S corporation conversions , Should you strike while the iron’s hot? - John M. Leask II CPA/ABV, CVA

Viewpoint on Value
March/April 2013
S corporation conversions
Should you strike
while the iron’s hot?
Both sides of the story
Taking a balanced approach
to damages calculations
Help your valuator help you
How to ask the right questions
Assessing the worth
of a noncompete
E-mail: Mac@LeaskBV.Com
S corporation conversions
Should you strike
while the iron’s hot?
ubchapter S election can potentially provide
date and to allocate it to the company’s assets. This
shareholders with more flexibility in business
enables taxpayers to quantify which portion of the
decisions, income and capital gains tax consid-
gain should be taxed as C corporation gains and
erations, and distribution alternatives. And if you’re
which portion should be taxed as flow-through gains
contemplating electing S status, it may be prudent
to shareholders.
to plan now to minimize future taxes — especially
since the recent enactment of new tax laws in which
If a business is contemplating a Subchapter S elec-
individual income tax rates have changed. But there
tion, there’s no time like the present to start the clock
are several valuation issues and implications worth
on the 10-year recognition period. Asset and stock
considering before you take a precipitous leap toward
values are at all-time lows for many companies.
Subchapter S status.
Suppose a business elects S status while asset and
Potential tax savings
stock values are low, and it sells assets or stock before
the recognition period expires. Then the portion of
C corporations pay taxes twice. First, they’re charged
the gain taxed at C corporation rates will be mini-
corporate-level income taxes. Shareholders then pay
mized and the portion of the gain taxed as flow-
tax personally on C corporation distributions. But
through gains to shareholders will be maximized.
S corporations are flow-through entities for tax pur-
poses. This means that income, gains and losses flow
through to the owners’ personal tax returns. S cor-
porations are not taxed at the corporate level.
Double taxation of C corporations becomes a major
issue when the owners decide to sell assets or transfer
equity. Management can elect Subchapter S status
when contemplating a sale to minimize corporate-
level capital gains tax. But the Internal Revenue Code
imposes a 10-year waiting period before gains on
sales of assets or equity held by a newly converted
affecting value
S corporation can be treated as pass-through gains to
Not every business can elect
shareholders. And while the Small Business Jobs Act
Subchapter S status. Qualifying
of 2010 reduced this “recognition period” to five years
businesses must:
(if the fifth year in the recognition period preceded
the 2011 tax year), the reduction is not currently appli-
cable to S corporations started in 2012 or 2013.
Be domestic corporations,
Use a calendar fiscal year,
Recognition period gains
If a business sells assets or stock within the recogni-
Offer only one class of stock
tion period, only the appreciation in value from the
(though differences in voting
date of the S corporation election will be exempt
rights are permitted),
from corporate-level tax. So it’s important to estab-
lish the company’s fair market value at the conversion
Section 338(h)(10): Make everybody happy
Buyers and sellers sometimes butt heads when structur-
ing deals. Buyers of S corporations prefer asset sales
because they get a step-up in basis, which allows them
to start depreciation and amortization anew. Also, they
let buyers cherry-pick assets and liabilities.
Sellers, however, prefer stock sales, because sellers
pay less tax. S corporation shareholders recognize the
same gain or loss, regardless of whether assets or equity
is sold. But part of the gain on an S corporation asset
sale may be taxed at ordinary income rates, which are
higher. Most gains on S corporation stock sales are usu-
ally taxed at capital gains rates, which are lower.
But an S corporation stock sale may be treated as an asset sale for federal tax purposes if 1) the buyer
and seller jointly consent to elect Section 338(h)(10), and 2) the sale involves at least 80% of the com-
pany’s equity. Now everybody’s happy — sellers pay less tax and buyers receive stepped-up basis in the
company’s assets.
