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How the Court Undervalued the Plaintiffs’ Equity in Ferolito v. AriZona Beverages - Part I

  • Sutter Securities Financial Services, San Francisco


Part I of this article criticizes that the tax-effecting of an S corp in a major New York fair value decision. Part II criticizes the application of a marketability discount in this case.
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Domenick Vultaggio and John Ferolito
co-founded AriZona Beverages in
1992; it has grown to become the
largest privately owned beverage com-
pany in the United States. The Ferolito
and Vultaggio families each own 50
percent of the parent company, Bever-
age Marketing USA, Inc. (BMU), an S
corporation whose subsidiaries manu-
facture and distribute AriZona Tea and
several other proprietary products
(collectively, “AriZona”). By mutual
agreement, Mr. Vultaggio was the
manager of the business. After years of
shareholder disputes, Mr. Ferolito
sought dissolution under New York
Business Corporation Law (BCL)
§1104-a in order to require Mr. Vultag-
gio either to dissolve the company or
to purchase his interest. Mr. Vultaggio
then exercised his right under BCL
§1118 to purchase Mr. Ferolito’s shares
of BMU at their fair value. Fair value is
the standard courts use to measure the
value of dissenting or oppressed share-
holders. The goal of this standard is to
equitably remunerate the petitioner for
that which he has lost. Because the
parties disputed the value of AriZona,
the trial court1determined the fair
value of AriZona and of Mr. Ferolito’s
shares in Ferolito v. AriZona Beverages
In my opinion, the Ferolito deci-
sion contains two substantial prob-
lems, both of which result in material
benefits to Mr. Vultaggio, the continu-
ing shareholder, at the expense of Mr.
Ferolito, who is being bought out. The
first is that the Court applied an exces-
sively high tax rate of 43.5 percent to
normalize AriZona’s pretax income.
The second is that the Court applied a
material discount for lack of mar-
ketability (DLOM) to Mr. Ferolito’s
interest in this situation where any
DLOM was neither reasonable nor
equitable. The result of applying an
erroneous tax rate and 25 percent
DLOM is that Mr. Ferolito will receive
only about 34 percent of the value of
AriZona and Mr. Vultaggio will retain
66 percent.3This windfall to Mr. Vult-
aggio is all the more unfortunate
because Mr. Ferolito’s right to have his
shares purchased (NY BCL § 1118) was
predicated on his receiving fair value.
This article, Part I, discusses the
challenges in determining the appro-
priate tax rate for courts to use when
tax-affecting S-corporation earnings
and the substantial impact of applying
an inappropriate rate. Part II, which
will appear in the next issue, discusses
the application of DLOMs in New York
fair value cases.
the court’s Valuation
of ariZona
AriZona’s revenues for the 12 months
ended September 30, 2010, were about
$1 billion and its EBITDA was $173
million. The trial court concluded that
AriZona’s value approached $2 billion
on October 5, 2010, and was a few per-
cent less than that on January 31,
2011.”4In arriving at its valuation, the
Court tax-affected AriZona’s earnings
using an erroneous 43.5 percent rate.
Several experts testified in the
case. Valuation testimony was provid-
ed by Z. Christopher Mercer (Mercer
Capital) and Christopher Stradling
(Lincoln Intl.) for Mr. Ferolito and by
Professor Richard Ruback (Harvard
Business School) for the defendants.
Supporting testimony was given by
Michael Bellas (Beverage Marketing
Corp.), Basil Imburgia (FTI Consult-
ing), and David Tabak (NERA) for Mr.
Ferolito and by Dr. Shannon Pratt for
the defendants.
Mr. Mercer testified that the
appropriate rate for tax-affecting Ari-
Zona’s earnings was 38 percent, which
is a blended C-corporation rate reflect-
ing federal and state corporate income
taxes. Mr. Vultaggio argued that Ari-
Zona’s earnings should be tax-affected
using a 43.5 percent rate. The Court, in
accepting the 43.5 percent rate, wrote
that Mr. Ferolito’s expert had not pro-
vided sufficient rationale or support
for application of the 38 percent rate.
