In Brief

One of the key elements of the Tax Cuts and Jobs Act of 2017 is its lowering of corporate tax rates. As a result, the valuation of pass-through entities may now be simplified, as the more complex models used in the past to compare pass-through entities to C corporations should no longer be necessary. The author argues that, in the current environment, the IRS should reconsider its position on tax effecting, an approach which will likely lead to more accurate valuations of pass-through entities such as service companies, which will not receive the most beneficial treatment under the TCJA.


One effect of the passage of the Tax Cuts and Jobs Act of 2017 (TCJA) may be to simplify the process for valuing certain pass-through entities. Under the new tax rates, there should be no valuation premium awarded to the pre-tax earnings of those pass-through entities whose shareholders cannot use the new 20% qualified business income (QBI) deduction for income from pass-through entities, as compared to C corporations. As a result, the procedure of tax effecting the earnings of these entities is now a logical step in the valuation process. These circumstances would pertain to many pass-through service companies, as well as those subject to limitations on the QBI deduction due to low wages. For those pass-through entities where the benefit of the new 20% QBI deduction is expected to be usable, the author believes that a procedure of partial tax effecting, at a rate less than the 21% corporate rate, would be appropriate. This article explores the situation under the new TCJA rates.

Nature of the Valuation Issue for Pass-through Entities

A common method of valuing companies is the income approach, which relies on estimating future income and then applying an appropriate discount rate to obtain a discounted present value. Valuation experts often look to public company data, such as that compiled by Duff & Phelps, for data on discount rates.

One issue with this procedure is that public company data comes primarily from C corporations and therefore measures returns that investors have obtained after corporate-level taxes but before personal taxes on corporate dividends and capital gains. The tax situation for pass-through entities (e.g., partnerships, limited liability companies, sub-chapter S corporations) is different. According to IRS statistics, of the approximately 33.4 million business returns filed in 2013, only about 1.6 million were from C corporations (see IRS Integrated Business Data, Table 1: Selected financial data on businesses, The other 95% were from sole proprietorships (72%), S corporations (13%), and partnerships (10%). Pass-through entities do not pay corporate income taxes, and their owners are taxed on the entities’ income in their personal tax returns, whether that income is distributed or not. As a result, an adjustment to income or discount rates may be needed before a valuation analyst can apply discount rates based on public companies to pass-through entities.

Under the right set of tax rates, a simple and straightforward way to deal with the different tax situations of C corporations and pass-through entities in the valuation process is to impute a corporate-level tax on the pass-through entities’ earnings and then apply a discount factor based on public company data. This is called “tax effecting.” Tax effecting was for many years the normal process in valuation, and was accepted by courts and the IRS. Later, however, the IRS came to reject tax effecting; in the 1999 case of Walter L. Gross Jr., et al. v. Comm’r [78 TCM (CCH) 201 (1999)], the Tax Court upheld the IRS’s position that a pass-through entity should be valued without imputing corporate taxes, the result of which is, clearly, an increase in the entities’ estimated values.

Since Gross, the courts and the valuation community have held several differing positions regarding the valuation of pass-through entities. The IRS has consistently argued that there should be no tax effecting, and the Tax Court has upheld this position in several cases. Some valuation experts have continued to argue that tax effecting is appropriate, and this position has been upheld in some valuation cases in other courts. Still other experts have argued that pass-through entities’ valuation should reflect a premium due to their different tax status, but that the premium implied by ignoring corporate taxes entirely is too large; they recommend measuring the premium by carefully considering the tax rates applicable to the case at hand. This can be done by imputing a tax lower than the corporate tax rate (i.e., partial tax effecting), by adjusting the discount rate, or by other means. Some court decisions have followed this approach. The PPC Guide to Business Valuations summarizes the current situation as follows:

Most valuation practitioners compensate for the pass-through entity level tax advantages by applying a premium to the pass-through entity’s tax-effected value, when appropriate. However, there seems to be little consensus as to which model or method should be used to arrive at the appropriate premium, if any.

Some valuation experts have continued to argue that tax effecting is appropriate, and this position has been upheld in some valuation cases in other courts.

Impact of Tax Rates on the Propriety of Tax Effecting

The examples in this section demonstrate the relation between tax rates and the validity of using tax effecting in valuation. As illustrated by the examples below, in some time periods, the combination of personal, corporate, and capital gains rates worked to allow the owners of pass-through entities to keep more pretax earnings than the owners of otherwise identical C corporations. Prior to 1980, pass-through entities had no significant advantage. At this time, tax effecting earnings was an appropriate way to value the companies’ pretax income and avoid ascribing a premium to the earnings that was not real. From 1986 to 1993, the advantage of pass-through entities was so large that valuing the pretax earnings and assuming zero corporate tax (not tax effecting) was sensible. From 1994 to 2017, the owners of pass-through entities had an advantage, but it was smaller than simply “not tax effecting” would provide. Partial tax effecting, in some way, would have been reasonable. Under the TCJA rates, from 2018 onwards, large pass-through entities will have no significant advantages over C corporations in their ability to provide after-tax returns to owners. Tax effecting will again be appropriate.

