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.
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@example.com.