The Judge justified his selection by
stating, “[T]he tax rate of 43.5 percent
urged by Vultaggio reflects the actual
pass-through tax rate paid by both Vul-
taggio and Ferolito over the years.”5
The Judge’s language in his discussion
of the tax rate reveals that the depth
and clarity of analysis necessary for an
informed decision on the appropriate
tax rate for an S corporation was either
absent or had failed to enlighten him.
gilbert e. matthews, cfa
Sutter Securities Incorporated
San Francisco, CA
How the Court Undervalued the
Plaintiffs’ Equity in
Ferolito v. AriZona Beverages
Part I: Tax-Affecting S Corporation Earnings
A large profitable company
structured as an S corpora-
cannot be worth less
than it would be had it been
a C corporation.
Continued on next page
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[T]he Court notes that Mercer
never testified to any rationale for
a tax rate of 38%. His reports and
the demonstrative exhibits used
throughout his testimony also do
not offer any support for using
that tax rate. There is no basis for
the Court to impute a rationale for
such a rate, much less to assume
that a willing buyer would neces-
sarily pay the lower C-Corporation
tax rate of 38% percent.6[Emphasis
The Court recognized the obvious fact
that the shareholders of AriZona bene-
fitted from its tax structure:
[C]entral to AriZona's financial
success is its status as an S-Corpo-
ration. Simplified greatly, this
means that Arizona's profits are
passed on directly to its sharehold-
ers and taxed at the individual
level, rather than the potentially
higher corporate level.7
Nonetheless, the Court applied a high-
er tax rate to AriZona as an S corpora-
tion than would have been applicable
if it were a C corporation. A large prof-
itable company structured as an S cor-
poration cannot be worth less than it
would be had it been a C corporation.
Although the various studies of rela-
tive values of S corporations and C cor-
porations in acquisitions differ as to
whether or not S corporations com-
mand a premium over C corporations,
no study has ever concluded that S cor-
porations sell at a discount (see
EMPIRICAL STUDIES later in this arti-
the court should haVe
tax-affected ariZona at a
c-corporation tax rate
The Court erred in applying the indi-
vidual owner’s tax rate to AriZona.
The Court recognized that
[t]he tax rate component of the
DCF analysis requires the Court to
determine the tax rate that would
be paid on AriZona’s future
income. A greater tax rate neces-
sarily reduces the potential cash
flow and the resulting valuation,
while a lesser tax rate necessarily
increases the potential cash flow
and the resulting valuation.8
However, the Court failed to recognize
an important distinction between C-
corporation tax rates and the taxes
paid by individual shareholders.
Investors set up S corporations to avoid
double taxation and to reduce the effec-
tive tax rate on income. By reducing
the aggregate tax burden, S-corpora-
tion shareholders have more cash
available for reinvestment indeed,
this is why AriZona’s S-corporation
status was important for its growth.
C corporations must pay corpo-
rate tax prior to making distributions
and shareholders must then pay addi-
tional tax on any dividends. Moreover,
C corporations cannot circumvent this
double taxation by paying high
salaries or bonuses to its control share-
holders because the payments in
excess of “reasonable compensation”
are subject to substantial additional tax
and/or penalties.9
The taxes paid by S-corporation
shareholders constitute the entire taxes
on the earnings of the business – there
are no “dividends.” Thus the dividend
tax is avoided: the shareholder pays
only once.10 If the S-corporation struc-
ture were not tax-efficient (for exam-
ple, if personal income tax rates
become materially higher than corpo-
rate rates), S-corporation shareholders
would likely convert to a more tax-
friendly corporate structure. In con-
trast, a C-corporation shareholder
bears not only the burden of taxes at
the corporate level but also an addi-
tional individual income tax when
those earnings are distributed as divi-
dends. Shannon Pratt’s classic book,
Valuing a Business, elucidates:
It is important to recognize that
both C corps and S corps pay taxes
on corporate income. Whether
that tax is actually paid by the cor-
poration or the individual is
absolutely irrelevant. What is rele-
vant is the difference between the
value of a company valued as a C
corporation . . . and [as] an S corpo-
ration. It is for this reason that
most S corporation models begin
by valuing the company ‘as if ’ a C
corporation . . . and then go on to
recognize the benefits of the Sub-
chapter S election. Many analysts
have confused the S corporation
tax issue by focusing on the
deductibility of corporate taxes.
