When discussing the valuation of flow-through entities and interests, the focus is usually on S corporations. However, partnerships are increasingly popular entities of choice.
Partnerships are tax-driven and tax-effected entities, but not all partnerships are holding companies; many are active trades or businesses. There is no tax at the entity level; owners are taxed on the income as generated or benefit from the losses incurred as if they generated the income or loss.
“Partnerships provide flexibility in structuring the economics of operations among and between owners,” says John T. Alfonsi, CPA/ABV/CFF, CFE, CVA, a managing director of Cendrowski Corporate Advisors LLC.
Smart Business spoke with Alfonsi about the differences between partnerships and S corporations, and the valuation issues that come with them.
How do partnerships compare to S corporations?
While both are flow-through entities, there are significant differences for federal tax purposes. Generally, shareholders of S corporations are limited to domestic individuals, while individuals, foreign and domestic corporations, trusts and other partnerships may own partnerships. As such, the pool of hypothetical and actual buyers for a partnership interest is significantly greater than that of buyers of an S corporation interest, assuming the entity wishes to maintain its status as a flow-through entity.
There is also a significant economic difference in the allocation of income and distributions. S corporations are limited to common stock and there cannot be any differences in rights to distributions or liquidation proceeds. Similarly, S corporation income and loss may only be allocated pro-rata, based on the number of shares owned. Partnerships have greater flexibility. There may be different classes of interest, which provide for differing rights to income and distributions; they do not have to be allocated ‘straight up.’ As such, partners are allowed to structure their arrangements more freely than S corporation shareholders.
What valuation issues come up at the entity level?
The issue as to whether to tax-effect income at the entity level has been subject to a great amount of debate and analysis, resulting in numerous models and approaches to dealing with the single level of tax issue. Of particular note is a partnership distribution provision that is common in many partnership agreements, which provides for mandatory annual distributions to partners to cover tax liabilities associated with the entity’s income. In effect, the tax liability on entity earnings is reflected as a distribution to the equity holders rather than as an expense at the entity level.
Section 754 elections, in particular, are unique to partnerships. A Section 754 election allows the entity to adjust the basis of partnership assets upon a sale or exchange of a partnership interest, the death of a partner, or certain distributions of cash or property. S corporation rules have no counterpart. The effect of a Section 754 election is a potential increase or decrease in depreciation expense, a gain or loss on the sale of affected assets and nonprorata allocations of the deduction, gain or loss. It does not affect cash flow.