Although many business valuation analysts are well-aware of the “tax-affecting” issue, it's not something estate planners and tax attorneys typically think of when advising clients who own pass-through entities such as S corporations and limited liability companies (LLCs).

They should. During the last five years, the “tax-affecting” issue has dramatically changed the way the Internal Revenue Service and many analysts estimate the value of pass-through entities. The result, too often, has been much higher taxes for clients.

To properly advise clients about wealth preservation strategies, estate planners and tax attorneys need, at minimum, a layman's understanding of the tax-affecting debate and its potential impact on how pass-through entities are valued for estate and gift tax purposes.

Pass-through entity valuation changed forever on July 29, 1999, when the U.S. Tax Court rendered the now-famous decision in Gross v. Commissioner.1 This opinion meant heartburn for many valuation analysts because the Tax Court accepted a valuation analysis that did not tax-affect (that is to say, reduce) the projected earnings of the subject S corporation (an Ohio-based Pepsi-Cola bottling company.) In response, I and several other valuation analysts developed models designed to address the questions about tax-affecting and support its practice.

But to understand all that, we need to take a quick look at the basics of tax-affecting, how it impacts the value of pass-through entities, and what that means to clients' pocketbooks.


Pass-through entities are not subject to corporate income taxes.2 Instead, the earnings of the company are reported on the individual tax returns of the owners, based on their respective equity interests in the company. As a result, the equity owners essentially pay the income taxes of the company on their personal tax returns.3 Because most information used to value pass-through entities is derived from publicly traded C corporations — which are subject to corporate income taxes — valuation analysts typically reduced (that is, “tax-affected”) the reported earnings of the pass-through entity using an assumed tax rate in the range of 35 percent to 40 percent.

Tax-affecting was generally considered appropriate because it accounted for the taxes paid by the equity owners on their personal tax returns. Most analysts believed that tax-affecting made the earnings of pass-through entities more economically consistent with the publicly traded C corporation information (for example, price/earnings multiples, etc.) used to value pass-through entities.

And — until Gross — tax-affecting was widely accepted. Even IRS publications advocated tax-affecting when valuing pass-through entities.4

Then, in Gross, the Tax Court announced that it wasn't reasonable to tax-affect an S corporation's projected earnings without facts to support the notion that the loss of the S corporation election was foreseeable. As a result, the indicated value of the taxpayer's equity interest increased by more than 60 percent. (See “An Unhappy Taxpayer,” this page.)

Understandably upset, the taxpayer appealed the decision to the U.S. Court of Appeals for the Sixth Circuit. Unfortunately for the taxpayer, the Sixth Circuit in 2001 upheld the Tax Court's decision. The taxpayer petitioned the Supreme Court, which refused to hear the case, officially ending the appeals process.

But the story was far from over. Business valuation experts responded with a barrage of negative articles decrying the valuation analysis accepted by the Tax Court. Most commentators asserted that tax-affecting was the correct treatment and that the Tax Court simply got it wrong. Surely, the Tax Court would recognize the error of its ways in subsequent decisions. Right? Wrong.


In 2001 and 2002, Gross was followed by Heck v. Comm'r,5 Adams v. Comm'r,6 and Wall v. Comm'r.7 Each of these matters involved pass-through entities and tax-affecting. In Heck, experts for both the taxpayer and the IRS did not tax-affect the analysis. In Adams, the expert for the taxpayer conducted the analysis on a pre-tax basis. The Tax Court was not fooled by this attempt to get around Gross and rejected this analysis. In Wall, experts for both the taxpayer and the IRS tax-affected. But the Tax Court gave little weight to these experts' opinions, finding that either's analysis “was likely to result in an undervaluation” of the subject company's common stock.

After Adams, there was quiet for four years. Then, in 2006, the Tax Court came roaring back with Dallas v. Comm'r.8 In this decision, the Tax Court once again rejected the validity of tax-affecting the earnings of a pass-through entity.


For those who think tax-affecting is solely a Tax Court issue, think again. Look at Delaware Open MRI Radiology Associates v. Howard B. Kessler.9 This decision was handed down on April 26, 2006, by a court widely regarded as the nation's preeminent forum for resolving corporate and shareholder disputes: the Court of Chancery of the State of Delaware.

Delaware Open MRI was a shareholder dispute involving an S corporation radiology clinic. In its decision, the Delaware court criticized the valuation analysis of both sides, stating that neither had taken the most reasonable approach. One of the experts tax-affected; the other did not. In its decision, the Delaware court provided a summary table that reflected its thinking on tax-affecting. (See “A Move in the Right Direction,” p. 48.) The Delaware court concluded that a 29.4 percent tax rate (as opposed to the zero percent and 40 percent tax rates used by the opposing experts) equalizes the equity investment returns to S and C corporation shareholders after recognition of corporate and personal taxes. The court then used the 29.4 percent rate in its tax-affecting analysis to estimate the value of equity of Delaware Open MRI.