However, this is not the tax that an
investor avoids, and is not the tax
that is forgone when a corporation
elects subchapter S. . . . [W]hen [an
investor] receives [a] dividend
from the publicly traded [C corpo-
ration] stock, the investor will have
to pay a dividend tax on it. In the
case of an S corporation, this tax is
avoided; and . . . the benefit of the
avoided dividend tax must be taken
into consideration.11 [Emphasis
What Dr. Pratt is recommending is that
the valuator should value the company
using a C-corporation tax rate (as Mr.
Mercer did), and, if appropriate,
increase that valuation to reflect the ben-
efits of the S-corporation structure. In
this case, the Court acknowledged that
the tax rate applicable to a C corp is
lower than the aggregate taxes paid by
S-corp shareholders. However, the
Court instead reduced the valuation by
using personal tax rates with no
adjustment for the benefits of being an
S corporation.
fair Value under the new
York dissolution statute
Under the New York dissolution
statute, the standard of value is “fair
value.” In the Beway12 case, the New
York Court of Appeals defined “fair
value” as the amount that would be
paid by an arm’s-length buyer:
[I]n fixing fair value, courts should
determine the minority sharehold-
er’s proportionate interest in the
going concern value of the corpora-
tion as a whole, that is, ‘what a
willing purchaser, in an arm’s
length transaction, would offer the
Continued on next page
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corporation as an operating busi-
ness.’13 [Emphasis in original]
The Court quoted Beway and added
that it
value[d] AriZona using the ‘finan-
cial control’ measurement, that is,
‘the value of a company exposed to
a representative group of buyers
who are not expecting synergies,
who are looking at the value of the
business on a standalone basis.’14
Under New York fair value, the Court
should have considered the nature of
the potential “willing” and “represen-
tative” buyers of a large company like
AriZona. An S corporation is limited
to 100 shareholders. Corporations,
partnerships, and non-resident aliens
may not be shareholders. Because of
these limitations, it is highly likely that
any potential acquiror would be either
a C corporation or a foreign corpora-
tion. An acquiror would be unable to
continue AriZona’s S-corp status and
thus would be unable to benefit from
its S-corp tax advantages. Any acquiror
would consider the corporate tax rate
applicable to the earning power being
acquired, i.e., the C-corporation tax
rate. Assessing fair value from the
viewpoint of a buyer, it is appropriate
to value AriZona, an S corporation, at
the C-corporation tax rate, as Mr. Mer-
cer did.
empirical studies of
premiums in s-corp
Empirical studies have been conducted
to address the question of whether S
corporations really are valued more
highly than C corporations. These
studies have attempted to determine
whether, in practice, premiums have
been paid for control of S corporations.
The results are mixed.
Some studies have concluded
there is an S-corp premium. The pre-
miums they have found are far lower
than posited by the Gross decision and,
on average, marginally lower than the
premium in Delaware MRI, which is
discussed later in this article. One aca-
demic study of acquisitions of S corpo-
rations for stock concluded that the
“average tax benefits in S corporation
acquisitions are equal to approximate-
ly 12–17 percent of deal value.”15
Another study of S-corporation trans-
actions from 2000 to 2006 stated:
Results of the regression show that
the magnitude of the ‘S corpora-
tion premium’ indeed depends on
the level of these variables. In par-
ticular, the findings are (1) the pre-
mium depends positively on net
sales; (2) the premium is higher for
the cases in which the transaction
is done through Asset sales rather
than Stock sales; and (3) the premi-
um is higher for the cases in which
firms are bought by private buyers
rather than public buyers.16
In contrast, other empirical studies
have found that there is no premium
for stock sales of S corporations. A
study of transactions from 1991 to
early 2002 found “no significant empir-
ical evidence to support the existence
of an ‘S’ premium for the stock sales of
S corporations.”17 A 2004 article deter-
mined that “the S-Corp premium is not
meaningfully statistically significant in
any test that we conducted.”18 A study
of 2001–2010 transactions found “no
significant transaction price premium
for closely-held S corporations over
closely-held C corporations.”19
Although there is conflicting evi-
dence as to whether or not S corpora-
tions do or do not sell at premiums,
there is no evidence at all to support
the Ferolito court’s conclusion that Ari-
Zona, as an S corporation, is worth less
than a comparable C corporation.
how should Valuation
professionals tax-affect
s-corporation earnings?
There are three alternatives that have
been used by courts and the valuation
community to tax-affect the earnings
of Subchapter S corporations: (1) do
not tax-affect, (2) tax-affect as if the S
corporation were a C corporation, or
(3) tax-affect in a manner that gives
effect to the tax benefits of an S-corpo-
ration structure.
The concept of not tax-affecting
S-corporation earnings is generally
rejected by the valuation experts but,
since the Gross20 decision in 1999, some
courts, primarily the U.S. Tax Court
using a fair-market value standard,
have valued S corporations without
tax-affecting their earnings.21 This
position values an S corporation at
more than 1½ times the value of an
otherwise identical C corporation. The
Tax Court’s position, which has been
adopted by the IRS, fails to recognize
the essential fact that earnings of S cor-
porations are not tax-free. Although S
corporations do not pay corporate
income tax, their earnings are not tax-
free– they are taxed as personal income
to shareholders whether or not any dis-
tributions are made. Any investor would
take into account the potential taxes
payable on a business’s earnings,
regardless of whether the company or
its shareholders pay the taxes.
Pointedly, one of the appellate
judges in Gross dissented with respect
to tax-affecting an S corporation, writ-
[T]he court’s decision to tax affect
the stock by 0% did not accurately
reflect the fair market value of G&J
stock as determined under the
willing buyer/willing seller stan-
dard. Instead of relying upon real-
world evidence, the court reverted
to its own perception of the proper
approach to tax affecting, thereby
deviating from the time-sensitive
willing buyer/willing seller stan-
dard. I therefore would hold that
to the extent it was based upon the
use of a 0% tax affect the court’s
ultimate valuation . . . was clearly
Indeed, prior to the 1999 Gross deci-
sion, the IRS Valuation Guide, which is
used by IRS appeals officers, stated:
If you are comparing a Subchapter
S Corporation to the stock of simi-
lar firms that are publicly traded,
the net income of the former must
be adjusted for income taxes using the
Continued on next page
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corporate tax rates applicable for
each year in question, and certain
other items, such as salaries.2 3
[Emphasis added].
The Gross court quoted this sentence,
but it ruled that the IRS was “not
estopped from disregarding a fictitious
corporate tax when valuing an S corpo-
ration.”24 This ruling ignores the essen-
tial fact that the earnings stream being
valued is, in fact, taxed, albeit at the
shareholder level. Had the Ferolito
decision used the Gross approach, Ari-
Zona would have been materially
The Gross decision has been
widely criticized. Professor Keith Sell-
ers and Nancy Fannon commented:
In [the Gross] case, the Tax Court
first examined and then rejected
the concept of ‘tax affecting’ the
earnings of a Subchapter S corpo-
ration when using the income
approach to estimate the fair mar-
ket value of a firm. . . . This is a
conclusion that has been rejected
outright by the majority of private
equity analysts.25
They explained:
[In] sharp conflict with both the
Tax Court and the IRS, the valua-
tion profession has developed a
number of widely accepted mod-
els which attempt to quantify any
true ‘premium’ that should be
attached to the fair market value of
a pass-through entity vis-à-vis a
similar Subchapter C corporation.
