Cecil v. Comm’r: The U.S. Tax Court Agrees with Taxpayers on Tax Affecting

Seven years in the making, the U.S. Tax Court opinion of Cecil v. Comm’r has recently highlighted and opined upon two very important and contentious valuation issues that will have significant implications as to how business appraisals are performed for years to come.

First, regarding the long and hotly debated topic of “tax-affecting” the cash flows of pass-through entities (i.e., assuming the cash flows of pass-through entities are subject to a hypothetical entity-level tax), it is clear that, while the Tax Court does not universally endorse the concept, it will accept tax-affecting if all credible experts in a particular tax court case make similar types of adjustments in their respective valuation opinions.

Second, for valuing noncontrolling interests in entities holding real assets that generate stable income, like real estate or timber, the Cecil opinion makes it clear that the Income Approach is the primary valuation approach that should be considered. This will be the focus of a future blog article.

Tax-Affecting is Here to Stay… Sometimes

The Tax Court was forced to reluctantly accept the commonly held view shared by valuation experts for both the taxpayers and the IRS that tax-affecting was appropriate and applicable to valuations of pass-through entities. The Tax Court is not required to accept any opinions presented by experts and has, on many occasions, exercised its right to disagree with experts based on the facts and circumstances of a particular case. But after the Cecil trial was held in 2016, the Tax Court issued its opinion of tax-affecting in 2019 in the Estate of Jones v. Comm’r. The Tax Court found that the taxpayer’s expert’s opinion of tax-affecting was persuasive. This opinion was bolstered by the fact that the IRS expert obviously also supported tax-affecting but was strategically not asked by the IRS to opine directly on this topic. This maneuver was not lost on the Tax Court.

The record-setting delay in the delivery of the Cecil opinion was, in all likelihood, due to the Court awaiting the decision of the well-publicized Michael Jackson estate tax case. In 2021, the Tax Court rendered its opinion in Estate of Jackson v. Comm’r and found that tax-affecting was not permissible. The justification for tax-affecting offered by the taxpayer’s experts was based on a rather weak argument that a taxable entity (i.e., a C corporation) would be the most likely willing buyer of the Jackson Estate’s interests in three pass-through entities. The IRS valuation experts convincingly disagreed with this assumption. As such, the Tax Court did not find the argument offered by the taxpayer’s experts sufficiently persuasive and sided with the IRS valuation experts on this particular issue.

The Irrelevance of the C Corporation Buyer

The “C corporation buyer argument” for justifying tax-affecting is not new to the Tax Court, having previously appeared in Dallas v. Comm’r. The “C corporation” argument presented by the experts in Dallas was that the company, which was an S corporation, would most likely either be purchased by a C corporation or lose its S corporation status at some point in the future. The Tax Court found this speculative reasoning without merit.

In Estate of Jones, no claim was made that the hypothetical buyer of the estate’s interest would most likely be a C corporation; nevertheless, tax-affecting was ruled to be appropriate in this case. In Cecil, no mention was made of the C corporation argument being advanced by any of the three experts.

As it turns out, the “C corporation buyer” argument only partially justifies tax-affecting and, in most cases, should not be used as the sole argument for tax-affecting the cash flows of a pass-through entity. Consideration should also be given to the fact that the market data on guideline public companies used for determining valuation multiples, discount rates or capitalization rates is derived primarily from C corporations. An adjustment must be made for this mismatch, or the result will be over-valuation. On the other hand, the tax benefits associated with the pass-through nature of the subject entity must also be recognized in the form of a positive adjustment to value.

A Two-Step Process

Thus, tax-affecting is a two-step process. The first step is to transform the pass-through entity’s cash flows to a post-corporate tax basis. The second step is to recognize and measure the tax benefits attributable to the pass-through structure of the entity and to factor the appropriate adjustment into valuation calculus. It is a widely held misconception that when using this methodology, the valuation expert must always conclude that a hypothetical willing buyer would be a C corporation. (If it could be proven unequivocally that the only possible buyer for the interest would be a C corporation, then, in that rare instance, step two of the analysis would become irrelevant.)

Apart from providing weak justifications for tax-affecting (or no justifications at all), experts on the side of the taxpayers lost a significant number of cases prior to Estate of Jones and Cecil, due to having stopped the economic analysis after completing step one. That is, they considered the value-lowering effects of having a C corporation tax rate but failed to take into account the tax benefit or liability impacting the personal tax returns of the owners of the pass-through entity. The valuation benefit of tax-affecting is likely to be overstated if there is no recognition of the fact that the economic advantage of the pass-through is its marginally lower tax rates.

The Court Endorses the SEAM Method

In Cecil, all three of the appraisers tax-affected, but one of the three stopped at step one. While the Court found this particular appraiser’s valuation analysis to have been the most persuasive of the three experts, the Court disregarded that appraiser’s tax affecting analysis since the pass-through tax benefit was ignored. The other two experts did perform step two, and both agreed that the best method to account for the “premium” associated with the Company’s S corporation status was the S Corporation Economic Adjustment Model, or “SEAM” method ((or, alternatively, the Van Vleet Method). The Court ultimately selected the SEAM-derived pass-through premium concluded by one of the experts without offering an explanation.

Note that there are other methods by which to estimate the S corporation premium –most notably the Fannon Method and the Treharne Method. All three methods have their strong and weak points but, arguably, the SEAM has a wider following among the appraisal community.

S Corporation Discount?

Somewhat ironically, after the changes of the 2017 Tax Cuts and Jobs ACT, the pass-through premium has shrunk significantly with the lowering of the federal corporate income tax rate to 21%, a level that more closely matches the taxes affecting owners of pass-through entities.

After 2025, the sun-setting of the Qualified Business Income (QBI) deduction and limited deductibility of state and local taxes would ostensibly cause the tax code to favor C corporations resulting in a “liability” rather than a benefit for owners of pass-through entities. Thus, without further changes to the tax laws, the “S corporation premium” may soon become the “S corporation discount.”

Further Reading

There have been a number of posts and articles about the Cecil case, but a particularly good one is found in the May issue of Trusts & Estates. Written by Robak, the article covers some of points addressed in this article as well as several other.

For more information about tax affecting in valuations, visit our Trusts and Estate Valuation Services page or contact us. We are here to help.

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