When reading the U.S. Tax Court decision in Gallagher v. Commissioner,1 I was reminded of the 1993 comedy “Groundhog Day.” As you may recall, Phil Connors (played by Bill Murray) is a TV weatherman who finds himself repeating the same unpleasant day over and over again when covering the annual Groundhog Day event in Punxsutawney, Pa. Gallagher is similar to the movie in that we seem to be stuck in a perpetual time loop with respect to the valuation of equity interests in S corporations. Valuation experts continue to make the same mistakes over and over again as if endless repetition will eventually break the will of the Tax Court. Nothing, it appears, could be further from the truth.



As of the date of death on July 5, 2004 (the valuation date), Louise Paxton Gallagher (the decedent) owned 3,970 units of Paxton Media Group, LLC (PMG). Her ownership interest represented approximately 15 percent of the 26,439 outstanding units of the company. PMG was a family-held company that published newspapers and owned and operated a television station. As of the valuation date, PMG reported approximately $169 million in revenues and $74 million in equity.

The estate tax return reported the fair market value of the decedent’s units at $34.9 million or $8,800 per unit. This value was based on an appraisal conducted by PMG’s chief executive officer, David Paxton. Although not stated in the published opinion, the similar last names suggest that David Paxton was a relative of the decedent. The Internal Revenue Service audited the return and sent a notice to the estate that proposed a $49.5 million value for the decedent’s units and assessed a tax deficiency of nearly $7 million.

Prior to the start of trial, the estate obtained an appraisal from Richard C. May, who valued the decedent’s units at $28.2 million. The IRS also obtained an appraisal from John A. Thomson, who valued the decedent’s units at $40.9 million, which was nearly $9 million less than the $49.5 million the IRS had initially determined. Both experts used the discounted cash flow (DCF) method of business valuation in their respective analyses.

For those not familiar with business valuation, the DCF method involves projecting the revenues and earnings of a company over future periods. The nominal amounts of these projected earnings are then reduced (that is, discounted) using a discount rate that reflects business investment risks and the time value of money. The sum of these discounted projected earnings provides an estimate of the company’s value.   

In Gallagher, there were disputes among the experts regarding which projected revenue growth rates, profit margins and cash flow adjustments to use in the DCF method. These types of disputes are typical in adversarial situations and are somewhat mundane. The more interesting dispute relates to the issue of tax-affecting. In this context, tax-affecting involves reducing the projected earnings of an S corporation using a measurement of estimated income taxes. As you might expect, tax-affecting lowers the appraised value of an S corporation when all other factors are held constant. In Gallagher, May tax-affected the projected earnings whereas Thomson didn’t.



Tax-affecting the projected earnings of an S corporation in the DCF method has been the subject of significant controversy within the valuation profession and the IRS  ever since the Gross v. Commissioner2 decision in 1999. This issue is significant in the estate and gift tax environment because tax-affecting can have a material impact on the appraised value of a company. “A Question of Value,” this page, illustrates the valuation significance of tax-affecting versus not tax-affecting.

As “A Question of Value” demonstrates, both scenarios begin with company revenues of $300,000, operating expenses of $200,000 and before-tax income of $100,000. The tax-affected analysis is reduced by $35,000 based on an income tax rate of 35 percent, which results in net income of $65,000. The untax-affected analysis is based on an income tax rate of zero, which results in net income of $100,000. These earning measurements are then capitalized (that is, converted into an indication of business value) using a valuation multiple of 10, which results in company values of $650,000 and $1 million, respectively. As demonstrated, the indication of value for the untax-affected scenario is 53.8 percent higher than the tax-affected scenario. Although “A Question of Value” doesn’t reflect the mechanics of the DCF method, the valuation impact of tax-affecting versus not tax-affecting is conceptually the same.

Given that S corporations aren’t taxable entities,3 the court has consistently questioned the propriety of tax-affecting ever since Gross. In Gallagher, Judge James S. Halpern, citing Gross, stated: 


Absent an argument for tax-affecting PMG’s projected earnings and discount rate, we decline to do so. As we stated in Gross v. Commissioner, the principal benefit enjoyed by S corporation shareholders is the reduction in their total tax burden, a benefit that should be considered when valuing an S corporation. Mr. May has advanced no reason for ignoring such a benefit, and we will not impose an unjustified fictitious corporate tax rate burden on PMG’s future earnings.


At first blush, this statement seems to reject the use of tax-affecting. However, Judge Halpern also stated: 


Since most data on which stock valuation is based is derived from publicly traded C corporations, appraisers may tax-affect an S corporation’s earnings to reflect its
S status in its stock value.


It seems clear that Judge Halpern hasn’t ruled out the concept of tax-affecting the projected earnings of S corporations, when C corporation empirical data is used in the valuation analysis. However, it’s equally evident from Gallagher—as well as multiple other Tax Court decisions4—that an S corporation valuation report must contain conceptually sound reasons for doing so.


Tax Attributes

To understand the reasons for tax-affecting, it’s necessary to have a general understanding of the valuation-related tax differences among S corporations, C corporations and their respective shareholders.