These models, which are widely
used throughout the valuation
profession, incorporate current
and anticipated shareholder-level
taxes in the determination of fair
market value. [The] results of a
stream of fruitful academic
research suggest that ... the IRS
and the Tax Court [are] incorrect in
their valuation of pass-through
entities.26 [Emphasis added]
There have been numerous other
explicit criticisms of the Gross conclu-
sion in valuation and legal literature.27
Reflecting the accepted view of valua-
tion experts, Shannon Pratt concluded,
“There is consensus in the business
valuation community that the [tax
court] decisions generally do not com-
port to good economic theory.”28
James Hitchner commented, “It was
alarming how the so-called Gross
method appeared to be adopted by the
IRS, various courts, and even some in
the appraisal community.”29
Some valuation experts favor the
second approach of tax-affecting earn-
ings of S corporations at the rate appli-
cable to C corporations. Mercer wrote
in 2004:
S corporations are worth the same
as otherwise identical C corporations
at the enterprise level. Operating
cash flows are identical, and there
is no rationale that suggests that
their enterprise values should be
anything but identical.30 [Emphasis
Clearly, the value of a large S corpora-
tion to a generic acquiror is neither
increased nor decreased (as in Ferolito)
by its tax status. A buyer who cannot
benefit from an S-corporation’s ability
to avoid double taxation would not
pay a premium for the seller’s S-corpo-
ration status. New York does not per-
mit an S-corp premium to be applied in
an appraisal because “a rational pur-
chaser of 100% of a company would
not pay a premium based on a compa-
ny's status as an S-corporation.”31
The third approach is to value an
S corporation by taking into account
the financial benefits of the difference
between taxes payable on S-corp earn-
ings and the aggregate C-corp taxes
payable at the corporate and personal
levels. Several alternative methods for
tax-adjusting S corporations have been
proposed by valuation experts.32 For a
review of these alternative methods,
see Hitchner’s Financial Valuation Appli-
cations and Models, pp. 594-624.
delaware mri
Then-Vice Chancellor Leo Strine, Jr.
(now Chief Justice of the Delaware
Supreme Court) utilized this approach
in a 2006 appraisal case, Delaware
MRI,33 and, in my opinion, his method
is worthy of consideration and adop-
tion. He calculated the effective pro
forma S-corporation tax rate at the cor-
porate level that would give share-
holders the same after-tax earnings
that C-corporation shareholders would
receive after both corporate taxes and
taxes on corporate dividends. Using a
40 percent corporate tax rate, a 40 per-
cent personal tax rate, and a 15 percent
tax on S-corporation dividends, he
determined that a 29.4 percent rate
should be used to tax-affect the S-cor-
poration’s earnings (see chart below).34
In addition, the Massachusetts
Supreme Court subsequently accepted
this method in Bernier v. Bernier,35 a
divorce case, which described Strine’s
[T]he judge asked: if the S corpora-
tion at issue were a C corporation,
at what hypothetical tax rate could
it be taxed and still leave to share-
holders the same amount in their
pockets as they would have if they
held shares in an S corporation? In
other words, the judge asked what
the effective corporate tax rate
would be for the S corporation
shareholder, although the entity
itself paid no corporate tax.36
C Corp S Corp S Corp Valuation
Income Before Tax $100 $100 $100
Corporate Tax Rate 40% 29.4%
Available Earnings $60 $100 $70.60
Dividend or Personal
Income Tax Rate 15% 40% 15%
Available After Dividends $51 $60 $60
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impact of tax structure
Going-concern value is impacted by
the tax structure if less taxes are
payable, shareholders benefit and the
value of the company is higher. A val-
uation of a company as it is being run
should take this into account by tax-
affecting earnings to reflect the tax
benefits to S-corp shareholders.
Both New York and Delaware
define fair value as the shareholders
pro rata interest in the value of the cor-
poration, but the definition in New
York, as discussed above, differs in one
substantive respect from Delaware.
