Factors Affecting the Size of the S-Corporation Premium

S-Corporations offer unique income tax advantages relative to otherwise identical C-Corporations. The two primary income tax advantages include avoidance of the dividend tax and the ability to utilize undistributed profit to step-up an investor’s income tax basis. These two income tax benefits can result in substantial cash flow savings at the investor level relative to otherwise identical C-Corporations. Accordingly, valuation practitioners commonly add a valuation premium – known as the S-Corporation premium – when valuing an interest in an S-Corporation. This valuation premium is often related to the present value of the income tax savings of the S-Corporation relative to the C-Corporation. Many factors, however, including distribution policies, holding periods, and other qualitative characteristics of the corporation, are relevant in determining the size of the S-Corporation premium. The purpose of this article is to highlight some of the primary economic and qualitative factors that should be considered by valuation professionals when determining the size and application of the S-Corporation premium.

Personal & Corporate Income Taxes
The most significant economic factor affecting the S-Corporation premium is the relative income tax burden of the S-corporation relative to the C-Corporation. Accordingly, proper analysis of the S-corporation requires careful consideration of the prevailing tax rates and income tax attributes of S-Corporations and C-Corporations. S-Corporations, for example, generally face only one level of tax based upon the individual’s marginal income tax rate. C-Corporations, on the other hand, face two levels of tax: once at the corporate level based upon corporate income tax rates, and then again at the investor level based upon the applicable dividend and capital gains tax rates. S-Corporations will only command a valuation premium relative to a C-Corporation when the total income tax burden of the S-Corporation is less than that of the C-Corporation. The present value of the tax savings will dictate the magnitude of the S-Corporation premium adjustment. Indeed, depending upon the applicable tax rates as of the valuation date, an S-corporation can theoretically command valuations that are higher, lower, or even equal to an otherwise identical C-Corporation. Accordingly, valuation practitioners must carefully identify difference in income tax treatment in order to identify the source of the income tax differential. Panel A provides an illustrative example of how prevailing taxes rates affect the S-Corporation premium.

Panel A – Illustration of Income Tax Benefits
As an illustrative example, consider a debt-free corporation that operates in the state of Florida, generates $1,000,000 in pre-tax income, and distributes all income in the form of dividends. Under current income tax law, this C-Corporation would pay tax at the rate of 34% and distributions would be subsequently taxed at a rate of 23.8% assuming a qualified dividend paid to an individual in the highest income tax bracket. An S-Corporation, however, would pay tax only once at a rate of 43.8% assuming an individual in the highest marginal income tax bracket. Accordingly, an investor in a C-Corporation would incur a total tax of $497,080, leaving $502,920 in income after taxes. An investor in the S-Corporation would incur total taxes of $438,000, leaving $562,000 in income after taxes. If the investor wanted a 10% return after-taxes, the C-Corporation would be worth $5,029,200 and the S-Corporation would be worth $5,620,000, or an 11.75% increase relative to the C-Corporation’s value. The difference in total taxes paid is $59,080 and the present value of this tax is $590,800, or also 11.75%, of the C-Corps value. This shows that the primary economic driver is the difference in the total taxes paid, and that the valuation premium is equal to the net present value of the tax savings. In this case, the S-Corporation’s total tax was $438,000, or 43.8% of income, while the C-Corporations total tax was $497,080, or 49.71% of income. The lower tax for the S-Coporation reflected a combination of an avoided 23.8% dividend tax, offset by a higher personal tax rate of 43.8% relative to the corporate rate of 34.0%.
C-Corporation		S-Corporation
Taxable Income	$1,000,000	Taxable Income	$1,000,000
Corporate Tax 34%	(340,000)	Corporate Tax 0%	(0)
Income After-tax	$660,000	Income After-tax	$1,000,000
Flow-Through Tax 0%	(0)	Flow-Through Tax 43.8%	(438,000)
Dividend Tax 23.8%	(157,080)	Dividend Tax 0%	(0)
After-tax Income	$502,920	After-tax Income	$562,000
Capitalization Rate	10%	Capitalization Rate	10%
Indicated Value	$5,029,200	Indicated Value	$5,620,000
Valuation Premium	na		11.75%
Total Tax Paid	$497,080		$438,000
Tax Savings			$59,080
Capitalization Rate			10%
Value of Tax Benefit			$590,800
Value of Benefit % of  Value			11.75%

 