Have no more than 100 shareholders — including
individuals, certain trusts and estates but excluding
partnerships, corporations, foreign individuals and
If a business is
entities, and ineligible corporations, and
contemplating a
Distribute and liquidate assets to shareholders on
Subchapter S election,
a pro rata basis.
there’s no time like the
These eligibility requirements limit the pool of
present to start the clock
potential buyers of S corporation interests, but,
if they’re not adhered to, the company’s
on the 10-year
Subchapter S status will be lost. A lim-
ited pool of potential buyers reduces
recognition period.
an interest’s marketability. Therefore,
an S corporation may result in a higher
discount for lack of marketability than
The annual tax burden can be substantial for highly
an otherwise identical C corporation
profitable S corporations — and even more sub-
stantial for high-income taxpayers in light of recent
tax rate increases. When an appraiser calculates
S status and control
discounts for lack of control for S corporations,
Although S corporations are required to make pro rata
historic and expected distributions and earnings are
distributions to shareholders, they aren’t required to
relevant considerations.
distribute income to shareholders. So minority share-
holders, who lack control over paying distributions,
Projected earnings
may find themselves required to pay personal-level
One contentious issue valuators face when valuing
taxes on S corporation income, regardless of whether
S corporation interest is whether to tax affect earnings.
the company actually distributed any cash to cover
In other words, should they subtract corporate-level
those respective shareholder tax liabilities.
taxes — as if the S corporation were a C corporation —
The right choice
before applying the income or market approaches?
In deciding whether to convert to an S corporation
and when, companies must consider several pros
The IRS began challenging the practice of tax affect-
and cons. However, time is of the essence. As the
ing in 1999 and has had some success with the issue
economy heats up, corporate profits and asset values
since then. Many valuators contend that tax affecting
are likely to recover, and mergers and acquisitions
is still appropriate. What’s clear, however, is that
will probably return to favor. Valuation profession-
valuators can’t mechanically tax affect S corporation
als, working with tax advisors, can help determine the
earnings without considering the facts of each case
right choice for your circumstances. l
and relevant case law.
Both sides of the story
Taking a balanced approach to damages calculations
ourts are leery of do-it-yourself
calculations and hired guns. In
cases involving damages, cre-
dentialed, independent financial experts
bring reasonableness and credibility to
the table by considering both sides of
the story.
Data and context
Historic trends and statistical anal-
ysis can be useful tools in damages
calculations — if put in a real-world
context. If they aren’t, the court might
deem the analysis too speculative. For
example, when predicting lost profits
using historic revenue and expense
trends, a valuator typically factors in
economic data such as the guideline
companies’ performance, market surveys
For instance, defendants aren’t responsible for losses
and the company’s prelitigation financial projections.
caused by external events, such as weak economic
conditions, new technological advances or new com-
Unlike traditional appraisal assignments, damages
petitors. A balanced analysis also factors in increased
calculation analyses may benefit from hindsight. This
cost savings — such as reduced overhead costs, work-
means valuators can use ex post data, not merely infor-
ing capital requirements and capital investments —
mation known or knowable when the injury occurred.
that may result from the defendant’s alleged wrong-
doing. In essence, it’s necessary to consider all factors
The defendant’s actions might not necessarily be
(both pro and con) that may have caused profits
the sole reason the plaintiff’s profits have declined.
to decline.
Mitigating factors
Courts expect plaintiffs to take reasonable steps to
mitigate damages once they have discovered a defen-
dant’s wrongdoing. An independent expert considers
what the plaintiff did — or could have done — to
offset the defendant’s tortious acts. For example, the
plaintiff might have selected an alternative supplier,
reduced excessive capacity or, in the event of eminent
domain, made an effort to find a suitable alternative
location. Generally, the defendant bears the burden
of proving that the plaintiff failed to reasonably miti-
gate damages.
A balanced analysis factors
in increased cost savings —
such as reduced overhead
costs, working capital
requirements and capital
investments — that may
of severe economic harm” that would persuade it to
rule in favor of Rose Acre Farms.
result from the defendant’s
alleged wrongdoing.
Sanity checks
After an appraiser has estimated damages, his or her
It’s important to keep in mind that damages are
final step is to ask: “Does this number make sense?”
seldom permanent. Most plaintiffs can eventually
To answer, the appraiser needs to reconcile his or her
recover from a defendant’s wrongdoing.
conclusion with alternative damages calculations.
