How the IRS Values S Corps with Commentary June 16, 2015 MICHAEL GREGORY MICHAEL GREGORY CONSULTING LLC Presenter 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 Aid on S-Corps ASA, CVA, MBA, and Mediator MN Supreme Court 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 2 1
Michael Gregory Consulting LLC Mediation and Negotiation Business Valuation Review Developing Leaders www.mikegreg.com mg@mikegreg.com 651-633-5311 managingresolutions.org Seven Books and Seven Videos on IRS Related Issues at www.mikegreg.com 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 3 Disclaimer 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. 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 4 2
Introduction to Today s Presentation 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 Court Cases Summarized Consider Valuation Approaches Personal Observations 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 5 IRS Job Aid on Non-Controlling Interests in S-Corps 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 Note Authors and Implications 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. 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 6 3
IRS Job Aid on Non-Controlling Interests in S-Corps Introduction Gross v. Commissioner T.C. Memo 1999-254, aff d 272 F. 3d 333 (6 th Cir. 2001cert denied, 537 U.S. 827 (2002) Large Business and International (LB&I) Engineering Program Revenue Ruling 59-60 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 7 IRS Job Aid on Non-Controlling Interests in S-Corps Identification of Property to be Value Check the Box Familiarize Yourself with State and Local Laws Determine Facts 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 8 4
IRS Job Aid on Non-Controlling Interests in S-Corps Background and Approach Revenue Ruling 59-60 (Read Background and Definitions and Eight Factors Again) Nature of the Business Economic Outlook and Industry Earnings Capacity Dividend Paying Capacity Intangibles Sales of Stock and Size of Block Market Price of Guideline Companies 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 9 IRS Job Aid on Non-Controlling Interests in S-Corps Additional Factors for Consideration Public Market Data - C Corps (Ibbotson Associates Morningstar) Unclear S or C Comingling Investor Level Taxes There is a Mismatch This is a Fundamental Error 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 10 5
IRS Job Aid on Non-Controlling Interests in S-Corps Additional Factors for Consideration Shareholder s Agreement Appropriate Tax Rates Effective Average Rate is Between Zero and Maximum Statutory Tax Rate Universe of Hypothetical Buyers See Shareholder s Agreement Consider the Universe Hypothetical Seller Hypothetical Sale 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 11 IRS Job Aid on Non-Controlling Interests in S-Corps Additional Factors for Consideration Identify the Most Important Factors Ability to Otain Equity Ability to Obtain Debt Additional Investor Taxes 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 12 6
IRS Job Aid on Non-Controlling Interests in S- Corps: Executive Summary Joint Effort LB&I and SBSE Revenue Ruling 59-60 IRC 1362(a) Small Business Elect S Corp IRC 1371(a) Rules Domestic Entity 100 or Fewer Interest Holders (Resident Individuals, Estates, Certain Trusts, Certain Pension Plans and Charities) One Class of Stock (Voting and Non-Voting) Reflect Risks 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 13 IRS Job Aid on Valuing Non- Controlling Interests in S Corps Background on S-Corps Gross Case Revenue Ruling 59-60 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 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 14 7
IRS Job Aid on Valuing Non- Controlling Interests in S Corps The Hypothetical Seller Hypothetical Sale Identify the Most Important Factors Evidence-Based Valuation Analysis A View from the Tax Court 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 15 IRS Job Aid on Valuing Non- Controlling Interests in S Corps Appendix B: Gross T.C. Memo 1999-254, aff d. 272 F.3d 333 (6 th Circuit) 2001, cert denied 537 US 827 (2002) (Corp) Wall TC Memo 2001-75 (Corp) Heck T.C. Memo 2002-34 (Corp) Adams T.C. Memo 2002-80 (Corp) Dallas T.C. Memo 2006-212 (Corp) Guistina TC Memo 2011-141 (Limited Partnership) Gallagher TC Memo 2011-148 (LLC) 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 16 8
IRS Job Aid on Valuing Non- Controlling Interests in S Corps A View from Academia Merle M. Erickson and Shing-wu Wang, Tax Benefits as a Source of Merger Premiums in Acquisitions of Private Corporations, The Accounting Review, Vol. 82, No. 2, pp 359-387 (2007) Premiums for Control 338 (h)10 Acquisitions Appendix C More Detail 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 17 IRS Job Aid on Valuing Non- Controlling Interests in S Corps Theory Based Valuations Not Tested 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 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 18 9