Distribution Policy
In addition to taxation, distribution policy is also an extremely important factor to consider when determining the S-Corporation premium. S-Corporations that distribute all income in the form of dividends, for example, will often command the greatest valuation premiums because they maximize the dividend tax savings relative to otherwise identical C-Corporations. On the other hand, S-Corporations distributing less than 100% of their taxable income will often command significantly lower valuation premiums relative to the fully distributing corporation. This is the case because such corporations essentially shift a portion of their economic return away from tax inefficient dividends to more tax efficient long-term capital gains, thereby reducing the total relative tax savings. In fact, by minimizing distributions and deferring capital gains perpetually, C-Corporations can often mimic the income tax benefits of the S-election. Accordingly, high growth S-corporations with low distribution payouts may warrant significantly lower valuation premiums relative to low growth S-corporations with high distribution payouts. Most importantly, certain S-Corporations do not even pay distributions sufficient to cover the income tax liability of their shareholders. This can create an extremely unattractive investment profile for a minority investor and may actually warrant a valuation discount relative to a C-Corporation. Valuation practitioners, therefore, must carefully consider how the distribution policy of the corporation may affect the valuation.

Holding Period
Another key factor that affects the S-Corporation premium is the holding period. The holding period is relevant because it may affect the length of time that the S-Corporation benefit accrues to a minority shareholder. For example, in some cases, a business may be sold in a control transaction wherein the benefits of the S-election are not paid for by the hypothetical buyer. In such a scenario, a minority investor would only receive (and, therefore, pay for) the tax benefits that accrue during the time period prior to sale. This can also occur in a variety of planned exits in which the S-election is lost, including IPO, liquidation, or a financing to a non-qualified shareholder. Accordingly, valuation practitioners must consider how long the S-benefits are expected to accrue to a minority before applying a valuation model, which often make an assumption of perpetual benefits. In addition to affecting the length of time for the benefits to accrue, the holding period may also affect the length of time that a shareholder can build-up their income tax basis. The holding period will also affect the present value of the capital gains tax savings, as well as the effective capital gains tax rate one could expect to pay if incorporated as a C-Corporation. All of these factors, therefore, must be adequately considered by the valuation professional.

Leverage
Leverage is another critical factor that valuation practitioners must consider when valuing an S-Corporation. For example, C-Corporations can often mimic the income tax advantages of the S-election by paying out taxable income in the form of interest on debt; that is, the C-Corporation can optimize the capital structure and deduct the interest payments to minimize (or even eliminate) the corporate tax and avoid the double-tax on dividends. Shareholders could simply purchase the debt instead of the stock to obtain the economic benefits of the C-Corporation, which, on an after personal tax basis, would be quite similar to the benefits of owning the S-Corporation stock directly. S-Corporations generally cannot benefit from leverage in the same way that taxable C-Corporations can because S-Corporations cannot deduct interest payments at the corporate level. Accordingly, a corporation’s ability to leverage and optimize the capital structure may significantly reduce the applicable valuation premium for an S-Corporation. In fact, Jalbert (2002) demonstrates that the valuation premiums on master-limited partnership, a form of pass-through entity, are negatively related to the use of debt. Valuation practitioners, therefore, must consider how optimizing the capital structure may affect the application of the S-Corp premium.

Shareholders’ Agreement
The shareholders’ agreement should also be considered when selecting the appropriate S-Corporation premium, as this document often contains important provisions regarding distribution policy as well as methods for protecting the S-election. For example, certain shareholder’s agreements contain provisions that require the controlling shareholder to make distributions sufficient to cover the income tax liability of the shareholders. This type of provision can greatly enhance the attractiveness of the S-Corporation and will generally make it more likely for an investor to pay for the benefits. Similarly, certain shareholder’s agreements contain provisions that prohibit the controlling shareholder from terminating the S-election or that limit the shareholder base to eligible S-Corporation purchasers. These provisions can also provide greater assurance that the benefits of the S-election will not terminate. Shareholder’s agreements that do not contain similar provisions may greatly increase the risk to a prospective shareholder and, therefore, limit the benefits that investors are willing to pay for.  Valuation practitioners may need to address these issues by increasing the discount for lack of marketability, adjusting the discount rate, or limiting the S-Corporation benefits in the cash flow stream.

