Page 57 - Business Valuation for Estates & Gift Taxes

portfolio would turn over during a 20- to 30-year period. As a result, the court held that the built-in gains
discount should be calculated as the present value of paying off that liability in the future.

Tax-Affecting Pass-Through Entities

Up until the late 1990s, valuation analysts commonly incorporated the philosophy of tax affecting all en-
tities at a 40-percent tax rate or at the median effective tax rate of the public company guideline group
used in their analyses. This held true after normalizing the income statement of a C corporation and then
tax affecting the adjusted pre-tax earnings. It also held true for pass-through entities such S corporations,
partnerships, or LLCs.

In 1999, the Gross vs. Commissioner decision was handed down by the Tax Court (T.C. Memo 1999-
254, affd. 272 F 3d 333 6th Cir. 2001), which concluded that S corporation shares are inherently more
valuable than C corporation shares. This case, as well as other notable cases, led to the evolution of var-
ious theories and financial models in use today. While Tax Court challenges highlighted the difference
between C corporations and pass-through entities, improved technology, wider access to data, and other
market forces have helped evolve the sophistication of the valuation profession.

Some well-known authors who have developed models for valuing non-controlling interests in pass-
through entities include the following:

 Chris Treharne

 Daniel Van Vleet

 Chris Mercer

 Roger Grabowski

 Nancy Fannon

These models take into consideration distributions, retained net income, holding periods, tax rates, addi-
tional discounts for minority and marketability, and the potential for a step-up in basis.

The theory on this topic continues to evolve. Some analysts now propose that the proper approach is not
to adjust the tax rate applicable to the earnings stream but rather to adjust the rate of return expected by
the investor.

Goodwill

In the sale of a closely held business, a valuation issue that arises is whether the owner’s goodwill be-
longs to the corporation and should be included in the value of the closely held business, or does the
owner’s personal asset separate from the value of the business.

Goodwill is defined as, "[T]he ability to earn a rate of return in excess of a normal rate of return on the
net assets of a business, after reasonable compensation to operating personnel." fn 12

fn 12 Pratt with Niculita Valuing a Business, 5th edition.

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