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Valuing Pass-Through Entities

Valuing Pass-Through Entities

Eric J. Barr

ISBN: 978-1-118-84861-6

Oct 2014

272 pages



The clarity and guidance valuation analysts have been thirsting for

The business appraisal community regularly names the valuation of pass-through entities as a major issue of concern. Courts, appraisers, and the IRS have long been at odds on the topic, and the contention within the appraisal community itself over methods and inputs further complicates the issue. Valuing Pass-Through Entities provides clarity for the analyst tasked with valuation, offering clear explanations of the different perspectives and approaches to the process.

Valuing Pass-Through Entities cuts through the chatter to:

  • Explain the advantages and limitations of different types of pass-through entities
  • Analyze the different viewpoints currently dividing the appraisal community
  • Gain a fresh perspective on landmark cases
  • Explain how to properly utilize a court-tested model
  • Examine detailed sensitivity analyses of different inputs under the income and market approaches

The book includes illustrative examples, templates, and a useful technical supplement, plus case studies that demonstrate the real-world effects of various pass-through entity valuation methods and inputs. Detailed analyses and an easy-to-apply model simplify the process while positively affecting outcomes.  The companion website provides the text of landmark court decisions, a blog featuring industry trends and tidbits, additional articles, and the insight of the author and other industry leaders.

Valuation requires the successful juggling of multiple variables, many of which can have a major impact on value. Analysts need to know how to balance each factor and apply the appropriate rates and discounts, but a lack of standard practice often leaves the issue too subjective. Valuing Pass-Through Entities clears the air, providing real-world guidelines and tools.

Foreword xi

Preface xiii

Acknowledgments xv

About the Author xvii

CHAPTER 1 Introduction 1

Definition of Value 2

Beauty and Value 2

Premise of Value 4

Approaches to Value 5

The PTE Conundrum 7

CHAPTER 2 The History of Federal Statutory Tax Rates in Maximum Income Brackets and the Evolution of Different Forms of Business Entities 11

Origins of the United States Internal Revenue Code 13

Years 1913 Through 1938 14

Years 1939 Through 1953 19

Years 1954 Through 1985 22

S Corporations 23

Tax on Unreasonable Compensation 27

General Utilities Doctrine 28

Years 1986 Through 2013 29

Limited Liability Companies 30

Summary 32

CHAPTER 3 Effective Federal Individual and Corporation Income Tax Rates 41

Effective Federal Income Taxes on $10,000 of 2012 CPI Adjusted Taxable Income, 1913–2013 42

Effective Federal Income Taxes on $100,000 of 2012 CPI Adjusted Taxable Income, 1913–2013 51

Effective Federal Income Taxes on $1 Million of 2012 CPI Adjusted Taxable Income, 1913–2013 57

Summary 67

CHAPTER 4 Comparison of Different Entity Forms 71

Business Life Cycle 71

Benefits and Limitations of PTEs 75

Financial Statements of C Corporations and PTEs 76

PTE Status and Bank Financing 78

Prevalence of PTEs 79

Change in Form of Entity 81

CHAPTER 5 Income Approach and Value to the Holder 85

Value to the Holder versus Value to the Buyer 86

Jurisdictional Issues 87

Delaware Open MRI Radiology Associates, P.A. v. Howard B. Kessler 87

Bernier v. Bernier 92

Limitations of Delaware Open MRI and Bernier 93

The Modified Delaware MRI Model 94

Flexibility of the MDMM 98

CHAPTER 6 Inputs to Modified Delaware MRI Model 101

Normalized Pretax Income 101

Entity-Level Income Taxes on Pass-Through Earnings 103

Income Retained in the Business 104

Effective Federal and State Income Tax Rates on Pass-Through Income 107

Dividend Tax Rates 111

Summary 121

CHAPTER 7 Income Approach and Investment Value 123

Measuring Investment Value 124

Deal Structure 126

CHAPTER 8 Income Approach and Fair Market Value 131

Characteristics of FMV 131

Determining FMV 134

Example of Failing to Consider Floor and Ceiling Values 135

CHAPTER 9 Fair Market Value Court Decisions 139

Number of Federal Estate and Gift Tax Returns 140

Gross v. Commissioner 141

Estate of Heck v. Commissioner 145

Wall v. Commissioner 146

Estate of Adams v. Commissioner 149

Robert Dallas v. Commissioner 151

Gallagher v. Commissioner 153

Analysis of Cases 154

CHAPTER 10 The Market Approach 157

Revenue Ruling 59–60 157

Appraisal Standards Board Standards 159

AICPA Statement on Standards for Valuation Services 160

Guideline Public Company Method 161

Guideline Public Company Method and PTE Value to the Holder 163

Guideline Public Company Method and PTE Investment Value 168

Guideline Public Company Method and PTE Fair Market Value 169

Guideline TransactionsMethod 171

CHAPTER 11 Individual State Income Taxes 175

Statutory Individual State Income Tax Rates 175

Effective Individual State Income Tax Rates 176

CHAPTER 12 Discounts, Premiums, Bylaws, and State Laws 181

PTE Agreements 181

State Law 183

Nevada Senate Bill 350 183

CHAPTER 13 Valuing Complex PTE Ownership Interests 187

Reasons for Complex Capital Structures 187

Option-Pricing Method 188

Example 1: Preferred-Member Units 190

Example 2: Joint Venture 193

Example 3: S Corporation with Unreasonable Officer/Stockholder Compensation 196

Appendix A: Checklist 199

Appendix B: Case Study: Bob's Cruises 215