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June 2017 | Issue 86 Background Constellis Group,  Inc. is a private security firm.  In December 2013, the Company formed an Employee Stock Ownership Plan (“ESOP”), which purchased 100% of Constellis’s voting stock.  Wilmington Trust NA was named Trustee of the ESOP.  Less than a year after the ESOP was created, the ESOP sold all […] More...


March 2017 | Issue 85 Introduction Richard and Steven Parker are brothers who ran a flower business in Scotch Plains, New Jersey.  Richard is the President of Parker Interior Plantscapes (“PIP”), which installs and services plants and flowers in commercial settings.  Steven is the President of Parker Wholesale Florists (“PWF”), which is a garden center.  […] More...

Dell Appraisal Spawns a Multitude of Valuation Approaches

February 2017 | Issue 84 Introduction A Delaware Chancery appraisal case involving computer company Dell Inc. gave rise to a multitude of valuation measurements.  It is instructive to see how the court sorted through them in coming up with its final appraisal conclusion.  The case is In re Appraisal of Dell Inc., 2016 Del. Ch. LEXIS […] More...

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Sub-S Corp Valuation Issues Addressed in Delaware Chancery Decision

June, 2006 | Issue 3

Subchapter-S corporations present a special valuation challenge to business appraisers. The appraisal profession has in recent years been wrestling with the thorny question of how to treat the income tax status of Subchapter-S corporations when performing a business valuation. The issue is whether or not, or to what extent, one should include in a valuation an amount to reflect the fact that Sub-S corporations do not pay Federal corporate income taxes.

A Recent Case
Vice Chancellor Strine, of the Delaware Chancery Court, was faced with this issue recently in an appraisal/entire fairness action called Delaware Open MRI Radiology Associates, P.A. (Consolidated C.A. No. 275-N, April 26, 2006).

The case involved a group of eight radiologists that owned a company called Delaware Open MRI Radiology Associates, P.A. (Delaware Radiology). The company performs MRI scans. A radiology practice owned by the eight radiologists, called Fox Chase Medical Center Radiology Associates, P.C. (Fox Chase) performed the diagnostic “reads” of the scans made by Delaware Radiology.

All eight doctors were originally together in one practice. In 1999, however, three of the eight partners left Fox Chase to start a new practice. This created a number of problems which ultimately led the five remaining Fox Chase doctors, who collectively owned 62.5% of the Delaware Radiology shares, to decide to effect a squeeze-out merger of the three minority shareholders of the company.

The terms of the merger, which took effect on January 20, 2004, provided for a payment to the minority shareholders of $16,229 per share (equivalent to a valuation of $6.5 million for the company in its entirety). The minority shareholders, unhappy with this valuation, submitted a demand for an appraisal. Their appraisal expert valued the company at $66,074 per share (equivalent to $26.4 million for the whole company).

Subchapter-S Tax Issue
There were a number of issues involved in this litigation. For purposes of this discussion, however, we will confine ourselves to a consideration of the Court’s treatment of the Subchapter-S tax issue.

The opposing valuation experts took utterly differing positions on the issue of the proper treatment of Sub-S taxation (or lack of taxation). The appraiser for the majority shareholders treated the company as if it were a normal or C corporation for valuation purposes. He applied a 40% corporate tax rate to the earnings of the company. The argument that supports this approach is that if the most likely buyer of the company is a C corporation, the buyer will, after the acquisition, be faced with paying corporate income taxes on the earnings of the acquired company. If the buyer will receive no benefit from the acquired company’s S-Corp. status, it will analyze the company’s earnings as if the company did pay corporate income taxes. In other words, the buyer will “tax affect” the target company’s earnings by an amount which corresponds to normal C corporation taxes.

The appraiser for the minority shareholders, on the other hand, asserted the proposition that because Delaware Radiology is an S corporation, it faced no corporate-level income taxes. Any taxes, he reasoned, would be paid at the stockholder level and should not be considered in valuing Delaware Radiology as an entity. Accordingly, he did not tax affect its earnings at all in performing his valuation.

The Court’s Analysis
The Court had problems with both approaches. The Judge described his problem with the majority approach this way; “Delaware Radiology is a very small entity. The record reveals no set of circumstances in which it is likely that Delaware Radiology will convert to C corporation status….The S corporation tax status is a highly valuable attribute to the shareholders of Delaware Radiology…an appraisal petitioner is entitled to be paid for that which has been taken from him… As a matter of fairness, the merger price had to take into account these (S-Corp.) benefits and provide fair compensation for the (minority group’s) loss. (The majority group’s) approach denied the (minority group) members the value they would have received as continuing S corporation stockholders in Delaware Radiology and, therefore, ensured that the merger price was lower than fair value.”

The Court found the minority approach to be “equally flawed,” in that it “overstates the value fairly belonging to the (minority group).” He pointed out that if the universe of buyers is principally composed of C corporations, it would be highly misleading to do a market-based comparable acquisition valuation of an S corporation using sales of C corporations to C corporations and then to assume that an S corporation would be sold at a higher price because of its tax status.

He summarized the dilemma as follows; “I am not trying to quantify the value at which Delaware Radiology would sell to a C corporation; I am trying to quantify the value of Delaware Radiology as a going concern with an S corporation structure and award the (minority group) their pro rata share of that value.”

The Court’s Conclusion
After due consideration, the Judge developed an approach that he felt properly captured the value of the company’s S status without overstating it, as he felt would be the case if the minority group approach were adopted. For purposes of analysis, he assumed a hypothetical corporation that had $100 of pretax earnings, and paid out all of its after-tax earnings to its shareholders. He then calculated how much of this $100 would remain with the shareholder after all taxes had been paid. He made the calculation twice, once assuming that the company was a C corporation, and once assuming that it was an S corporation. He then compared the amount retained by the shareholder after all taxes. Using a corporate and personal income tax rate of 40%, and a dividend tax rate of 15%, he found that the C corporation shareholder would retain $51 out of the $100, and the S corporation shareholder would retain $60 out of the $100.

He then calculated a hypothetical corporate tax rate which, if applied, would leave a C corporation shareholder with the same after-tax earnings that he would have if the company were an S corporation. That rate is 29.4%, as is shown in the last column of the table below:

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

The Court then applied this tax rate of 29.4% to the pretax earnings of the company for purposes of calculating its value in order “to measure with the greatest practicable precision the fair value of the (minority group’s) interest in the going concern value of Delaware Radiology.”