Introduction Perhaps there has been no more controversial business valuation issue than the appraisal of pass-throughtax entities (e.g., S corporations, limited liability companies, partnerships). The uncertainty that surrounds the issue and the magnitude of the dollars involved, in many cases, can be extremely large. For the valuation practitioner who has studied this issue and clearly understands the economic realities of value and the uncertainties of the IRS audit process, giving meaningful guidance to taxpayers who are looking for certainty has been extremely difficult. As a preface to the information that follows, the reader should understand the following: • This analysis is based on economic, financial and valuation theory; • It is critical to understand that there may be a difference between valuing an entire company, versus valuing a minority interest in it; • Each entity and each ownership interest in an entity may have unique characteristics that must be examined and considered. As a result, no valuation model can be applied blindly without consideration of the specific attributes of the subject ownership interest; and • In some cases, ownership interests in S corporations will be worth less than an otherwise similar C corporation interest. In some cases, they will be worth the same. In some cases, they will be worth more than otherwise similar C corporation interests. Although the phrase “S corporation” is typically used, the analysis and conclusions often are consistent with other pass-through tax entities. Exceptions, however, may exist. The reader is responsible for his/her own use and due diligence in the application of the presented material. The author makes no warranty as to its fitness for any use and accepts no liability for its application. The following discussion is an excerpt from a copyrighted white paper prepared by the author and Nancy J. Fannon of Fannon Valuation Group, and presented to the U.S. Treasury Department at the request of the S Corporation Association (used with permission). The analysis that follows presumes that the appropriate standard of value is fair market value, as defined in Rev. Rul. 59-60: “[T]he price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” Thus, the analysis considered both the buyer’s and seller’s perspectives. Additionally, the buyer and seller are hypothetical – rather than specific (e.g., family members) – investors. In its most basic terms, the role of a business appraiser is to determine the present value of an investor’s future benefits. Dr. Shannon Pratt confirms the assumption, stating: “[T]he cost of capital, derived from investors’ expectations and the market’s consensus of those expectations, is applied to expected economic income, usually measured in terms of cash flows...” [emphasis in original] “Future benefits” can be defined as the economic income stream available to equity investors. A common measure of economic income is net cash flow available to equity investors (“net cash flow”). The cash flow generated by company operations is available for distribution to equity holders, may be retained by the company, or it may be partially distributed to investors and partially retained by the company. Mathematically, net cash flow is defined in Exhibit 1, lines 1 to 10. Additionally, lines 11 to 15 restate the components of net cash flow and – depending on the form of the entity, C or S corporation – also depict components (i.e. dividends and distributions) of the company’s Retained cash flow. Using a formula to restate the preceding sentence, recognize that: