To Tax Affect Or Not To Tax Affect

The tax affecting in question in Estate of Gallagher (see main article) is somewhat controversial. Even though S corporations don't pay corporate level income taxes, valuators would routinely tax affect projected S corporation earnings at a C corporation equivalent rate, which allows the value derived from the income approach to be consistent with the required rate of return derived from publicly traded companies (for example, both on an after-tax basis).

In addition, the corporation could:

• Lose its S status (for example, by being acquired by a C corporation), or
• Fail to distribute sufficient income to cover its shareholders' tax liabilities.

In 1999, however, the Tax Court ruled in Gross v. Commissioner that tax affecting was inappropriate in valuing a minority interest in an S corporation. The court explained that the primary benefit of S corporation status is the absence of corporate-level taxes, a benefit that shouldn't be ignored in determining its value.

That doesn't mean that tax affecting is never justified, in Gross, the court was influenced by the lack of evidence that the corporation in that case was likely to lose its S status. In fact, many valuation experts believe that tax affecting continues to be appropriate if there a good reason for doing so.