IRS Job Aid on Valuing Non- Controlling Interests in S Corps 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 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 19 IRS Job Aid on Valuing Non- Controlling Interests in S Corps Example 1 Six Broad Questions: 1. Are Electing S Corps Common in Business and Industry? 2. How Has the Business Changed and What is Expected in the Future? 3. What is the Economic Outlook? 4. What is the Market Like for Potential Buyers? 5. Is Maintaining the S Corp Status the Most Productive Use? 6. What Are the Interests of the Seller? Gross Case Met This Criteria Don t Tax Affect 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 20 10
IRS Job Aid on Valuing Non- Controlling Interests in S Corps 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 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 21 IRS Job Aid on Valuing Non- Controlling Interests in S Corps 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 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 22 11
IRS Job Aid on Valuing Non- Controlling Interests in S Corps 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 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 23 IRS Job Aid on Valuing Non- Controlling Interests in S Corps Appendix A Rev Rul 59-60 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) 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 24 12
IRS Job Aid on Valuing Non- Controlling Interests in S Corps 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 359-387 (2007) Code Section 338(h)10 77 purchases of large privately held S Corps 1994 2000 compared with 77 C Corp purchases without 338(h)10 Elections as Stock Purchases 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 25 1120S-Corporations: Background What is an 1120S-Corporation? Why was it invented? What are the benefits of the S election? What are the disadvantages of the S election? Additional considerations 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 26 13
1120 S-Corporation S-Corporations elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders pay taxes once based on individual rates. S-Corporation shareholders avoid double taxation on the corporate income. S-Corporations are responsible for tax on certain built-in gains and passive income. Today, there are more S than C-Corporations (66%) according to IRS data. 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 27 Requirements to be an S-Corp Be a domestic corporation Have only allowable shareholders Including: individuals, certain trusts, and estates May not include partnerships, corporations, or non-resident alien shareholders Have no more than 100 shareholders Have one class of stock Not be an ineligible corporation, i.e. certain financial, insurance, or DISCs Submit form 2553 signed by all shareholders 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 28 14
Background Internal Revenue Code 1361 to 1379 Added in 1956, modified in 1982 Purpose was to allow small enterprises advantages Allowed corporate form without tax of C-Corp disadvantage 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 29 No Double Taxation. Advantages of S-Corps S-Corp income flows through pro-rata to the S-Corp shareholders on income and losses FICA and Medicare taxes on wages only Taxed at their individual tax rates. S-Corp is a conduit normally not subject to tax. 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 30 15
Advantages of S-Corp, continued In contrast, C-Corp pays corporate income tax Recipient of dividends from C-Corp pays taxes. Limited liability Advantage for a start-up company Allows immediate use of losses by shareholder. C-Corp losses must wait for positive income to be used. 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 31 Advantages of S-Corp, continued Possible business valuation issue Note: For tax years after 12/31/2004, up to six generations of family members treated as one shareholder Note: Differences among voting rights do not by themselves create more than one class of stock Note: Disproportionate distributions do not automatically create more than one class of stock Simple structure 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 32 16
Advantages of an S-Corp Build-Up in Basis Positive S-Corp income not distributed serves to increase basis. This can decrease capital gains taxes upon sale. In contrast, the basis in C-Corp shares does not buildup. Example: You buy shares of IBM for $150 per share IBM has income of $2 per share. Your basis does not increase by $2 to $152, it remains $150 Capital gain/loss is based on the $150 per share you paid. 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 33 Disadvantages of an S-Corp (Keep These in Mind Relative to Risk) Restrictive capital structure limiting access to debt; Shareholder s risk associated with personal tax payments on income at the corporate level; Limit on type and number of owners; and Restrictions on entity structure. 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 34 17
Additional Considerations Changes in Federal Tax Law Changes in laws concerning S-Corporations Minority versus controlling interests Marketplace for the interest 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 35 Converting from a C to an S-Corp: Disadvantages of S-Corps No partnership shareholders (except for single member LLC shareholders) Only certain trusts may be shareholders Grantor trusts Voting trusts Testamentary trusts (2-year limit) Electing small business trusts (ESBTs) Qualified subchapter S trusts (QSSTs) 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 36 18