The Exhibit compares the after-tax cash returns of the owners of a pass-through company with $10 million of pretax income to the returns of the owners of an otherwise identical C corporation under certain simplified assumptions:

  • State and local taxes are ignored.
  • The owners are in the top tax brackets.
  • Any after-tax income that is not distributed by a C corporation will eventually result in capital gains to the owners, and capital gains taxes will be computed without any discounting.
  • Funds left in a pass-through entity add to the owners’ basis and are not later subject to capital gains taxes.


Illustrative Case of Company in Different Time Periods, with $10 Million Pretax Income Dividends Equal to Owners’ Personal Tax Burden, Except 1980*

1980/81; 1988; 2002; 2004–2010; 2013–2017; 2018, no pass-through benefit; 2018, with pass-through benefit Panel A—Enacted tax rates (maximums) Individual; 70.0%; 28.0%; 39.0%; 35.0%; 39.6%; 37.0%; 29.6% Corporate; 48.0%; 34.0%; 35.0%; 35.0%; 35.0%; 21.0%; 21.0% Capital gains; 37.0%; 28.0%; 15.0%; 15.0%; 20.0%; 20.0%; 20.0% Dividends received; 70.0%; 28.0%; 39.0%; 15.0%; 20.0%; 20.0%; 20.0% Net investment income tax (NIIT); -; -; -; -; 3.8%; 3.8%; 3.8% Panel B—Computation of after-tax returns to owners of pass-through entity (dollars in thousands) Tax on pass-through income; $7,000; $2,800; $3,900; 3,500; 4,340; 4,080; 3,340 After-tax cash return to owners; $3,000; $7,200; $6,100; 6,500; 5,660; 5,920; 6,660 Panel C—Computation of after-tax returns to owners of C Corporation (dollars in thousands) Entity tax; $4,800; $3,400; $3,500; $3,500; $3,500; $2,100; $2,100 After-tax income; $5,200; $6,600; $6,500; $6,500; $6,500; $7,900; $7,900 Assumed dividend*; $0*; $2,800; $0*; $3,500; $4,340; $4,080; $3,340 Income left in company; $5,200; $3,800; $6,500; $3,000; $2,160; $3,820; $4,560 Personal tax & NIIT on dividends; $0; $784; $0; $525; $1,033; $971; $795 Capital gains & NIIT on retained funds; $1,924; $1,064; $975; $450; $514; $909; $1,085 Net after-tax cash return to owners; $3,276; $4,752; $5,525; $5,525; $4,953; $6,020; $6,020 Panel D—Measures of pass-through advantage, if any Ratio: pass-through return ÷ C corporation return; 0.92*; 1.52; 1.10; 1.18; 1.14; 0.98; 1.11 Implication for tax effecting; Full; None; Partial; Partial; Partial; Full; Partial *The most tax-effective strategy for a C corporation in 1980 and 2002 would have been to pay zero dividends. For other years, dividends are assumed to equal the personal tax liability of the pass-through entities.

The first column of the Exhibit reflects the tax rates in effect in 1980 and 1981. A pass-through entity’s owners would have paid taxes of $7 million and kept $3 million of the entity’s $10 million of earnings. An identical C corporation would have owed $4.8 million in corporate income tax, and the eventual capital gains taxes on the $5.2 million of income retained in the company would have been $1.924 million. The C corporation’s owners would have retained, after taxes, $3.276 million, which is more than the pass-through entity’s owners. This advantage would have been reduced, or become a disadvantage, however, if the company paid more dividends, because dividends were taxed at 70% and capital gains were taxed at 37%. The upshot is that the C corporation’s owners could be at least as well off as the owners of a pass-through entity under these tax rates, and there was no reason for a valuation premium on pass-through entities. Under these tax rates, a sensible way of avoiding ascribing a premium to the earnings of the pass-through entities was to tax effect the earnings. (There was also no net cash advantage for owners of pass-through entities over shareholders of C corporations that chose tax-optimal dividend policies in the period from 1960 to 1980, and thus tax effecting was also appropriate in this earlier period.)

The next column of the Exhibit, for 1988, reflects the impact of the Tax Reform Act of 1986, which lowered rates and also equalized the treatment of capital gains and ordinary income for individuals. In 1988, the tax paid by owners of a pass-through entity on $10 million of entity income would have been $2.8 million, leaving $7.2 million after taxes. (The author has assumed that the pass-through entity would pay dividends sufficient to allow the owners to pay their taxes, although this payment does not affect the total taxes they owe.) Assuming that a C corporation also paid $2.8 million in dividends, then the following taxes would have been applicable: $3.4 million of corporate income tax; $784,000 of personal taxes on dividends; and eventually $1,064,000 of personal capital gains taxes on the $3.8 million of earnings left in the company. This means that the owners of the C corporation would have been left with only $4.752 million, after taxes, far less than the $7.2 million retained by owners of pass-through entities. The ratio of cash retained by the owners of pass-through entities to C corporation owners is 1.52; this is equivalent to the ratio of pretax income to income after corporate tax at a 34% rate (1 divided by 0.66). In other words, a valuation expert could get the premium ratio of 1.52 simply by not imputing any tax effect to pass-through earnings. (Note that this only works mathematically when the individual rate, capital gains rate, and dividend rate are the same).

