Are there differences between partners and shareholders, as well?
Just as there are differences and similarities at the entity and interest levels, there are similarities and differences at the owner level. Both the S corporation shareholder and the partner are taxed on income as it is earned, rather than when it is distributed. This creates a tax burden at the owner level and none at the entity level.
Further, distributions of cash are generally tax free to the extent of the owners’ basis in their interests, and deductibility of losses is limited to the owners’ basis in their interests.
S corporation shareholders basis is determined based on the equity of their contributions. Partners, however, also get basis for their share of the entity’s debt, both recourse and nonrecourse. This allows partners to deduct more losses and receive more distributions on a tax-free basis than S corporation shareholders. Also, S corporation shareholders may be employees of their entities, whereas partners are treated as self employed.
What valuation issues come up at the owner’s level?
Most valuation issues arise at the owner’s level because of a partnership’s flexibility in allocating income and distributions. Section 754 elections allow a partnership to adjust the tax basis of its assets. Does this mean that partnerships with Section 754 elections in effect are more valuable than S corporations or partnerships without the election? This has a direct impact on holding partnerships whose assets have unrealized appreciation. Courts have held that no discount is allowed for the unrealized capital gain, unlike for C corporations, as a Section 754 election eliminates or mitigates this gain. There is no definitive case law dealing with this issue for S corporations.
Another important issue is the special allocation of income and distributions by partnerships. Partnership interests may resemble preferred stock more than common stock.
Accordingly, the valuation of these interests may be more focused on the income and cash flowing to the owner rather than ascribing a pro-rata portion of the entity value to a particular share of stock. Like preferred stock, the terms of partnership interests are potentially limited only by the imaginations of the owners and their advisers.
How would you summarize addressing these differences?
My recommendation would be not to take a cookie-cutter approach to valuing a flow-through entity. The significant differences between S corporations and partnerships require the professional to understand the allocation and distribution rights and provisions as part of the valuation process.
John T. Alfonsi, CPA/ABV/CFF, CFE, CVA, is a managing director of Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or [email protected].