C corporations are subject to corporate-level income taxes. After paying corporate income taxes, the remaining income is used to pay dividends or is retained by the company. When the company retains earnings, the value of the company necessarily increases, which results in an increase in the value of equity (a capital gain). C corporation shareholders are subject to income taxes on both dividends and equity capital gains. This second layer of taxation at the shareholder level is referred to as “double taxation.”

 S corporations are different from C corporations in that they aren’t subject to income taxes at the corporate level. The reported earnings of an S corporation are “passed through” to the personal income tax returns of its shareholders based on their pro rata ownership interest. In essence, the shareholders pay the corporate income taxes of the S corporation at ordinary income tax rates. Since the current C corporation income tax rates and personal ordinary income tax rates are essentially equivalent, C corporation and S corporation shareholders are in a roughly equivalent position at this point in the discussion. However, S corporation shareholders have a tax advantage over C corporation shareholders regarding double taxation. Generally speaking, S corporation shareholders don’t pay taxes on dividends (referred to as distributions by S corporations). Also, when an S corporation retains income—rather than paying distributions—the tax basis of its shares increases, which permits its shareholders to avoid capital gains taxes upon sale of their shares. Consequently, the S corporation shareholder avoids the double taxation treatment of C corporation shareholders.

The income tax treatments of C corporations, S corporations and their respective shareholders are different. In addition, these income tax attributes have a material impact on the value of their respective equity securities. Consequently, since C corporation market data is used in the valuation of S corporations, the beneficial income tax attributes of S corporations and their shareholders must be properly addressed in the analysis to conclude reliable indications of S corporation equity value. To do this correctly, the projected S corporation earnings used in the DCF method must first be tax-affected.


Why Tax-Affect?

The reasons for tax-affecting S corporation projected earnings are: 


1. The discount rate used in the DCF method is derived from empirical studies of market investment rates of return of publicly traded equity securities.


2. Publicly traded equity securities are issued by C corporations, which are subject to federal, state and local income taxes at the corporate level. Consequently, the discount rate used in the DCF method explicitly reflects C corporation income tax attributes.


3. Given this tax attribute, the discount rate may only be properly applied to measurements of income that also specifically reflect C corporation income taxes. Failure to do so results in an indication of value that lacks definition, is mathematically incorrect and is conceptually flawed.


When the projected earnings of an S corporation are tax-affected and discounted in the DCF method, the resulting indication of value is a C corporation equivalent value. In other words, this is the value of the S corporation as though it were a C corporation.  This indication of value is incomplete in that it fails to reflect the beneficial tax attributes of S corporation shareholders regarding double taxation. Consequently, this C corporation equivalent value must be adjusted to conclude a value that is conceptually reliable for S corporation shares. To do this, the adjustment must reflect the income tax differences among C corporations, S corporations and their respective shareholders.


Supportable Adjustment

The income tax attributes of S corporation shareholders result in higher after-tax investment returns when compared to C corporation shareholders. “Incremental Benefit,” p. 30, illustrates this investment return benefit.

The shareholder investment return after all corporate and personal income taxes for C corporation and S corporation shareholders is $55,250 and $65,000, respectively. Consequently, the S corporation shareholder enjoys an after-tax investment return that’s 17.6 percent higher than the C corporation shareholder. This incremental return is precisely the benefit that Judge Halpern was referring to in Gallagher when he stated: 


… the principal benefit enjoyed by S corporation shareholders is the reduction in their total tax burden, a benefit that should be considered when valuing an S corporation.


I agree with Judge Halpern’s statement. However, not tax-affecting the projected earnings in the DCF model—as done in Gallagher—substantially overstates the value of S corporation equity. “A Question of Value” and “Incremental Benefit” illustrate this conclusion by demonstrating the inconsistency between the incremental value derived by not tax-affecting and the incremental investment return enjoyed by S corporation shareholders. In other words, it’s inconsistent to conclude that S corporation equity is worth 53.8 percent more than C corporation equity when the after-tax investment return derived by S corporation shareholders is only 17.6 percent greater than the return derived by C corporation shareholders.

“After-Tax Investment,” p. 32, demonstrates that when the C corporation value of equity is adjusted using a factor that’s consistent with the incremental benefit enjoyed by S corporation shareholders (that is, 17.6 percent based on the example illustrated in “Incremental Benefit”), S corporation and C corporation shareholders earn an equivalent after-tax investment rate of return.

Given the income tax rates assumed in “Incremental Benefit” and “After-Tax Investment,” a conceptually supportable adjustment to the C corporation equivalent value of equity for an S corporation would be 17.6 percent. Of course, this adjustment would be different if other tax rates were used in the analysis. Based on my review of Gallagher, the Thomson and May analyses failed to fully reflect these concepts. 


So What Happened?

Based on my reading, neither expert in Gallagher used models that properly reflected the full spectrum of tax benefits enjoyed by S corporation shareholders. In addition, my understanding is that the models both experts used hadn’t undergone any form of peer review. Consequently, in a manner consistent with earlier S corporation decisions, the court, once again, decided that not tax-affecting was more correct than tax-affecting.  