Risk & Marketability Factors
Although S-corporation can generate significant tax benefits for their shareholders, S-Corporations cannot be properly valued without further consideration of their unique marketability and risk. S-Corporations possess unique qualitative differences from C-Corporations that may ultimately affect their relative attractiveness in the marketplace. S-Corporations, for example, are limited to only 100 shareholders and can only be owned by qualifying shareholders. In addition, S-Corporations are only allowed to have one class of common stock. These ownership restrictions can make S-Corporations significantly less marketable than otherwise comparable C-Corporations. In addition, minority investors in S-Corporations face other investor specific risks. The most significant investor specific risk is the risk that distributions are insufficient to cover the income tax liability of the shareholder. Investors in C-Corporations do not face this risk factor, which can greatly detract from value. Moreover, minority investors in S-Corporations face the risk that the S-election will be revoked or terminated. Minority investors also face uncertainty for the length of time in which the benefits of the election will last. Generally speaking, these factors may need to be addressed by increasing the marketability discount or the cost of capital.

Levels of Value
The level of value can also have a significant impact on the application of the S-Corporation premium. The two most common levels of value in business valuation include the level of control and the level of minority. Many appraisers question whether an S-Corporation premium is applicable at the level of control. This is the case because a controlling owner generally has the ability to determine the organizational structure of the business, and is, therefore, unwilling to pay for an election that it can elect for free. Moreover, controlling owners have the ability to optimize the capital structure to minimize the income tax disadvantages of a C-Corporation, and can determine distribution and compensation policies to maximize after-tax cash flows. Indeed, empirical studies that have examined pricing in the market for control generally find no discernible difference between the pricing of S-Corporations and C-Corporations. A minority interest holder, however, generally does not have the ability to maximize economic benefits in the same way that a controlling shareholder can. Accordingly, the S-Corporation premium is often considered to be most relevant in valuations at the minority level. Valuation practitioners should consider the level of value before applying a S-Corporation premium.

Hypothetical Buyers & Sellers
The hypothetical buyers and sellers – or the hypothetical market participants that govern the terms of trade for the asset being valued – must also be considered when determining the application of an S-Corporation premium. For example, the hypothetical buyers and sellers may dictate the relevant tax rates that should be utilized for purposes of valuing the S-Corporation. If the marketplace for the asset is primarily characterized by individuals in the highest marginal income tax bracket, their tax rates may be the most relevant for determining the value of the S-Corporation. This may contrast sharply with a market dominated by investors in the lowest marginal tax bracket or investors that do not pay tax. Similarly, hypothetical buyers and sellers may influence whether an S-Corporation premium will be valuable to market participants. If the business is likely to be sold to a non-qualified purchaser, such as a C-Corporation, such buyer may be unwilling to pay a premium for the S-election. Accordingly, appraisers must carefully consider how the hypothetical buyers and sellers may impact the determination of value.

Valuation Methodology
The valuation methodology is the final factor that should be considered when determining the size of the S-Corporation premium. Valuation methodology is important because it ultimately defines the base to which the valuation adjustment is being made. For example, under the income based approach, valuation practitioners commonly derive a cost of capital that is developed from publicly traded C-Corporations, whose rates of return are reported after corporate tax, but before shareholder level tax. This creates a mismatch between the discount rate and the cash flows being valued. Accordingly, the relative adjustment in the income approach has much less to do with relative taxes between “otherwise identical C-corporations,” but generally centers around adjusting the discount rate for the relative taxes that are embedded in the public market rate of return. This adjustment may differ materially from the adjustment in other valuation methodologies. In the market approach, for example, the valuation practitioners must actually determine the relative tax rates in each of the reference securities. Arguably, each comparable company could have a different adjustment depending upon the relative tax attributes of the security. Many valuation practitioners believe that no valuation adjustment is necessary in the asset based approach, although this is an area of continuing debate. The point is that valuation practitioners must consider the valuation methodology and the relative tax attributes that are embedded in that methodology. The same economic adjustment may not always be appropriate for different valuation methods.

Conclusion
The determination of the S-Corporation premium requires an extensive analysis of many underlying factors. Depending upon these factors, S-Corporations can command higher, lower, or even comparable values relative to an otherwise identical C-Corporations. No business valuation is subject to the same set of facts and circumstances. Accordingly, valuation practitioners must consider the totality of facts when determining the appropriate premium. Some of the most relevant factors bearing on this analysis include the relative income tax attributes of the S-Corporation, distribution policy, holding periods, and leverage. In addition, qualitative factors such as the shareholders’ agreement, level of value, hypothetical buyers and sellers, and valuation methodology all affect the application of the premium. Moreover, even if S-Corporations generate tax savings for the investors, these benefits can be offset by the greater risk and lower marketability of electing S-Corporations. All of these factors must be reflected in the valuation of an S-Corporation. These issues often require the assistance of a professional

If you require assistance valuing your S-Corporation, please contact our Valuation Advisory Services Department. Our team of professionals can assist you in determining whether your S-Corporation warrants a valuation premium.