A Working Holiday – Independence Day and the I.R.C.

Thoughts of Independence Day evokes thoughts of watermelon, fireworks, barbecue and time with family and friends .  Every once in a while, however, the heavens are aligned  in such a way that a work crisis happens at exactly the same time as a major holiday.  So this holiday I have not spent time eating watermelon, or barbecue or shooting off fireworks but rather I have spent my time writing a brief for a case which “must be closed’ immediately.  However,  I have no complaints because the issue involved is one which I find extremely interesting and enlightening as It has to do with valuing an interest in  a corporation and determining the amount of income from an S corporation to be used as a variable in a formula used to compute the value of the company.  Lets break that down:  the chapter of the Internal Revenue Code (IRC as it is affectionately known by tax lawyers and CPA s) under which the tax treatment of a corporation is determined is known as chapter C.   That chapter pretty much governs the tax treatment of all corporations and provides rules for determining if a corporation is a corporation for federal tax purposes. Within that chapter is a section known as sub chapter S which allows for a special kind of tax treatment when the corporation meets certain criteria such as having no more than a set number of shareholders and only one class of stock.  If a corporation makes an election to be treated as an S corporation then the corporation no longer pays taxes on its income.  However, the income passes through the corporation to the shareholders in proportion to their shareholdings.  The shareholders then report the income on their individual income tax returns and pay tax on it at their tax rate,  Ordinarily, a C corporation (a regular corporation receiving tax treatment under  Chapter C) must include in income and pay tax on amounts distributed to its shareholders in the nature of dividends.  The shareholder also, must report a distribution of income from the corporation on their tax return and also pay tax on it. So making the S election can save money in terms of a reduced overall tax bill  Now the plot thickens.   When the interest in an S corporation becomes part of a decedent’s estate, and must be valued. the question becomes how do you go about this.   One way many appraisers prefer to use is called an income approach.  The income approach has a number of variables but one is called a discounted cash flow analysis.  In that approach the average or mean cash flow of the corporation is determined and then it is plugged into a formula which determines the present value of that cash flow for a given number of periods with the last period stretching into the future.  One of the big issues here is how to go about determining the net cash flow of the company.  In making that determination with regard to an S corporation many appraisers will reduce the amount of the earnings by an estimated income tax rate.  In their mind this is necessary to equalize the tax treatment of S corps and C corps. They reason that since the interest rate and other variables in the formula are determined using measures based in the earnings of C corporations the “tax affecting” of the S corps income s necessary to level the playing field.  However, the government, specifically the Internal Revenue Service, takes a contrary position.  Based on a number of cases coming out of the United States Tax Court reducing the earnings in this situation is a no no. And, that is the issue I have been grappling with these past few days. In some ways it has been a fascinating ride but in others a real drag having to sit inside for long hours when it seems everyone else are out and about and celebrating independence. Jokingly, I tell my life that a woman works from sun to sun but a lawyer’s work is never done. ( no chauvinism here) She is not amused and rightly so as work around the house is really never done. So while I have lost the chance to engage in the activities of one of my favorite holidays I, on the other hand,  have gained a great deal of knowledge about a very interesting area of law.

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