impose an entity-level tax REITs can still be subject to at least some entity-level income taxation, even if profits are fully distributed 35

36 BUILT IN CAPITAL GAINS TAXES 36

37 Valuation Considerations C Corporations Asset holding company Nonoperating assets of an operating company Seasoned S Corporations Generally not appropriate May consider depreciation recapture tax obligation Recognition Period S Corporation Magnitude of built-in capital gains tax Holding period risk Remaining term of recognition period 37

38 Holding Periods for C to S Corp Conversions 2010 Small Business Jobs Act shortened C to S conversion holding periods on unrealized built-in gain to five years beginning in 2011 Prior holding period was 10 years for sales or exchanges beginning before 2009, and 7 years for tax years beginning in 2009 or American Taxpayer Relief Act extended holding period reduction to 5 years for recognized built-in gain in 2012 and legislation retained the five year period for 2014 Legislation introduced to make the five year period effective for 2015 and later years but that legislation has not been enacted to date 38

39 BIG Tax Assessment Fair Market Value of Assets $ 100,000 Tax Basis of Assets (40,000) Built-in Gain at S Corporation Conversion 60,000 Corporate Tax Rate on Gain (%) 40.0 S Corporation Taxes on Gain 24,000 S Corporation Recognition of Gain 60,000 Less: S Corporation Taxes Paid on Gain (24,000) Taxable Gain to Shareholders 36,000 Shareholder Ordinary Income Tax Rate (%) 40.0 S Corporation Shareholder Taxes on Gain 14,400 Fair Market Value of Assets 100,000 Taxes Paid by S Corporation (24,000) Taxes Paid by S Corporation Shareholders (14,400) S Corporation Shareholder Net Proceeds $ 61,600 39

40 S Corps Recognition Period Total Built-in Holding Value of Capital Period Total Maximum Total Gains Risk BIG BIG Assets Tax Discount Discount Discount Present Value 10 Years Remaining 100,000 38, % 38.40% 38.40% Present Value 9 Years Remaining 100,000 38, % 38.40% 38.40% Present Value 8 Years Remaining 100,000 38, % 38.40% 38.40% Present Value 7 Years Remaining 100,000 38, % 38.40% 38.40% Present Value 6 Years Remaining 100,000 38, % 38.40% 38.40% Present Value 5 Years Remaining 100,000 38, % 38.40% 37.91% Present Value 4 Years Remaining 100,000 38, % 38.40% 31.70% Present Value 3 Years Remaining 100,000 38, % 38.40% 24.87% Present Value 2 Years Remaining 100,000 38, % 38.40% 17.36% Present Value 1 Year Remaining 100,000 38, % 38.40% 9.09% Present Value at Expiration 100,000 38, % 38.40% 0.00% 40

41 Equity Valuation Discount S Corps BIG Tax Discount 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% Remaining Time in Recognition Period Holding Period Risk BIG Tax Discount 41

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