A full discussion of the analysis reflected in the May and Thomson reports is well beyond the scope of this article. However, here are brief summaries of the tax-affecting issues. 

The May report contained adjustments that attempted to capture the S corporation tax benefits and provide justification for tax-affecting. These adjustments included calculating the hypothetical C corporation dividend taxes avoided by PMG shareholders based on the expected distributions to be paid by PMG. Unfortunately, these adjustments didn’t provide sufficient conceptual justification for tax-affecting S corporation projected earnings. As previously discussed, the earnings of an S corporation are tax-affected so that they’ll be mathematically and conceptually consistent with the C corporation discount rate used in the DCF method. Also, the C corporation equivalent value that results from this analysis must be adjusted to reflect the full spectrum of beneficial tax attributes of
S corporation shares. The May report failed to conduct the analysis in this manner, and the court wasn’t convinced that the adjustments were either conceptually supportable or reliable. Consequently, the court removed the tax-affect adjustment from the projected earnings. This adjustment resulted in the largest proportion of the increase in value provided by the May report.

The Thomson report attempted to capture the S corporation tax benefits by adjusting the discount rate used in the DCF method. This adjusted discount rate was then applied to the projected earnings of PMG that weren’t tax-affected. The adjustments to the discount rate appeared to be subjectively determined with little empirical support to back them up. Judge Halpern also stated that he was “not convinced as to the accuracy of his analysis” regarding this component of the discount rate. In addition to these issues, the application of a C corporation discount rate to measurements of earnings that aren’t tax-affected is mathematically incorrect, conceptually flawed and foundationally unreliable. No manner of adjustments to the discount rate can correct this flaw. Consequently, the resulting indication of value provided in the Thomson report is unreliable.

Given the deficiencies of the S corporation analysis both experts submitted,  the court was left with the decision of whether to tax-affect or not tax-affect. Consistent with earlier rulings in Gross and multiple other Tax Court cases, Judge Halpern removed the tax-affect and recalculated the equity value of PMG. Judge Halpern made other adjustments as well and essentially created his own DCF method based on selected components of the analysis each expert provided. 

The Gallagher opinion, as amended, contains an appendix that illustrates the DCF method Judge Halpern used to estimate the $35.8 million value of the decedent’s ownership interest. I used his DCF method to conduct the analysis on a tax-affected basis using the same corporate, individual and shareholder tax rate assumptions contained in “Incremental Benefit.” To conduct the analysis properly, it was necessary to tax-affect both the earnings and the discount rate used by Judge Halpern in his analysis. Based on these calculations, the value of the decedent’s ownership interest would have been $29.9 million. Interestingly, this value is within 5 percent of the $28.2 million value concluded in the May report. Also of interest is the fact that the $35.8 million value eventually concluded by Judge Halpern is within 3 percent of the $34.9 million value originally reported on the estate’s tax return.


Issue Unresolved

Gallagher offers some interesting insights into the Tax Court’s current thinking regarding the valuation of S corporations. Unfortunately, the tax-affecting issue remains unresolved, because the court wasn’t convinced that the S corporation analysis provided in both expert reports was accurate and adequately supported. The Tax Court has been consistent since 1999 in stating that it won’t allow the projected earnings of an S corporation to be tax-affected in a DCF method unless there’s a conceptually sound argument for doing so.

Currently, business valuation experts are moving in the direction of tax-affecting and quantifying the
C corporation equivalent value of S corporation equity and then making appropriate valuation adjustments to reflect the tax differences among C corporations, S corporations and their respective shareholders.
In my view, this is a move in the right direction and consistent with good analysis and the direction of the Tax Court. There are S corporation models that conduct the analysis in this manner, including the S Corporation Economic Adjustment Model (SEAM) I developed, as well as models developed by Chris Treharne and Roger Grabowski. Each of these models has undergone substantial peer review in the business valuation community.

Regardless of the S corporation model or method used in the analysis, it’s important that the valuation report include a conceptually sound discussion regarding the decision to tax-affect the projected earnings used in the DCF method. Failure to do so may have undesirable results with the IRS and the Tax Court.



1. Estate of Louise Paxton Gallagher et al. v. Commissioner, T.C. Memo. 2011-148, amended by T.C. Memo. 2011-244.

2. Walter L. Gross, Jr. et al. v. Comm’r, T.C. Memo. 1999-254, aff’d 272 F.3d 333
(6th Cir. 2001).

3. S corporations aren’t subject to federal income taxes, but may be subject to income taxes at the state level. For the purposes of my discussion in this article, I’ve assumed that S corporations aren’t subject to either state or federal income taxes. 

4. Gross, supra  note 2; Estate of Richie C. Heck v. Comm’r, T.C. Memo. 2002-34; Estate of William G. Adams, Jr. v. Comm’r, T.C. Memo. 2002-80; John E. Wall v. Comm’r, T.C. Memo. 2001-75; Robert Dallas v. Comm’r, T.C. Memo. 2006-212.