Tax Affecting Part 2: What Rate to Use?
In Part 1, the concept and rationale of tax affecting was discussed. Tax affecting the earnings is considered necessary to match the derived discount or capitalization rate to the definition of economic income being discounted.
This arises frequently with entities that do not pay taxes at the entity level, but rather pass the income and tax attributes out to the equity holders. The usual examples involve pass-through entities (PTEs), including partnerships, limited liability companies and S corporations.
In establishing a discount or capitalization rate to apply to cash flows or economic benefits, the data generally is reflective of public corporations and are based on returns after the payment of the corporate-level income taxes. However, if the entity is not subject to tax then this has the effect of applying an after-tax rate of return to pre-tax economic income. Shannon Pratt, a well-known authority in the field of business valuation, considers such an approach as a "common error in the estimation and use of cost of capital." (Pratt and Grabowski, Cost of Capital, Applications and Examples, 4th Ed. page 675)
If the cash flow being discounted then has to be tax-affected, the next question is what tax rate is to be used: individual rates or C corporate tax rates?
We have heard it argued that the individual tax rate should be applied as that is the rate that the individual partners, members or shareholders pay. The alternative argument is that the C corporate rate should be used. The theory is that the discount or capitalization rate was derived from C-public corporation data and should be applied to the economic income reflecting C-level tax. Otherwise, to use a different rate would be the kind of mismatch considered an error by Pratt.
Recently, a Tax Court opinion allowed tax affecting the economic income of a partnership. In the discussion, the opinion makes reference to the rate used in the tax affecting. In Estate of Aaron U. Jones v. Commissioner, T.C. Memo, 2019-101, the court makes reference to the appraiser using a "proxy for the combined federal and state income tax rates they would bear if they were C corporations, albeit taxed at individual, not corporate rates, in order to adjust for the differences between pass-through entities and C corporations (like the public companies used for comparison in the valuation process … ."
The reference to using the individual rate might lead to the idea that individual rates should be used. In order to understand that reference, we have discussed the point with the appraisal firm that was involved and whose analysis was adopted by the court.
The appraiser in fact did not use the individual rate but rather a 38 percent rate that was a combination of the corporate federal and state income tax rates. It was a coincidence that federal and state rates approached numerically the individual rate.
Since the recent federal income tax changes, the corporate rate now is significantly lower. As the spread between corporate tax rate and individual rates widen, the total tax burden of two layers of tax on C corporation and the one level for owners of PTEs has narrowed.
Some may still use the individual rate that formally was nearly the same as the corporate rates. We have heard the argument that the benefit of the lower rate would not be enjoyed by the individuals. It's an argument, but still faces the admonition of Pratt to match the economic income/cash flow (tax affect) with the discount rate (determined by the use of data reflecting the C tax structure of public companies).