Tax affecting has been narrowly applied in Tax Court, and the IRS opposed it for many years. The IRS has apparently turned the corner, as its expert in the Pierce v. Commissioner, T.C. Memo. 2025-29 tax affected S corporation earnings. This shouldn’t be construed as them caving on the issue. The Court in Pierce still took seriously (i) the justification for tax affecting and (ii) the method used to determine the appropriate rate. Where experts have failed to adequately explain why tax affecting is necessary, the Courts have rejected it outright. See Estate of Gallagher, T.C. Memo. 2011-148. However, the Court has accepted tax affecting where its necessity was clearly laid out. See Estate of Jones, T.C. Memo. 2019-101.
Historically, the argument for tax affecting was that taxes are not avoided by virtue of an S corp election – they are simply paid by the shareholders personally. A logical argument, indeed, but one that posed hard-to-deal-with issues: how do you calculate the appropriate tax rate? How do you know the tax rates paid by a shareholder or the shareholders?
So, the argument improved to note that the rates of return used to value privately held S corporations are those derived from C corporations. See Dallas v. Commissioner T.C.M. 2006-212. These returns are calculated using returns after corporate level taxes but before investor (dividend) level taxes. To deal with the mismatch between pre-tax returns on the S corporation to the after-tax returns to the C corporation, analysts deduct a hypothetical tax from the S corporation’s earnings. See Estate of Cecil T.C. Memo 2023-24. This is because there is a mismatch between the pre-tax cash flows in the S corp and the after-tax rate of return. A mathematical sense of equivalency is lost. How? Let’s look at the numbers (quickly, I promise).
If you have the standard rate of return equation cash flow divided by value equals rate of return:
CF / Value = RoR %
$10 / $100 = 10%
Let’s say this is all pre-tax, i.e., the $10 in cash flow is pre-tax. The resulting 10% RoR is necessarily pre-tax as well.
We can rearrange this formula to a standard valuation metric by pretending we know cash flow and RoR, but wish to solve for value.
CF / RoR = Value
$10 / 10% = $100
Now let’s look at what happens if we apply a tax rate to the RoR and, second, a tax rate to the RoR and the cash flow. Let’s assume a tax rate of 21%.
$10 / 10% x (1-21%) = $126.58
And now if we tax affect both the CF and the RoR
$10 x (1-21%) / (10% x (1-21%)) = $100
See how we have achieved equality.
So, the point here is the application of an after-tax rate of return to pre-tax cash flows will by default produce an incorrect value indication. Since the fundamental approach to valuation – the income approach – is often based upon after-tax C corp returns, this provides a strong position from which to argue the necessity of tax affecting.
Of course, if one begins with a pre-tax rate of return, tax affecting is a non-issue.
Another reason gets at the heart of the fair market value standard: hypothetical buyers and sellers would consider the fact that taxes are not avoided by virtue of an S election, they are just paid by the shareholders personally on pass through earnings.
Several methods have been posed to Tax Court to determine what the tax affecting rate should be. One method is the Delaware Chancery Method (DCM). “This method of tax affecting applies a reduced fictitious tax rate at the entity level to account for the lower overall tax burden of a passthrough entity.” See Del. Open MRI Radiology Assocs., P.A. v. Kessler, 898 A.2d 290, 330. We’ll talk about these methods in another article.