Tax Affecting: A Controversial Issue in Pass-Through Business Valuations

Tax affecting is one of the most debated issues when valuing interests in privately held businesses using the income approach. This term refers to discounting the projected earnings of pass-through businesses for hypothetical entity-level taxes. Unlike C corporations, pass-through entities — such as S corporations, partnerships, limited liability companies and sole proprietorships — don't pay entity-level taxes.

While seemingly technical, tax affecting has significant implications when valuing businesses for gift and estate planning, litigation, and merger and acquisition purposes. Court decisions on tax affecting have varied significantly over the years. In addition, proposed tax law changes could reshape how valuation professionals approach this issue.

No Entity-Level Tax for Pass-Through Entities

For decades, the IRS and valuation professionals have been at odds over how to value pass-through businesses because of their unique tax characteristics. All items of income, loss, deduction and credit from pass-through entities are reported on the owners' personal tax returns, and owners pay taxes at the individual level. Distributions to owners generally aren't taxable to the extent that owners have positive tax basis in the entity.

For the most part, operating as a pass-through entity is a smart tax-saving strategy for entities that qualify. However, for minority owners that have no control over distributions, this favorable tax treatment may be less advantageous — especially if the business doesn't distribute enough cash to cover the owners' tax obligations from the business.

Inconsistent Legal Precedent

In the 1990s, valuation professionals often tax affected earnings when valuing pass-through entities. However, the U.S. Tax Court ended that practice with its landmark decision in Gross v. Commissioner (T.C. Memo. 1999-254, July 29, 1999, affd. 272 F. 3d 333, 6th Cir. 2001). The court dismissed the application of hypothetical corporate taxes to the income of an S corporation, effectively creating a valuation premium for operating as a pass-through entity. It was followed by several more Tax Court cases that disallowed tax affecting.

However, some recent cases suggest courts may sometimes be open to tax affecting. For instance, the U.S. District Court for the Eastern District of Wisconsin reopened the door to tax affecting in Kress v. Commissioner (2019 WL 1352944, U.S. District Court, E.D. Wisconsin, Case No. 16-C-795, March 26, 2019). Here, the court accepted the application of a hypothetical corporate tax rate to an S corporation's earnings. It highlighted the disadvantages of subchapter S status, including limits on access to credit and on the ability to reinvest in the company.

More recently, the Tax Court allowed tax affecting when valuing 2014 transfers of pass-through business interests to a trust. In Pierce v. Commissioner (T.C. Memo 2025-29, April 7, 2025), both valuation experts agreed to tax affect earnings because a hypothetical buyer and seller would consider that factor in valuing the S corporation. The court ruled that, when the data used to value an S corporation is based on C corporation data, tax affecting may be appropriate to account for "the mismatch from pretax cash flows and after-tax discount rates."

It accepted the taxpayers' expert's application of a 26.2% hypothetical tax rate under the Delaware Chancery method. However, the opinion warns, "We are not necessarily holding that tax affecting is always, or even often, a proper consideration for valuing an S corporation."

IRS Job Aid

An IRS job aid, "Valuation of Non-Controlling Interests in Business Entities Electing To Be Treated as S Corporations for Federal Tax Purposes," provides useful guidance on tax affecting. It may be applied more generally to all types of pass-through entities valued for any purpose, not just for tax reasons.

According to the job aid, valuators should consider the following factors when deciding how to handle entity-level taxes:

• Size and composition of the pool of hypothetical buyers,
• Economic interests of the hypothetical seller,
• Actual revenue available to and the actual expenses to be paid by the entity that has elected to be taxed as an S corporation,
• Availability at the entity level of equity and debt capital, and
• Probable holding period of the transferred interest.

When tax affecting a company's projected earnings, a valuator should provide valid reasons that a hypothetical investor would discount the earnings for entity-level taxes. The job aid points out that, while avoiding entity-level taxes is an important benefit to consider when valuing an S corporation, valuators also must consider the downsides of owning a minority interest in an S corporation.

Evolving Tax Laws

The valuation dates in the landmark cases discussed above were before Congress passed the Tax Cuts and Jobs Act (TCJA). It's important to note that the Delaware Chancery method could produce different results if applied in the context of today's tax law.

In general, the TCJA narrows the tax differential between C corporations and pass-through entities. Starting in 2018, the law permanently lowered the corporate tax rate to a flat 21%, from a graduated system that topped out at 35%, helping to reduce the negative impact of double taxation. But the 21% rate is much lower than the rates many pass-through entity owners face, which, under the TCJA can be as high as 37%.

So the TCJA also introduced a new deduction of up to 20% of qualified business income (QBI) for owners of pass-through businesses. The QBI deduction is subject to numerous limitations and restrictions and is in effect only for 2018 through 2025. However, Congress is now considering legislation that would extend this break beyond 2025 and expand it.

Business valuation experts must consider current tax law and any expected changes when addressing tax affecting. They can consider only facts that are "known or knowable" on the valuation date. Uncertainty about the QBI deduction's future adds another layer of complexity to tax affecting.

An Ongoing Debate

When it comes to tax affecting pass-through entities, there's no clear-cut guidance that prescribes a specific tax rate or denies tax affecting altogether. Rather, tax affecting may be permitted on a case-by-case basis, depending on the facts and circumstances. It's critical to evaluate the interplay between entity structure, tax law and valuation methodology. We can help you understand this issue and provide detailed support for handling income tax issues related to pass-through entities.