When preparing their summary table, the Delaware court properly recognized that: (1) shareholder income tax attributes are important in the valuation of a pass-through entity; and (2) there are differences in the income tax attributes of C corporations, pass-through entities and their respective shareholders. However, Delaware Open MRI did not (as some have suggested) provide a valid model for the valuation of pass-through entities. That's because the court's analysis fails to address a number of important factors, including:

  • dividend payout ratios of the C corporations used in the analysis;
  • potential differences in the capital gains and dividend tax rates;
  • differences between non-controlling and controlling equity interests; and
  • how to address indications of value provided by other business valuation approaches.

The Delaware court took a long step towards correct thinking on the valuation of equity interests in pass-through entities. Unfortunately, the court's analysis is not sufficiently detailed, comprehensive or analytically supported to permit its use as a valuation model.


After Gross, several analytical models were developed that address the valuation of pass-through entities. (See “Today”s Models,” p. 49.) In 2001, I developed the S Corporation Economic Adjustment Model (SEAM). This model is based on a series of equations that equalize the after-tax equity returns to shareholders of C corporations and pass-through entities. The equations produce a multiple that is used to adjust the value of a pass-through entity when such value is estimated using publicly traded C corporation data. Using this model, the earnings of the pass-through entity are tax-affected.

During the previous four years, I have submitted to the IRS multiple valuation reports on estate and gift tax matters using the SEAM analysis. Several of these matters were subjected to audit and the IRS accepted the SEAM analysis. Although I have no direct knowledge, it is my understanding that the models proposed by valuation experts Roger J. Grabowski, Z. Christopher Mercer and Chris D. Treharne have met with similar success.

Still, many analysts are valuing pass-through entities as though they were C corporations. What may be worse: many analysts don't tax-affect at all for fear of rejection by the IRS and/or the Tax Court. Conceptually, both approaches are incorrect and can lead to erroneous indications of value. I recommend that analysts consider the more recently developed valuation models to estimate the value of pass-through entities. I also strongly encourage estate planners and tax attorneys with clients that own pass-through entities to become familiar with the tax-affecting issue and its potential impact on the value of pass-through entities. Don't let your clients' pass-through entities get over- or undervalued. I'm sure you are well-aware of the impact that would have on their tax bills and estate plans.


  1. Walter L. Gross, Jr. et al. v. Commissioner, T.C. Memo 1999-254, aff'd, 272 F.3d 333 (6th Cir. 2001).
  2. Certain states tax pass-through entities at the entity level; however, the tax rates are generally below 2 percent and therefore are ignored for the purposes of this article.
  3. Pass-through entities often distribute sufficient cash to the equity owners to pay for this personal income tax obligation.
  4. See the following Internal Revenue Service publications: Examination Technique Handbook and Valuation Guide for Income, Estate and Gift Taxes: Valuation Training for Appeals Officers.
  5. Estate of Richie C. Heck v. Comm'r, T.C. Memo 2002-34.
  6. Estate of William G. Adams, Jr. v. Comm'r, T.C. Memo 2002-80.
  7. Estate of John E. Wall v. Comm'r, T.C. Memo 2001-75.
  8. Robert Dallas v. Comm'r, T.C. Memo 2006-212.
  9. Delaware Open MRI Radiology Associates, P.A., v. Howard B. Kessler, et al., C.A. No. 275-N (Del. Chan. 2006).


Because Gross rejected “tax-affecting,” the value of the plaintiff taxpayer's equity interest in an S corporation ballooned more than 60 percent

Projected Income Statement Taxpayer Analysis IRS Analysis
Revenues $100,000 $100,000
Expenses (60,000) (60,000)
S Corp income 40,000 40,000
Tax-affecting (16,000) -
Net income 24,000 40,000
Valuation Analysis Taxpayer Analysis IRS Analysis
Net income $24,000 $40,000
Divided by: capitalization rate 0.10 0.10
Equals: indicated value of equity 240,000 400,000
Value increase 66.7%
— Daniel R. Van Vleet


The Delaware Chancery Court in Delaware Open MRI reduced the tax-affect from 40 percent to 29.4 percent to reflect certain tax-related differences between C and S corporations

C Corp S Corp S Corp Valuation
Income before taxes $100,000 $100,000 $100,000
Tax affecting (%) 40 - 29.4
Available earnings 60,000 100,000 70,600
Dividend taxes at 15% 9,000 - 10,600
Personal taxes at 40% - 40,000 -
Available after taxes $51,000 $60,000 $60,000
— Daniel R. Van Vleet


There are now four main methods for taking into account the principal tax-related differences between S and C corporations. These models were developed by:

  • Roger J. Grabowski, managing director of Duff & Phelps LLC in Chicago;
  • Z. Christopher Mercer, chief executive officer of Mercer Capital in Memphis, Tenn.;
  • Chris D. Treharne, president of Gibralter Business Appraisals, Inc. in Longmont, Colo.; and
  • Daniel R. Van Vleet, managing director of Duff & Phelps LLC in Chicago.— Daniel R. Van Vleet


Great Impressions: Completed close to the artist's death in 1906, Paul Cézanne's “Portrait de Vallier,” a watercolor depicting Cézanne's gardener, fetched $17.40 million at Christie's “Impressionist and Modern Art Evening Sale” on Nov. 6, 2007, in New York.