In Gross v. Commissioner, the Sixth Circuit, in a 2-1 decision, upheld the Tax Court’s finding that S corporation stock should be valued without tax affecting  corporate earnings. This ruling is significant because it raises questions about the use of tax affecting in prior valuations of S corporations.

The case centered on the gift tax valuation of stock in G&J Bottling, one of the largest independent Pepsi-Cola bottlers in the United States. Experts on both sides used the income approach to estimate value but disagreed on whether future corporate earnings should be reduced by a hypothetical corporate income tax. The taxpayer’s experts said it was appropriate to reduce the corporation’s future income to reflect taxes that would be payable if G&J were a C corporation, even though as an S corporation, G&J didn’t pay corporate taxes. The IRS expert did not tax affect future earnings.

Taxpayer’s Position
Appearing before the Tax Court, the taxpayer’s two experts argued that tax affecting was the standard practice in 1992, when the events of the case took place. They also argued that the Tax Court had approved tax affecting in previous cases and internal IRS documents recommended the method. In addition, they pointed out that the IRS had accepted use of tax affecting on a gift tax return by the same taxpayer four years earlier.

The taxpayer experts pointed to tradeoffs made by shareholders as a result of S corporation status that could be accounted for by tax affecting. They also said that tax affecting would compensate a hypothetical buyer for the risk that G&J would lose its S corporation status as well as the risk that distributions wouldn’t cover the shareholder’s tax obligations.

IRS Response
The IRS expert countered that there was no indication that G&J would lose its S status in the future. In fact, the company had a restrictive stock agreement prohibiting any transfers that would put its S status at risk. The expert also pointed out that the company had historically paid shareholder distributions of nearly 100 percent of net income.

Court’s Ruling
The Sixth Circuit said there was no compelling evidence that tax affecting was the standard in 1992. The court also commented that the IRS manuals recommending tax affecting were immaterial because they included a disclaimer and were used for training purposes only. Although the IRS had allowed and even approved tax affecting in the past, the court said, the Service wasn’t precluded from correcting the error and finding different results in different cases.

Finally, the court noted that there was no indication that G&J ownership would elect to terminate its S election and the company was in little jeopardy of losing its S status in the future.

In a dissenting opinion, one judge found the points raised by the taxpayer’s experts more convincing. He wrote, "the Tax Court’s judgment was less than sound in many respects, for it flies in the face of the evidence of the record." He was particularly swayed by the IRS’s support of tax affecting for S corporations in two of its training manuals, the IRS Examination Technique Handbook and the IRS Valuation Guide for Income, Estate and Gift Taxes: Valuation Training for Appeals Officers. In his opinion, the dissenting judge stated, "Although I do not agree with Taxpayers’ contention that the IRS is somehow estopped from now disclaiming tax affecting as a recognized practice, I recognize that these documents reflect a certain acceptance of tax affecting as a valid method of valuation."

The decisions of the Tax Court and the court of appeals were based on the specific facts of this case. Tax affecting isn’t necessarily precluded in future cases, but attorneys and valuation experts must develop solid evidence supporting such an approach.