The ceiling for damages is the entire business’s
The big picture
value. But it’s rare for a defendant’s action to com-
Sometimes lost profits aren’t as relevant as lost busi-
pletely bankrupt a plaintiff. Another benchmark is
ness value in determining damages. To illustrate, egg
the number that reflects how much the defendant
producer Rose Acre Farms claimed in 1992 that the
actually profited from its wrongdoing. Alternatively,
USDA’s salmonella regulations resulted in a “regula-
an appraiser might compare the plaintiff’s damaged
tory taking” that violated the Fifth Amendment. The
operations to its performance in an undamaged loca-
Court of Federal Claims awarded $5.4 million to
tion or undamaged product market.
Rose Acre Farms.
In 2009, the U.S. Court of Appeals for the Federal
Reason wins
Circuit reversed that award, ruling that lost profits
The last thing any plaintiff wants to admit is that the
must reflect real-world costs and mitigations, including
alleged “wrongdoer” might have done something that
the value of Rose Acre Farms as a going concern and
saved the plaintiff money — or that external factors,
the government’s need to protect the public through
or the plaintiff itself, could be partially to blame for
food-safety regulation. The appellate court estimated
its financial losses. But an expert who takes a balanced
that government regulations caused the company’s
approach — using empirical data and reasonableness
eggs to lose only 10% of their value — nowhere near
rather than speculation and unfounded estimates — is
the 219% profit loss the plaintiff claimed. The court
most likely to convince the court that the damages
held that a 10% loss “did not even approach the level
calculation is objective and fair. l
Help your valuator help you
How to ask the right questions
ou undoubtedly understand how to run your
Do you understand the
business or practice, but do you know how to
appraisal’s purpose?
place a value on it? How do valuation experts
Valuations are valid as of a specific date and for a
determine what’s relevant when appraising an asset
specific purpose. Never reuse a valuation prepared
and ensure all bases are covered? Asking the right
for, say, gift tax purposes, later — unless your valu-
questions and obtaining clarification up front can help
ator specifically approves it. An appraisal purpose
you get the most from your valuator’s expertise —
dictates which valuation techniques are used. For
and avoid costly mistakes.
example, a divorce case might require the valuator to
separately value professional and entity goodwill for
What are your credentials?
equitable distribution of the marital estate.
It’s critical that you assess your valuation profes-
sional’s qualifications to determine whether he or she
In addition, your valuator needs to be familiar with
is credentialed and independent. Does your valuator
these eight factors when valuing a business under
belong to one or more business valuation profes-
Revenue Ruling 59-60:
sional organizations and possess business valuation
credentials? What percentage of your valuator’s time
Nature and history of the business,
is spent valuing businesses and how many years of
experience does he or she possess?
Economic and industry outlook,
You may also want to know whether your valuator
Book value and financial condition,
has had experience valuing companies in the same
Earnings capacity,
industry as the subject company. And be sure to ask
how many valuation reports he or she has prepared.
Dividend-paying capacity,
How do you define value?
Goodwill and intangible value,
Most appraisals call for “fair market value,” which is
the price at which property would change hands in a
Previous sales and size of the block, and
hypothetical transaction involving informed buyers
Comparable transactions.
and sellers not under duress to buy or sell. But some
assignments call for a different standard of value. A
company that’s considering acquiring a competitor
might be more interested in “strategic value,” which
is the value to a particular investor.
Is your valuator able to clearly define and explain the
appropriate standard of value? Keep in mind that, in
court, a judge may disregard an expert opinion that
measures an inappropriate standard of value.
Two levels of value — controlling and minority
typically apply to private business interests. Ask
whether your valuator has considered the levels of
value when selecting valuation methodology and
applying valuation discounts.
