Valuation of S-Corporations

An S-Corp election can have positive and negative impacts on the valuation of a minority interest in a closely-held company depending on the specific facts pertinent to the company. In the majority of cases, the S-Corp election has a net positive economic impact to the fair market value of a minority interest, but the net effect can vary materially between shareholders of the same company, and between potential buyers of a minority interest in the company. Therefore, the net economic impact cannot be modeled precisely. However, an average net benefit or detriment can be reasonably estimated. The following summary outlines the key positive and negative attributes of S-Corp share ownership. • Generally, S-Corp income is subject to only one level of taxation. • S-Corp shareholders receive an increase in tax basis to the extent that income (i.e., AAA account 1) exceeds S-Corp distributions. • After a ten-year holding period, S-Corps are no longer subject to built-in-gains tax on C-Corp appreciated assets. • Restrictions are imposed upon the types of permitted shareholders, which further limit marketability. • Only one class of stock is permitted. A corporation is considered to have one class of stock if all shares bestow equal rights to distributions and liquidation yield. Differences in voting rights are ignored for qualification purposes. • Shareholders are liable for entity taxes on 100% of earnings regardless of the level of cash distributions. • If assets acquired as a C-Corp are sold prior to the expiration of the 10-year S-Corp holding period, the company is subject to built-in-gains tax on the C-Corp appreciated assets. 1 Accumulated Adjustment Account (" AAA ") represents the accumulated previously taxed income which has not been distributed to the S-Corp shareholders. 2 • The tax deductibility of certain employee benefits for shareholder employees is more limited than for a C-Corp. • Tendency to distribute more income reduces retained earnings available to fund future growth. 2 This factor can be material for working capital and fixed asset intensive companies. • Basis of assets owned by an S-Corp is not adjusted upon sale of shares or the death of a shareholder. If an S-Corp owns depreciable property, such as rental real estate, the inability to adjust the basis of corporate assets (e.g. the real estate) means that a purchaser of S-Corp shares does not receive the benefit of increased depreciation deductions. By contrast, a purchaser of a partnership or …