New York defines going-concern value
as “what a willing purchaser, in an
arm’s length transaction, would offer
for the corporation as an operating
business.”37 Delaware, in contrast,
defines going-concern value as the
value of the company as the business is
being run, not as value to a purchaser.38
The Delaware statute states “the Court
shall determine the fair value of the
shares exclusive of any element of
value arising from the accomplishment
or expectation of the merger or consol-
idation.”39 The Delaware Supreme
Court “defined ‘fair value’ as the value
to a stockholder of the firm as a going
concern, as opposed to the firm’s value in
the context of an acquisition or other trans-
action.”40 [Emphasis added]
When the definition of fair value
looks at the value of the company as it
is being run (as in Delaware) rather
than value to a willing purchaser (as in
New York), the methodology applied
to tax-affect S-corp earnings in
Delaware MRI is a reasonable and
court-approved approach. When fair
value is defined as value to a willing
purchaser, as it was in Ferolito, the
appropriate tax rate would be the rate
applicable to a C corporation (as Mer-
cer testified), unless the potential
buyer would be able to benefit from S-
corp status. c
22 Gross, 272 F.3d 333 at 351.
23 Gross, T.C. Memo 1999-254 at 26.
24 Id. at 27.
25 Keith F. Sellers and Nancy J. Fannon, “Valuation of
Pass-Through Entities: Looking at the Bigger Picture,”
2012 American Taxation Association Midyear Meeting:
JLTR Conference, Dec. 2011, p. 1 (available at SSRN:
26 Sellers and Fannon, p. 2.
27 E.g., in George B. Hawkins and Michael A. Paschall,
“A Gross Result in the Gross Case: All Your Prior S
Corporation Valuations Are Invalid,” 23 Bus. Val. Rev.
10 (2002); R. James Alerding, Travis Chamberlain and
Yassir Karam, “S corporation premiums revisited: the
Erickson-Wang myth,” Bus. Val. Update (Jan. 2003);
John Phillips, “S-Corp or C-Corp? M&A Deal Prices
Look Alike,” Bus. Val. Update (Mar. 2004); Mercer, “Are
S Corporations Worth More than C Corporations?” 23
Bus. Val. Rev. 117 (2004); Franklin M. Fisher, Christo-
pher F. Noe and Evan Sue Schouten, “The Sale of the
Washington Redskins: Discounted Cash Flow Valua-
tion of S-Corporations, Treatment of Personal Taxes,
and Implications for Litigation,” 10 Stan. J. L. Bus. &
Fin. 18 (2005); Courtney Sparks White, “S Corpora-
tions: A Taxing Analysis of Proper Valuation,” 37 Cap.
U. L. Rev. 1117 (2009); Daniel R. Van Vleet, “Warning!
The Service Believes S Corporations Are Underval-
ued,” SRR Journal (Fall 2010).
28 Pratt, Valuing a Business, 5th ed., p. 614.
29 James R. Hitchner, Financial Valuation Applications
and Models, 3rd ed. (Wiley, 2011), p. 577.
30 Z. Christopher Mercer, 23 Bus. Val. Rev. 117. Mercer
adds, “Interests in S corporations may be worth more
or less than identical interests in otherwise identical C
corporations” because “[t]he effective cash flows to
shareholders may be different.” Id.
31 Zelouf Intl. Corp. v. Zelouf, 2014 N.Y. Misc. LEXIS
4341 (N.Y. Sup. Ct., Oct. 6, 2014) at *19-*20.
32 See, e.g., Fannon, “Subchapter S Corporation Valua-
tion – A Simplified View,” 26 Bus. Val. Rev. 8 (2007);
Roger J. Grabowski, “S Corporation Valuations in the
post-Gross World–Updated,” 23 Bus. Val. Rev. 139
(2004); Chris D. Treharne, “Valuation of Minority Inter-
ests in Pass-Through-Tax Entities,” 23 Bus. Val. Rev.
105 (2004); Van Vleet, “The S Corporation Economic
Adjustment Model,” 23 Bus. Val. Rev. 167 (2004).
