Valuing Pass–Through Entities

Praise for Valuing Pass-Through Entities "By any metric, the valuation process is a complicated enterprise. This book, however, elucidates this exercise, making it comprehensible to the seasoned veteran and the beginner alike. Replete with examples, this invaluable resource would be useful for any practitioner in the field." —Jay A. Soled, JD, LLM, Director, Rutgers University Masters in Tax Program "From time to time in our field, a seasoned professional provides us with a fresh set of perspectives on a worn topic that causes us to think more deeply about what we do. Valuing Pass-Through Entities is such a book. Written in a lucid, accessible style, this book provides both a comprehensive treatment of tax rules and tax court rulings and their effect on pass-through entities and a carefully considered, clearly illustrated approach to using the Delaware MRI valuation formula. A satisfying read with a wealth of food for thought and practice!" —Sarah von Helfenstein, Founder and CEO, Value Analytics & Design LLC "Eric takes us on a logical journey that allows us to better understand how the specific ramifications of state and federal tax law impact the decision to tax affect pass-through entities. He takes us from the Delaware Chancery's decision in the Delaware Open MRI Radiology case to his Modified Delaware MRI Model (MDMM). This new and cogent methodology is well explained and thought out. He provides reasoning and explanations for us to follow in order to incorporate the MDMM in our valuation report. He also provides an extensive checklist to guide us through the exercise and calculations. This will enable us to form and perfect this particular 'art' to arrive at a better conclusion of value with a supportable process." —Ronald D. Rudich, Senior Director of Business Valuation and Litigation Support, Gorfine, Schiller & Gardyn, P.A. "Eric Barr has written an excellent book examining the valuation of pass-through entities. The book includes a detailed history of corporate and individual tax rates and presents a Modified Delaware MRI Model very useful to valuation analysts. Additionally, the book includes an insightful chapter on the value to the holder standard of value. The book also presents practical case studies beneficial to practitioners in applying the MDMM analysis." —John E. Barrett, Jr., CPA, ABV, CBA, CVA, Barrett Valuation Services, Inc.

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

EERIC J. BARR is a founder and comanaging member of Fischer Barr & Wissinger LLC and is the Director of the Firm's Business Valuation and Accounting and Assurance Services departments. Barr is a nationally sought-after thought leader, lecturer and webinar presenter on accounting, forensic and valuation matters.