Tax-Free Transfer of Shares
The relatively recent Tax Court decision in Cecil v. Commissioner marks a significant shift in the valuation rules for S corporations, providing owners with an easier pathway to transfer more shares tax-free.
Traditionally, the IRS has opposed the so-called “tax-affected” valuation method for S corporations, which adjusts the company’s projected cashflows downward for hypothetical entity level taxes, effectively lowering its valuation. The IRS has maintained that S corporations should not be valued by factoring in hypothetical entity-level taxes because S corporations do not pay federal taxes at the entity level. This approach has historically resulted in higher valuations for S corporation shares, which in turn has resulted in less opportunity to transfer shares tax-free.
The Tax Court’s acceptance of the tax affecting method in the Cecil case will have the effect of allowing business owners to transfer a greater portion of their business (in the form of S corporation shares) under the gift and estate tax exemption, which in 2024 permits up to $13.61 million in lifetime tax-free transfers.
Cecil Background and Valuation Method Change.
The Cecil case revolved around TBC, an S corporation based in Delaware which owned and operated the Biltmore House, the largest privately owned home in the United States. The taxpayers, William and Mary Cecil, had transferred shares of TBC to their children and grandchildren, which the IRS argued were undervalued. The Tax Court, however, accepted the taxpayers’ valuation of the S corporation shares, which incorporated tax affecting into the valuation methodology.
Why A Valuation Change Now?
The IRS had been under pressure from taxpayers and valuation firms to allow tax effecting. For many business owners, their company represents their largest single asset, making accurate valuation methods critical.
Takeaways:
- Take Advantage of Tax Affecting If Appropriate. While the IRS may still scrutinize valuation approaches and methods, the path to relying on a tax effected valuation approach is less treacherous in the wake of Cecil. Taxpayers should seek out the advice of experienced tax professionals who can provide guidance on valuation methods.
- Disclose Gifts. Taxpayer should ensure that they disclosure gift adequately on gift tax returns. Failure to do the same permits the IRS to contest the value of, or potentially attempt to re-value, gifts. Tax professionals can provide guidance on adequate disclosure requirements and the proper filing of gift tax returns.
- Obtain a Thorough Appraisal and Valuation. Taxpayers should acquire a thorough and proper valuation of their S corporation and should document all relevant factors used in the process of determining the value of the S corporation.
Future Questions.
The court’s decision in Cecil, while pivotal, did not provide comprehensive guidelines on when tax affecting would be accepted by the IRS and when it would be inappropriate, emphasizing instead that its appropriateness depends on the circumstances of each case. This lack of specific guidance provided by the Tax Court will need to be filled in by the IRS. However, the IRS is unlikely to issue detailed guidelines on this question which will likely leave business owners with some uncertainty and may result in some business owners needing to argue in support of their valuation position.
The Cecil decision marks a transformative moment in the valuation of S corporations, allowing more favorable conditions for tax-free share transfers of S corporation shares. However, taxpayers must still tread carefully when it comes to valuation methodology and should ensure valuations are well documented to avoid potential IRS scrutiny.
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This alert is intended to notify its readers of new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.