33 Delaware Open MRI Radiology Associates v. Kessler,
898 A.2d 290 (Del. Ch. 2006) (Delaware MRI). In a
Delaware appraisal, a company is valued as it is being
run by its current management, not as it might be run
by a financial buyer.
34 Delaware MRI at 330. Based on the difference
between a 29.4 percent tax rate and a 40 percent tax
rate, the S-corp premium was 17.7 percent.
35 873 N.E.2d 216 (Mass. 2007).
36 Id. at 230.
37 Beway at 168, quoting Blake at 146.
38 Lawrence A. Hamermesh and Michael L. Wachter,
“Rationalizing Appraisal Standards in Compulsory
Buyouts,” 50 B.C. L. Rev. 1021 (2009).
39 8 DEL. CODE ANN. § 262(h).
40 Golden Telecom, Inc. v. Global GT LP, 11 A.3d 214,
217 (Del. 2010).
1The Supreme Court in New York is the trial court. The
intermediate appellate level is the Appellate Division
and the highest is the Court of Appeals.
22014 N.Y. Misc. LEXIS 4709 (N.Y. Supr., Oct. 14,
2014) (Ferolito).
3As discussed below, the Court valued AriZona at about
$2.0 billion. The number would have been approxi-
mately $2.2 billion if it had applied an appropriate tax
rate. With a 25 percent DLOM, the Court valued Mr.
Ferolito’s shares at $750 million, which is 34 percent of
$2.2 billion.
4Ferolito at *58. Oct. 5, 2010, was the valuation date
for Mr. Ferolito’s personal interest and Jan. 31, 2011,
was the valuation date for other family interests.
5Ferolito at *42. It appears that the court did not ques-
tion that 38 percent was an appropriate C-corporation
tax rate, but instead concluded that the record did not
support using a C-corp tax rate rather than the person-
al tax rate.
6Ferolito at *41-*42.
7Ferolito at *15.
8Ferolito at *41.
9See, e.g., Wechsler & Co., Inc. v. Commissioner, T.C.
Memo 2006-173.
10 As in a partnership, S-corp shareholders are taxed on
all profits, whether or not they are distributed. In prac-
tice, when S corps are retaining earnings for growth,
they normally pay out at least the amount the share-
holders will owe in taxes.
11 Shannon P. Pratt, Valuing a Business, 5th ed.
(McGraw Hill, 2008), p. 618-19.
12 Friedman v. Beway Realty Corp., 87 N.Y.2d 161 (N.Y.
13 Beway at 168, quoting Matter of Blake v. Blake
Agency, 107 A.D.2d 139,146 (N.Y. App. 1985).
14 Ferolito at *19-*20, quoting Mercer’s trial testimony.
15 Merle M. Erickson and Shiingwu Wang, “Tax Benefits
as a Source of Merger Premiums in Acquisitions of Pri-
vate Corporations,” 82 Acctg. Rev. 359 (2007).
16 James A. DiGabriele, “The Moderating Effects of
Acquisition Premiums in Private Corporations: An
Empirical Investigation of Relative S Corporation and
C Corporation Valuations,” 22 Acctg. Horizons 415
(2008). The mean premium (before adjustment for
size) was 13.5 percent.
17 Michael Mattson, Kevin Shannon and David Upton,
“Empirical research concludes S corporation values
same as C corporations,” Business Valuation Update,
Nov. & Dec. 2002.
18 John Phillips, “S-Corp or C-Corp? M&A Deal Prices
Look Alike,” Business Valuation Update, March 2004.
19 Charles J. Russo, Lasse Mertins and Charles L. Mar-
tin, Jr., “Business Valuation Acquisition Premiums and
Tax-Affecting Earnings of Pass-through Entities”
(2011), available at
20 Gross v. Commissioner, T.C. Memo 1999-254; aff’d.
272 F.3d 333 (6th Cir. 2001).
21 See, e.g., Wall v. Commissioner, T.C. Memo 2001-75;
Dallas v. Commissioner, T.C. Memo 2006-212; Vicario
v. Vicario, 901 A.2d 603 (R.I. 2006); Hamelink v.
