One of the most debated topics in business valuation is whether to apply tax-affecting when valuing pass-through entities such as S-corporations, LLCs, or partnerships under the income approach. While these entities do not pay corporate-level income taxes, omitting tax-affecting entirely often leads to flawed and overstated valuations. This paper supports the reasoned use of tax-affecting to reflect economic reality and ensure comparability with guideline public companies and WACC-based models.

Introduction

Valuation professionals are frequently challenged by the question: Should earnings be tax-affected for pass-through entities? Despite the fact that S-corps and similar entities do not pay corporate taxes directly, their income is still taxed—just at the shareholder level. A failure to adjust for taxes when capitalizing earnings or discounting projected income often results in overstated values, especially when comparing to C-corporations or when using market-derived discount rates that inherently assume tax-affected earnings.

The Economic Argument for Tax Affecting

While S-corps avoid double taxation, their shareholders are not tax-exempt. Income flows through to owners, who must pay taxes at individual rates. Valuation methods based on free cash flow or net income must account for this burden to produce a value that aligns with investor expectations. Here’s why:

• Discount and capitalization rates are often derived from public companies or studies that reflect tax-affected C-corp data.
• Comparability requires consistency—applying those rates to pre-tax or untaxed S-corp income introduces a mismatch.
• Hypothetical buyers would still consider the tax impact on earnings when assessing return expectations.

Precedent and Professional Guidance

The valuation industry has historically diverged on this issue, but a growing body of professional literature and case law supports tax-affecting under the right conditions:

• Delaware Open MRI Radiology Associates v. Kessler (2006): Tax-affecting S-corp income was appropriate for comparability.
• Bernier v. Bernier (2007): Affirmed tax-affecting in divorce valuations to avoid unjust enrichment.

Implementing Tax Affecting: Methodology

A balanced approach is to apply normalized tax rates (often between 21–30%) to earnings before applying a discount or cap rate derived from market data. This reflects:

1. The economic burden borne by owners, even if indirectly.
2. The tax-affecting embedded in cost of equity and WACC benchmarks.
3. The alignment with publicly traded comparables, which are fully tax-affected.

Practical Challenges in Tax Affecting

Implementing tax-affecting for pass-through entities can present challenges, including:

• Selecting an Appropriate Tax Rate: Individual tax rates vary widely, and choosing a normalized rate (e.g., 21–30%) requires judgment to avoid over- or under-adjustment.
• Data Limitations: Market-derived discount rates may not perfectly align with the pass-through entity’s risk profile, complicating comparability.
• Stakeholder Pushback: Clients or opposing valuators may resist tax-affecting, citing the entity’s tax-exempt status at the corporate level.

Important Concept: Entity Value Should Not Depend on Tax Election Alone

A critical misconception in valuation is the belief that an S-corporation—or any pass-through entity—is inherently more valuable than a C-corporation solely because of its tax status. This logic is flawed for several key reasons:

1. Election of S-status does not create additional economic income.
2. Tax elections are reversible.
3. No rational buyer would pay more solely for the S-election.
4. Valuation is about economics, not legal form.

The courts and valuation literature consistently recognize that tax status alone is not value-creating, including rulings in Delaware Open MRI and Bernier. Thought leaders like Shannon Pratt reinforce that valuation must reflect economic substance.

Key takeaway: There is no legitimate basis to claim a company is worth more just because it elected S-corp status.

Counterarguments and Rebuttal

Critics of tax-affecting often argue that:

• S-corps have a tax advantage.
• Owners receive full benefit of pre-tax cash flow.

While partly true, these arguments ignore:

• The shareholder-level tax reality—someone still pays tax on the income.
• The market-based discount rates used—which already assume tax-affected income.
• The risk of value distortion when using unmatched inputs.

Valuators should instead consider separately disclosing the benefit of S-corp status, rather than overvaluing the company by omitting taxes altogether.

Conclusion

Tax-affecting income when valuing pass-through entities under the income approach is not just a valid option—it is an essential step to ensure consistency, realism, and credibility in valuation. The decision to tax-affect should be guided by economic substance, comparability to market data, and the assumptions behind discount rates. By addressing implementation challenges thoughtfully, valuation professionals can produce defensible and accurate valuations.