Converting a C to an S: Built-in Gains Tax BIG TAX S-Corporation is subject to BIG tax at the highest C- Corporation tax rate (currently 35%) based on the difference between the fair market value of the corporations' net assets over the adjusted basis of the net assets as of the first day of the first year the S election becomes effective. 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 37 BIG TAX The Internal Revenue Code has a presumption that any gains on disposition of assets during the 7- or 10-year recognition period is recognized as a built-in gain. Two ways of overcoming the presumption that all gains are recognized as built-in-gains: Asset sold or distributed was not held as of the effective date of the S status Gain had not been accrued as of effective date of the S status this is where an appraisal enters the picture 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 38 19
What is Taxed "Net recognized built-in gains" which is defined as the lesser of: The amount that would be taxable income of the S-Corporation for the taxable year if only recognized built-in gains and losses are taken into account, or the S-Corporation's taxable income for that year (as specially calculated) More issues here such as accounts receivable, pre-election on installment sales, completed contract method contractors, inventories, specific assets, etc. Don t forget intangibles Encourage client to hire an expert in real property and machinery and equipment if applicable 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 39 Estate of Richmond Estate of Helen P. Richmond T.C. Memo 2014-26 (Judge Gustafson) Read it See 5 th and 11 th Circuits Reduced Dollar for Dollar Assumption That Assets Will Be Immediately Sold Assumption That Earnings Will Be Retained Not the Case in the Estate of Richmond Concerns with Experts 20 to 30 Years versus 70 Years Discount Rates from 7% to 10.27% IRS Expert Not Unreasonable 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 40 20
S-Corp Compensation Issues Potential S-Corp compensation issues are unlike C- Corps Potential issue for S-Corps is under-compensation S-Corp under-compensation is often seen due to employment taxes. Owner might rather extract money through distributions Reference the following courts cases: Veterinary Surgical Consultants, P.C. vs. Commissioner, 117 T.C. 141 (2001), Joly vs. Commissioner, 211 F.3d 1269 (6 th Cir., 2000), and Joseph M. Grey P.C. vs. Commissioner, 119 T.C. 121 (2002) Compensation issue could affect business value. 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 41 When Are Appraisals Needed? Whenever the S-corporation includes a business, machinery and equipment, real estate, etc. Whenever an existing C-Corporation converts to an S-Corporation Whenever an S-Corporation acquires assets in a tax-free merger, etc. Whenever an S-Corporation distributes property (other than cash) to a shareholder 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 42 21
Court Cases Summarized Gross v. Commissioner, T.C. Memo 1999-254, 78 T.C.M. (CCH) 201, T.C.M. (RIA) 99,254, 1999 Tax Ct. Memo LEXIS 290 (July 29, 1999). Wall v. Commissioner, T.C. Memo 2001-75, 81 T.C.M. (CCH) 1425, 2001 Tax Ct. Memo LEXIS 97 (March 27, 2001); Estate of Heck v. Commissioner, T.C. Memo 2002-34, 83 T.C.M. (CCH) 1181, T.C.M. (RIA) 54,639, 2002 Tax Ct. LEXIS 38 (February 5, 2002); 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 43 Court Cases Summarized Estate of Adams v. Commissioner ( Adams ), T.C. Memo 2002, 83 T.C.M. (CCH) 1421, T.C.M. (RIA) 54,696, 2002 Tax Ct. Memo LEXIS 84 (March 28, 2002) Robert Dallas v. Commissioner, TC Memo. 2006-212 2006 WL 2792684 (U.S. Tax Ct. Sept. 28, 2006) Estate of Louise Paxton Gallagher v. Commissioner, TCM 2011-148. 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 44 22
Gross Result As a theoretical matter, we do not believe that tax-affecting an S- Corp s projected earnings is an appropriate measure to offset [the] potential burden associated with S-Corp s. Facts Gift valuation of minority shares Profitable soft-drink bottler Restrictive agreements History of distributing earnings Government expert used 0% S tax, Estate s 2 experts applied 40% corporate tax 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 45 Wall Result Because this methodology attributes no value to Demco s S- Corporation status, we believe it is likely to result in an undervaluation of Demco s stock. Facts Gift valuation of minority shares Profitable office supplies distributor and manufacturer Government appraiser applied 0% tax Taxpayer expert applied 34% corporate income tax 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 46 23
