Tax Affecting S Corporations and Other Pass-Through Entities

Matrimonial attorneys are often confronted with equity in an S-corporation business that must be valued as a marital asset. Among the many methods an appraiser uses to analyze value, one of the most common is an income-based analysis where anticipated future earnings of the business are translated into “value.” In a single-period model, the basic equation reflects a type of earnings divided by a “Capitalization Rate.” In a multi-period model, the appraiser uses forecasts of future earnings in each year brought back to present value by a “Discount Rate.” These rates are generally determined by application of public market evidence from large C corporations that pay taxes and that the individual investor expects to pay a dividend tax. Since S corporations and other pass-through corporate structures carry no tax obligations, should the appraiser tax affect or not? Following four 1999-2002 tax court cases and subsequent similar cases, frenzy has gripped the business valuation community to develop a new theory for the valuation of S corporations and the interests in them. Expect to see some application of this theory to be employed by appraisers of S-corporation marital interests.