Hamelink, 2013 Minn. App. Unpub. LEXIS (December
30, 2013).
The application of DLOMs in New York
cases will be discussed in Part II of this
article, which will appear in the next issue.
The author thanks Michelle Patterson,
PhD, JD, for her helpful comments and
ResearchGate has not been able to resolve any citations for this publication.
Full-text available
This paper presents the results of a moderated multiple regression analysis to show that, all else held equal, there exists a positive premium in the valuation of S Corporations over C Corporations in the period of January 2000 to November 2006. The results of the regression show that the magnitude of the “S Corporation premium” is indeed dependent on the level of interactions of several independent variables. In particular, the results of this study found that (a) the premium depends positively on net sales; (b) the premium is higher for the cases in which the transaction is done through Asset sales (rather than Stock sales); and (c) the premium is higher for the cases in which firms are bought by Private Buyers (rather than Public buyers).
In five decisions, sufficient evidence was not presented to the tax court regarding the valuation of Subchapter S corporations. Not surprisingly, in all five decisions, the tax court declined to deduct income taxes from corporate earnings when calculating the value of the S corporations for gift and estate tax purposes. These decisions, beginning with the case of Gross v. Commissioner,1 have emboldened the Internal Revenue Service (IRS) into taking groundless positions and have hampered the ability of small businesses to transition ownership.
Recent Court decisions require that S Corp shareholders and their advisors reconsider how the value of their S corps are determined. We provide three methods of quantifying the differences between S corps and C corps based on the facts and circumstances of the specific company.
Scholes et al. (2005) predict that S corporations, and other conduit entities, such as partnerships and LLCs, can sell for a tax-driven purchase price premium relative to C corporations. We test this conjecture by comparing purchase price multiples in a sample of taxable stock acquisitions of S corporations to purchase price multiples for a matched set of taxable stock acquisitions of privately held C corporations. Consistent with Scholes et al.'s predictions, we find evidence that the organizational form of the target influences acquisition tax structure and acquisition price. Specifically, the evidence supports the conclusion that conduit entities (S corporations) fetch a tax-based purchase price premium relative to similar C corporations. Furthermore, our estimates indicate that average tax benefits in S corporation acquisitions are equal to approximately 12-17 percent of deal value.
This Article makes several contributions to the literature on Delaware appraisal law. We first argue that the "going concern value" standard adopted by the Delaware courts as the measure of "fair value" in share valuation proceedings is superior to its two main competitors, market value and third-party sale value, on grounds of both fairness and efficiency. Application of the going concern value standard has two important consequences. First, it is critical that going concern value be measured in a way that includes not only the present value of the existing assets of the corporation, but also the present value of the reinvestment opportunities available to and anticipated by the firm at the time of merger. Second, going concern value should not include the value of corporate control in a case where the merger creates control through the aggregation of previously dispersed shares. In that case, the benefits created by the aggregation of shares belong to the party that created the increased value.We address differently, however, the situation where a pre-existing controlling shareholder squeezes out the minority. Our concern here is the potential for a controlling shareholder to acquire the minority shares at a price that fails to reflect the firm's going concern value. Where a controller fails to present a valid discounted cash flow analysis and relies instead on a comparable company analysis that is based solely on historical data, the minority shareholders and the court are deprived of access to projections of future free cash flows of the firm. We therefore advocate that in this situation the courts adopt a penalty default in the form of a presumption that fair value includes the value of control as reflected in comparable company acquisitions. Such a presumption is consistent with common law doctrines of fiduciary duty and the entire fairness standard, as well as adverse evidentiary inferences drawn from failure to produce relevant evidence. The controller as faithful fiduciary can avoid the proposed presumption by preparing and submitting to judicial scrutiny a valid discounted cash flow analysis. The opportunistic controller, on the other hand, is subjected to a fair value determination that amounts to third-party sale value minus synergies.