Heck Result Court s model used only 1.5% CA tax Court conflated experts discounts into minority discount Facts Estate valuation of minority interest Profitable sparkling wine vintner Government expert applied 0% federal and 1.5% CA rate Also applied 10% discount Loss of S-Corp status and shareholder taxes Taxpayer expert applied 1.5% CA rate Also applied 10% discount Right of first refusal and other specific issues 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 47 Adams Result Court rejected increasing discount rate for hypothetical S-Corp tax [I]t is appropriate to use a zero corporate tax rate to estimate net cash flow when the stock being valued is stock of an S-Corporation. Facts Estate valuation of 61.59% of voting common Profitable retail insurance agency Government expert applied 0% tax rate Taxpayer expert applied 0% rate, but Increased discount rate to adjust for hypothetical corporate tax 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 48 24
Dallas Result Court did not accept tax applied to S-Corp Court rejected assumption that S-Corp would be lost Facts Sale of minority interests to trusts Cash plus notes deemed paid if seller died Profitable chemical manufacturer and distributor Taxpayer s two experts applied corporate tax rates One based on assumed loss of S-Corp status after sale One based on shareholder level income tax Taxpayer contended willing buyer would tax affect 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 49 Gallagher Result Court did not accept tax applied to S-Corp Court applied other adjustments Facts Did not WACC or CAPM Wanted equity and build-up method Not going public anytime soon Assumptions reviewed and comments 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 50 25
Court Cases Key Points Given facts in case and information before the Court the Court decided not to tax affect 1120S-Corporations Quote from Gallagher by Judge Halpren in Gallagher: Mr. May (petitioner s expert) failed to explain his reasons for tax affecting PMG s earnings and discount rate and for employing two different tax rates (39% and 40%) in doing so. Absent an argument for tax affecting PMG s projected earnings and discount rate, we decline to do so. As we stated in Gross v. Commissioner, T.C. Memo. 1999-254, the principal benefit enjoyed by S corporation shareholders is the reduction in their total tax burden, a benefit that should be considered when valuing an S corporation. Mr. May has advanced no reason for ignoring such a benefit, and we will not impose an unjustified fictitious corporate tax rate burden on PMG s future earnings. 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 51 Legal Issue vs Factual Issue Background Legal issue perspective Factual issue perspective Study team perspective IRS inconsistency problem What do you do? Don t tax affect Tax affect using models 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 52 26
Leading Models Regarding Tax Affecting Instead of tax affecting call it the adjustment associated with 1120S- Corporations Models considered here: Fannon Sellers Book Fannon Fannon Sellers paper Grabowski Mercer Treharne Van Vleet 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 53 Explore the Data Fannon Sellers Book Size Matters Less than $50 Million Books and Records More than $50 Million Books and Records Facts Matter Number of Unrelated Shareholders Financing Audited Financial Statements 338(h)10 Election Step up in Basis 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 54 27
Fannon Sellers Paper Valuation of Pass Through Entities, Looking at the Bigger Picture Dec 2011 Presented at 2012 American Taxation Association Mid-year Meeting Capitalization of S-Corps should have a higher ERP See Footnotes from Dhaliwal et al Increased Risks of S-Corps in ERP No Distributions, Distributions to Cover Taxes, High Distributions How much and why? 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 55 Grabowski Four Methods The Modified Traditional Method The Modified Gross Method The C-Corporation Equivalent Method The Pretax Discount Rate Method These methods provide widely varying results depending on assumptions Key assumptions are: Cash distributions Expected holding period; and Pool of likely buyers (most important) 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 56 28
Mercer List of six assumptions Uses the QMDM model to value DLOM as S and C for various scenarios Mercer asserts that the level of distributions does not affect value Important factors are: Length of holding period Extent of expected distributions Risk of loss of benefits 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 57 Treharne Introduces concept of a C-Corp valuation adjustment The reinvestment of retained earnings may or may not contribute to value Contribution of S-Corp: because the shareholder avoids paying the double taxation with C-Corp dividends See A Hands on Approach to S-Corporation and Pass-Through Entity Valuations by Paul R. Hyde and Shawn M. Hyde, IBA Business Appraisal Practice, First Quarter 2010 Contact me or Guy Sanschagrin for a Workbook Associated with this article 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 58 29
Van Vleet S-Corp economic adjustment model (SEAM) Used only for non-controlling equity interest in an S-Corp Two premises in the SEAM Model there are significant differences between the income tax treatment of C and S-Corps capital markets are efficient over the long run This is a mathematical model that needs four tax rates and dividend payout Six key caveats Carefully supported reasoning and analysis are needed 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 59 Theoretical Observations Job Aid 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. 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 60 30