Experienced valuators should have no trouble listing
the engagement letter is to achieve an understanding
these characteristics and explaining them in detail.
between you and your valuator. Therefore, it should
discuss your valuator’s duties, scope and responsibili-
What format will it take?
ties, as well as the proposed appraisal costs, retainers
and late fees, if applicable. If the assignment’s scope
Check to make sure your valuator has defined the
or the definition of value changes, ask your valuator
valuation parameters as well as other services that
to draw up a revised engagement letter or an adden-
might be required. For instance, an oral presentation
dum to the original contract.
may suffice in some situations, such as preliminary
settlement talks or merger consulting. But most
assignments call for greater formality and a full writ-
Is everyone on the same page?
ten report. The appropriate format is a function of
Nothing’s more frustrating than sitting down for a
your preferences, the valuation purpose and the users
consultation with a valuation professional and finding
of the valuation.
that you don’t fully understand the process. Ask the
right questions to ensure your business valuator will
Your valuator should summarize the project’s details
help you obtain a winning result. l
in an engagement letter. One of the main purposes of
Assessing the worth of a noncompete
Noncompete agreements are used to smooth management transactions after a merger or acquisition
closes. After all, business buyers don’t want valuable assets — such as trade secrets, key employees
and business relationships — to walk out the door with the seller.
But how much are noncompetes really worth? Purchase
price allocations have important tax and accounting impli-
cations when one is buying and selling business interests. In
an M&A context, noncompetes are contractual agreements
that restrict sellers from competing in the same industry for a
given time period within a specific geographic area. For tax
purposes, the value allocated to noncompetes must be rea-
sonable and agreed to by both sides.
Noncompete appraisal is often a sticking point for buyers
and sellers in business combinations. Buyers typically amor-
tize noncompetes over 15 years, regardless of terms or payment conditions. The higher the value
assigned to noncompetes, the more amortization the buyer can deduct in future periods.
Sellers normally recognize ordinary income for amounts allocated to noncompetes. Ordinary income
tax rates are generally higher than capital gains tax rates, so sellers typically prefer lower values
assigned to noncompetes.
A valuator typically begins by using the 11-factor test set forth in Thompson v. Commissioner to assess
economic reality, looking at such factors as the grantor’s (seller’s) business expertise, intent to com-
pete and economic resources as well as the potential damage to the grantee (buyer).
Next the valuator appraises the business with, and without, the noncompete agreement. Noncompete
value equals the difference between these two values, net of the expected tax savings from amortizing
the agreement and adjusted for the probability that the seller would actually compete with the buyer.
As a final step, an appraiser typically estimates the percentage of noncompete value to total selling
price. Then, as a sanity check, he or she compares the subject company’s ratio to the ratio observed
in comparable transactions.
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other
professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In
addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations. ©2013 VVma13
John M. Leask II CPA, LLC.
Business Valuation Services
765 Post Road, Fairfield, Connecticut 06824
John M. Leask II (Mac), CPA/ABV, CVA, values 25 to 50 businesses annually. Often, Mac’s valuations,
oral or written, are compiled in conjunction with the purchase or sale of a business, to assist shareholders
prepare buy/sell agreements, or to set values when shareholders purchase the interest of a retiring share-
holder. Here are examples:
Due Diligence & Assist with Purchase of a Business. Mac has assisted purchasers of businesses
by determining or reviewing the offer. He helps negotiate the price, perform due diligence prior to
closing and/or helps structure and secure financing. Services have included, but are not limited to,
verifying liabilities and assets, reviewing sales and expense records, and identifying critical issues
relating to future success, and helping management plan future operations.
Family Limited Liability Partnerships, Companies & Closely Held Businesses. Mac regularly values
various sized business interests for estate and gift tax purposes. He provides assistance to estate and trust
experts during audits of reports prepared by other valuators.
Mac also helps business owners and their CPAs and/or lawyers in the following ways:
• Planning — prior to buying or selling the business
• Prepare valuation reports in conjunction with filing estate and gift tax returns
• Plan buy/sell agreements and suggest financing arrangements
• Expert witness in divorce & shareholder disputes
John M. Leask II CPA, LLC.
• Support charitable contributions
Business Valuation Services
• Document value prior to sale of charitable entities
• Assist during IRS audits involving other valuators’ reports
• Succession planning
• Prepare valuation reports in conjunction with pre-nuptial agreements
• Understanding firm operations & improving firm profitability
More information about the firm’s valuation services (including case studies) may be found at www.LeaskBV.com.
To schedule an individual consultation or to discuss any other points of interest, Mac may be reached at 203 – 255 – 3805.
The fax is 203 – 380 – 1289, and e-mail is Mac@LeaskBV.Com.
If you have a business valuation problem, Mac is always available to discuss your options — at no charge.
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