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This paper presents an economic argument for how a discounted cash flow (DCF) analysis should properly account for taxes when valuing an S corporation. Through a simple numerical example, we demonstrate that ignoring taxes in a DCF analysis when valuing an S corporation potentially leads to an overestimation of value. To produce more meaningful valuation estimates, we propose that any DCF analysis used to value an S corporation should adjust cash flows to reflect its owners' personal tax burdens. Our approach has the possibility to affect litigation outcomes irrespective of whether the valuation estimates are used independently or in comparison to market prices. The advantage of our approach is that it results in claimants being "made whole" and nothing more.
Introduction
The discounted cash flow (DCF) method for valuing an asset takes the expected future cash flows that the asset will generate, and discounts them back to the present at an appropriate cost of capital to produce an estimate of current value. While the use of the DCF method has become increasingly common in U.S. courts, certain aspects of how the valuation technique is implemented are still being debated.89 For example, questions still remain about the treatment of taxes when valuing a partnership or S corporation using the DCF method.90 Partnerships and S corporations are not taxed at the corporate level.91 Instead, income for these entities is passed through to owners and taxed at the individual level in the year that it is earned. Is it appropriate, therefore, to ignore taxes when valuing a partnership or S corporation using the DCF method because, strictly speaking, these entities do not pay taxes? Alternatively, should a DCF analysis account for taxes when valuing a partnership or S corporation because the price a rational economic agent would be willing to pay for such an enterprise reflects its ultimate tax burden, regardless of where taxes are actually paid?
The U.S. Court of Appeals for the Sixth Circuit touched upon these questions in Gross v. Commissioner, an appeal of a 1999 United States Tax Court decision.92 The case involved a dispute between taxpayers and the Internal Revenue Service (IRS) over the fair market value of shares of stock in an S corporation for gift tax purposes. Valuation experts...