The next column of the Exhibit reflects the tax rates in effect in 2002. Both top individual rates, and the related taxes on dividends, were higher than in 1988, but capital gains rates had fallen. Under these circumstances, the most tax-effective procedure for a C corporation was to pay zero dividends. Following the same process used in the previous periods, owners of pass-through entities would clear $6.1 million after taxes, approximately 10% more than the $5.525 million of after-tax returns to owners of C corporations. While there is a premium attributable to the pass-through company earnings, it is not as high as what would have been computed if zero taxes were imputed. Instead, the premium is equivalent to assuming that the pass-through entity paid corporate taxes of 28.2%, rather than the statutory 35%. In other words, partial tax effecting would have been appropriate.

In the 2004–2010 period, the top individual rate was somewhat lower, and the tax rates for dividends equaled the rates for capital gains. The computations and results are similar to those for 2002. Since the tax rates on capital gains and dividends were equal, dividend strategy did not affect the results. The net after-tax return to the pass-through owners would have been $6.5 million, which is 1.18 times the $5.525 million in returns for C corporation owners. As in the prior period, this means that the premium to pass-through status was not as much as what would be computed from full tax effecting. Instead, partial tax effecting at a 23.5% rate, rather than the statutory 35%, would have been appropriate.

In 2013, there were various changes in tax rates that remained in effect through 2017. One was the enactment of the 3.8% net investment income tax (NIIT). It is assumed throughout that this tax is applicable to capital gains, dividends, and pass-through income, because the pass-through income will be treated as passive earnings. Again, because tax rates on dividends and capital gains were equal, dividend strategy did not affect the results. Under these circumstances, after-cash returns to pass-through owners would have been $5.66 million, or 1.14 times the $4.953 million in returns to C corporation owners. Once again, partially tax effecting at a 25.7% rate would have been appropriate.

The law gives a special 20% QBI deduction for earnings from pass-through entities, but this benefit will not be applicable to owners of all pass-through entities.

In 2018, under the TCJA, there are various changes. The top individual rate is 37%, and the corporate tax rate is 21%; the NIIT and top capital gains rates are unchanged. It is assumed that the 2018 rates will continue indefinitely, even though personal rates are scheduled to change over the next 10 years. The law also gives a special 20% QBI deduction for earnings from pass-through entities, but this benefit will not be applicable to owners of all pass-through entities. For example, many service companies are, by statute, not eligible for this deduction; the law also limits the deduction in cases where companies pay relatively little in wages. Therefore, the Exhibit contains computations both for companies where the 20% deduction is applicable and where it is not.

The end result is that, in 2018, C corporation owners will end up with slightly more after-tax cash than would owners of pass-through entities who are not able to use the 20% QBI deduction. The after-tax return to the pass-through owners will be $5,920,000, or 98% of the $6,019,800 retained by the C corporation owners. Under these circumstances, there is no premium to pass-through company earnings. Similar to the situation in 1980 and earlier, the easiest method of valuation would be to tax effect the pass-through entity earnings at the statutory corporate rates.

In cases where owners of pass-through entities are able to use the 20% QBI deduction, however, they should receive approximately 11% higher after-tax returns than owners of similarly situated C corporations. Out of the $10 million in pre-tax income, pass-through owners will have returns of $6.66 million, versus $6.02 million for C corporation owners. In this situation, as in 2002–2017, partial tax effecting to a tax rate of 12.6% would be appropriate. This is less than in 2017, which reflects the greater relative advantage of the pass-through form at the lower rates and when the 20% deduction is applicable.

Going Forward

The argument for the use of tax-effecting the earnings of pass-through entities for valuation purposes has varied over the last five decades based upon the prevailing tax rate environment. In 1980 and earlier years, there was no reason to assume pass-through entity earnings deserved a valuation premium, and tax-effecting by assuming pass-through income was subject to full corporate tax rates was a straightforward way of avoiding imputing an improper valuation premium. Over the last four decades, there have been periods when it may have been appropriate to assume pass-through income was subject to zero corporate taxes, and also periods when it was appropriate to tax-effect pass-through earnings at some fraction of the full corporate rate. During the 19 years since Gross, valuation experts and courts have come up with a variety of approaches to this valuation issue.

Based on the above analysis, under the rates set by the TCJA, the use of tax effecting will depend on whether it is reasonable to assume that the 20% deduction for pass-through income will be applicable. When it is not applicable, as in the case of many service companies, the earnings of large pass-through entities will not deserve any valuation premium, and tax effecting at the full corporate rate will be appropriate. Where the 20% deduction is expected to be usable after the valuation date, then partial tax effecting will likely be appropriate.

Given the above analysis, it is hoped that the IRS and the Tax Court will reexamine their positions on tax effecting in light of the changed law.

Daniel Tinkelman, PhD, CPA is an associate professor at the Murray Koppelman School of Business, Brooklyn College CUNY, Brooklyn, N.Y.