Taxes and Value: The Ongoing Research and Analysis Relating to the S Corporation Valuation Puzzle

This book is organized into eight short chapters with seven appendices. The book offers a novel approach to the valuation of pass-through entities by adjusting cost of capital measures rather than cash flows. The authors are critical of existing cash-flow-based models used to value pass-through entities as being speculative and proffer a novel approach. Much of the book is a review of published research which demonstrates that shareholder-level taxes are embedded in the rates of return of public companies. The authors state that the practice of applying cost-of-capital measures, derived from public company data, to the cash flows of privately held pass-through entities creates a mismatch which leads to incorrect outcomes. Apart from criticizing existing pass-through entity valuation models, the authors use published research to demonstrate the shortcoming of these models and propose a valuation method that entails removing the effect of shareholder-level taxes from the public company rates of return.

The first three chapters cover fundamental tenets in the valuation of pass-through entities. Chapter 1 provides an overview of existing valuation models that apply cost of capital measures, derived from public company return data, to the cash flows of pass-through entities. In Chapter 2 the authors explain implicit taxes as the difference between pre-shareholder tax returns and fully taxable returns on an identical tax favored investment. They assert that market returns can be adjusted to measure a more pure return; however, the measurement of a pure return is challenging due to factors such as changing tax regimes and difficulty in identifying marginal investors. In Chapter 3 the authors discuss how embedded shareholder-level taxes impact corporate investment decisions. The authors note the strong analytical support for shareholder-level taxes affecting the corporate cost of capital and the difficulty in quantifying this effect due to the confounding effects of holding periods and shareholder tax clienteles.

Chapter 4 is a review of published research linking shareholder-level taxes to business value. The authors focus on the literature relating to tax capitalization, which is the effect of taxes causing security prices to be lower than they otherwise would be.

Chapter 5 discusses the practical implications of the research presented in the previous chapter regarding tax capitalization. In light of this research, the authors state that those valuing privately held firms using historical public market data have two choices. One can attempt to remove the effects of shareholder-level taxes embedded in the returns. Alternatively, one can use unadjusted market returns, which warrant an adjustment to the private firm's cash flows or an adjustment to the value determination.

In Chapter 6 the authors note that a critical assumption in existing cash-flow-based models is that both public market investors and investors in pass-through entities pay taxes at the statutory rates. Premised on the research presented earlier in the book, the authors state that this critical assumption is false because a significant portion of the public market is held by institutional investors.

Chapter 7 focuses on the research of Dhaliwal, Krull, Li, and Moser (2005) that reveals a positive relationship between the cost of capital and the tax penalty. The chapter concludes with a discussion of the implications of the Dhaliwal, et al. findings for private firm valuation.

Although somewhat tautological, the themes presented in this book are condensed into the admonition that shareholder-level taxes do not affect security prices as if they were paid at statutory rates–as is commonly assumed.

In the final chapter the authors proffer a methodology for adjusting rates of return derived from historical public company data. The methodology consists of bifurcating the returns of publicly held firms into capital gain returns and divided returns. These returns are then adjusted for the effect of institutional ownership and summed in order to calculate a rate of return free of the effects of embedded shareholder-level taxes. Using an illustrative example, the authors estimate the total embedded shareholder-level taxes to be 130 basis points. Based on a 130-basis-point adjustment the authors calculate a pass-through entity premium of 8.3% based on the cost of equity and a 9.5% premium based on the weighted average cost of capital. These pass-through entity premiums are considerably lower than the premiums produced by the widely used cash-flow models that are in the range of 20% to 25%.

Because the authors proffer a novel valuation methodology, based on sound research, that produces markedly different results vis-à-vis conventional valuation models, forensic economists involved in the valuation of pass-through entities should be conversant with the topics presented. This book will also prove useful to forensic economists involved in the valuation of commercial damages and who rely on historical public-firm return data in the formulation of risk-adjusted discount rates. Forensic economists should be conversant with the effects of embedded shareholder level taxes in their damages calculations in light of this book's contribution to the business valuation literature. Because the idea of adjusting discount rates for embedded shareholder taxes is a novel concept, it has not been previously discussed in the forensic economic literature. The ideas espoused in this book are therefore a departure from conventional discount rate doctrine; hence, it would behoove forensic economists to be conversant with the ideas presented by the authors.