Theoretical Observations Expanded 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 for Control Valuation 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 61 James DiGabriele Study 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); and The premium is higher for the cases in which firms are bought by Private Buyers (rather than Public buyers). 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 62 31
Personal Observations S-Corps Are Growing Maximum Effective tax rate on corporations is 35% Wall Street Journal Reported 69% of U.S. Corporations as non-taxable in 2008, compared to 24% in 1986 3,500 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? 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 63 Look at subject Look at industry Personal Observations Continued Look at hypothetical buyers and sellers To tax affect or not to tax affect Consider alternatives Consider risks Make a professional determination 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 64 32
Personal Recommendation See the new Fannon Sellers Book (April 2015) Treharne Fannon Sellers Paper Consider Risks of S Corp with Discount Rate, DLOC and DLOM Reconcile Use at Federal and local Levels 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 65 Important Take Away Information if Working with the IRS Know with whom you are working at the IRS Understand the roles of participants Seek to understand interests Do not be afraid to ask questions Consider options Ask for a valuer Ask to elevate in management as a neutral party given ownership of the issue by the RA or ETA 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 66 33
Important Take Away Information if Working with the IRS The 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 Provides Real Insight Into How Business Valuers at the IRS Address This Issue. Commentary on the Job Aid by the Original IRS Champion 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 67 www.mikegreg.com 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 68 34
How the IRS Values Non-Controlling Interests in S Corps with Commentary by Original Champion 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 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 69 www.mikegreg.com 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 70 35
Title for IRS Reasonable Comp Job Aid 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 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 71 www.mikegreg.com 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 72 36
How to Work with the IRS, Second Edition How the Content of this Book and My Experience Can Help You Understand the IRS Official and Unofficial Rules of Engagement Use the IRS Official Organization to Your Advantage Understand Classification in General and Estate & Gift Tax in Particular Working with Technical Specialists at the IRS Discover the Issue Resolution and Mediation Processes at the IRS Using the IRS Evaluation Process to Your Advantage How to Work with Expert Witnesses Applying Strategic Thinking to Your Firm Follow These Golden Rules When Working with the IRS 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 73 www.mikegreg.com 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 74 37
Business Appraisers and the IRS 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 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 75 www.mikegreg.com 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 76 38
Valuing Interests in S-Corps From Chapter 5 in Business Appraisals and the IRS Pulled this chapter from the book based on customer feedback Covers the material in this presentation with 2 Example comparisons Sixty-three pages in length 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 77 www.mikegreg.com 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 78 39
Discount for Lack of Marketability and the IRS 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 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 79 www.mikegreg.com 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 80 40
The Wheels Are Falling Off the Wagon at the IRS Download for free at www.irswheels.com 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 This is a National Crises 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 81 www.mikegreg.com 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 82 41
The Servant Manager: 203 tips from the best places to work in America 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 83 www.mikegreg.com 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 84 42
Peaceful Resolutions 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 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 85 Michael Gregory Consulting, LLC mg@mikegreg.com www.mikegreg.com 651-633-5311 1945 Sharondale Ave. Roseville, MN 55113 Contact me with any questions or concerns 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 86 43
What Are Your Thoughts and Questions? 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 87 Thank You Very Much 2015 MICHAEL GREGORY CONSULTING LLC WWW.MIKEGREG.COM 88 44