Winter 2023 Insights

The valuation of an S corporation ownership interest is a typical assignment in the transfer tax context. In such equity interest analyses, valuation analysts (“analysts”) typically recognize the economic benefits of the S corporation’s tax pass-through entity (“TPE”) status—compared to that of a C corporation’s income tax status. Analysts have developed a variety of procedures to quantify the value impact (typically the value increment) associated with the S corporation’s TPE status. Many of these procedures involve the following three-step process: (1) value the subject entity as if it were a C corporation, (2) separately measure some (or all) of the income tax benefits related to the subject entity’s S corporation tax status, and (3) sum the two value components in order to conclude the total value of the subject S corporation ownership interest. However, analysts sometimes neglect to account for the fact that there are negative influences—as well as positive influences—associated with an entity’s S corporation income tax status. Such negative influences include restrictions on the number of and type of company shareholders, limitations on the current shareholders’ ownership exit opportunities, inadvertent disqualification events related to the S corporation status, special tax situations upon the death of the S corporation shareholders, state income tax requirements for S corporations, and other issues that may negatively impact the value of an S corporation ownership interest. In business and security valuations developed for transfer tax (and other) purposes, analysts should be aware of—and should intentionally consider—the “cons” as well as the “pros” associated with the subject entity’s S corporation income tax status.

Damages analysts are often retained to measure the amount of economic damages suffered by the damaged party in commercial litigation claims related to either (1) a breach of contract or (2) a tort. These damages analysts can serve their clients as either (1) consulting experts or (2) testifying experts. Such analysts apply generally accepted damages measurement methods and procedures to measure the amount of the damages suffered by the injured party. If the damages measurement analysis involves a lost profits or similar damages claim, the analyst has to consider how to handle the income tax liability that will be created as a result of the damages award. That is, if the damaged party is awarded an amount equal to the analyst’s damages measurement, that award may become taxable income to the recipient. In order to return the damaged party to the economic position that the party was in before the damages event occurred, the analyst may have to adjust the recommended judicial award amount (or the negotiated settlement amount) for this income tax liability. This discussion summarizes the income tax considerations related to the damaged party’s receipt of—and the damaging party’s payment of—a damages award.

This discussion considers the application of the cost approach to appraise special-purpose industrial and commercial property. This discussion focuses on the identification and measurement of economic obsolescence within application of the cost approach. This topic is particularly relevant to the unit principle appraisals of public utility and utility-type property for state and local ad valorem tax purposes. After considering the differences between unit principle property appraisals and summation principle property appraisals, this discussion describes and illustrates the generally accepted economic obsolescence measurement methods (with particular emphasis on the capitalization of income loss method). Appraisers who develop unit principle property appraisals have to be able to (1) identify and distinguish (qualitatively and quantitatively) the various elements (or types) of obsolescence in a cost approach analysis of special-purpose industrial and commercial property, (2) explain and apply the generally accepted economic obsolescence measurements methods, (3) report and defend the economic obsolescence measurement analysis in a unit principle property tax appraisal, and (4) respond to typical taxing authority objections related to the proposed economic obsolescence adjustment.

Fair value measurements are developed for numerous financial-accounting-related purposes. This discussion summarizes valuation analyst (“analyst”) best practices related to the development and the reporting of such fair value measurements. These best practices are intended to assist analysts to avoid the more typical errors and omissions related to such financial-accounting-related assignments. This discussion focuses on fair value measurements developed in compliance with Financial Accounting Standards Board Accounting Standards Codification topic 805, Business Combinations. However, most of the recommended analyst best practices also apply to fair value measurements developed for many financial accounting purposes.

Valuation, damages, and transfer price analyses—whether developed for transaction, litigation, taxation, financial accounting, regulatory compliance, or business planning purposes—should encompass (1) a reasonableness assessment of the relevant facts and circumstances, (2) compliance with relevant professional standards and application of generally accepted approaches and methods, and (3) due diligence related to the selected economic analysis variables. These selected economic analysis variables are sometimes referred to as analysis assumptions or analysis inputs. Insufficient due diligence of and inadequate support for the selected economic analysis variables can cause a transaction counterparty, another analyst, the Internal Revenue Service, a judicial finder of fact, a government regulator, or any other party to doubt the analyst’s conclusions. Supporting the selected economic variables with appropriate due diligence procedures is an important procedure in any valuation, damages, or transfer price analysis. Such due diligence may be particularly challenging during periods of significant economic uncertainty and volatility.

The U.S. Tax Court decision in Clary Hood, Inc. v. Commissioner provides important practical guidance to private companies and to private company owners—and to their legal, accounting, and compensation advisers—regarding the reasonableness of executive/shareholder compensation income tax deductions. In this decision, the Tax Court provides a fulsome discussion of its application of the so-called multifactor approach to reasonableness of executive compensation analysis. This judicial decision also provides important practical guidance to forensic accountants, financial analysts, valuation analysts, and other professionals who provide testifying expert services in reasonableness of executive compensation (and in other) federal taxation disputes.