Page 58 - Bankruptcy and Reorganization Services

pass-through entity cash flows. Many of these decisions were made in U.S. Tax Court and con-
cern the gifting of minority interests. On the other hand, state courts have ruled for and against
tax affecting of pass-through entities in recent cases dealing with marital property in divorce and
dissenting shareholder actions. fn 19

There have been two recent court decisions concerning the value of pass-through entities in a
bankruptcy setting that have supported tax-affecting cash flows and one court decision that did
not support tax affecting. In Doctors Hospital, the U.S. Bankruptcy Court for the Northern Dis-
trict of Illinois ruled that tax affecting the WACC was appropriate in a solvency valuation be-
cause the subject of the valuation was a 100% controlling interest. fn 20 In Veluchamy, the U.S.
Bankruptcy Court for the Northern District of Illinois noted that "Purchasers of S corporations
would in fact experience a reduction in the value of the corporations’ earnings because of the
need to pay personal income taxes on those earnings, and recognizing that tax effect in valuing S
corporations is appropriate." fn 21 However, in Paloian v. LaSalle Bank, the U.S. Court of Ap-
peals for the Seventh Circuit ruled that applying a 40% tax-affecting discount in a DCF analysis
was not relevant in determining solvency. fn 22

As previously noted, the decision about whether to tax affect the cash flows of a pass-through
entity should be based on the specific facts and circumstances of the entity and the purpose of the
valuation. If appropriate, there are different techniques that can be used to recognize the tax ben-
efits of pass-through entity status. A complete discussion of tax-affecting pass-through entities is
beyond the scope of this practice aid. Practitioners are encouraged to consult the available litera-
ture and recent court rulings on the topic.

Step 3: Estimate the Cost of Capital

The cost of capital is the rate of return, or yield that is required to compensate investors for the time val-
ue of money, as well as the financial risk of investing in a business or other financial asset. In other
words, the cost of capital represents the rate of return that a rational investor would require on a compa-
rable alternative investment. As it relates to business valuation, it is the rate of return that equates the fu-
ture cash flows of the business, on a present-value basis, with the current market value of that business.
In other words, the cost of capital is a measure used to equate risk with market value.

The estimation of the cost of capital for companies in financial distress may require special considera-
tions for risk factors and unstable capital structures. Estimating the cost of capital, and the considera-
tions for a company in financial distress, is discussed in chapter 11 of this practice aid.

fn 19 Courtney Sparks White, "S Corporations: A Taxing Analysis of Proper Valuation," Capital University Law Review 37, no. 4
(2009).

fn 20 In re Doctors Hospital of Hyde Park, Inc. v. Desnick, 360 B.R. 787 (Bankr. N.D. Ill. 2007).

fn 21 In re Veluchamy, (Bankr. N.D. Ill. 2014) http://www.ilnb.uscourts.gov/sites/default/files/opinions/veluchamy.pdf.

fn 22 Paloian v. LaSalle Bank, N.A., Nos. 09-2011, 09-2012, 09-2013, and 09-2026 (7th Cir. Aug. 27, 2010).

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