S Corps vs. C Corps: Tax-Affecting Pass-Through Entities in a Buyout

Valuation issues are some of the most impactful in shareholder disputes. An important, but perhaps underappreciated, issue in these disputes is how to account for a company’s tax status.

C corporation cash flows are subject to double taxation, at the entity level and again at the shareholder level, whereas pass-through entity (“PTE”) cash flows are subject only to shareholder-level taxation. Most often, a dollar earned by a PTE such as an S corporation is, therefore, worth more to its owner than a dollar earned by an otherwise identical C corporation, and valuation professionals must adjust the valuation of PTEs upward to account for it. However, there are many variables, and there are times where a C corporation could be significantly more valuable than a PTE.

This blog post — the second in a series on valuation issues in shareholder disputes — explores the issue.

Why It Matters

Most business valuation professionals start with a C corporation framework focused on revenue, net income, EBITDA, growth rates, and buyer-specific adjustments, among others.

But most businesses in America are not taxed as C corporations. Businesses taxed as sole proprietorships, partnerships, or S corporations make up roughly 94% of all U.S. businesses and employ more than half of the private-sector workforce (Tax Foundation analysis of Census and IRS data). Florida’s filing data tells a similar story. Of the state’s 4.1 million active business entities, more than 3 million are LLCs, most of which are taxed as PTEs, compared with roughly 800,000 corporations, at least some of which are taxed as S corporations. Put simply, PTEs are not the exception. They are the norm.

Since most business valuation professionals start with a C corporation framework, however, a shareholder getting bought out of a PTE must ensure that his or her attorney and business valuation professional are considering tax status (i.e., “tax affecting” the business).

Two Methodologies

There are several approaches a business valuation professional can employ to tax affect a PTE. This blog post will discuss two: (1) the Delaware approach, the model with perhaps the most support in the caselaw, and (2) the S Corporation Economic Adjustment Model (the “SEAM”), the model with perhaps the most support among business valuation professionals and academics. Both models are aimed at the same benefit — the second layer of tax that a PTE’s owners never pay — but they build it into the valuation from opposite ends.

The Delaware approach. Delaware Open MRI Radiology Associates, P.A. v. Kessler, 898 A.2d 290 (Del. Ch. 2006), was an appraisal case in which the Delaware Court of Chancery had to value a minority shareholder’s interest in an S corporation. Kessler rejected both extremes — taxing the earnings at a full C corporation rate (which charges the departing owners for a tax the company will never pay) and taxing them at nothing (which pays them for dollars no owner ever keeps). Instead, Kessler solved for the hypothetical “pre-dividend” entity-level tax rate that would leave the S corporation’s shareholders with the same after-tax dollars they actually keep, and applied the result. The opinion’s own illustration shows the calculation:

An S corporation’s owners keep $60 of every $100 of pre-tax earnings (middle column). The effective 29.4% tax rate in the right-hand column is the entity-level rate that leaves a C corporation’s owners with those same after-tax dollars — so Kessler applied an effective 29.4% rate, not 40% and not zero, to the company’s earnings.

The SEAM. The SEAM, or Van Vleet model, grew out of Gross v. Commissioner, T.C. Memo 1999-254, 1999 WL 549463 (T.C. 1999), aff’d, 272 F.3d 333 (6th Cir. 2001), in which the Tax Court accepted the IRS’s position that an S corporation’s earnings should not be tax-affected at all. Valuation professionals responded with models that measure what pass-through status is actually worth to the shareholder, rather than choosing between a full corporate rate and zero. In Estate of Cecil v. Commissioner, T.C. Memo 2023-24, 2023 WL 2256148 (T.C. 2023), the Tax Court accepted the use of the SEAM to adjust an S corporation’s value — evidence the model now stands on its own, not just as a reaction to Gross. The SEAM leaves the earnings taxed as a C corporation’s would, and then multiplies the concluded equity value by a calculated premium based on several inputs — the 1.18x for non-service businesses shown in the table below.

Caveat: The above table is illustrative only. It is based on $100 of pretax income at top combined federal and Florida rates. Actual figures depend on the company, the owners’ tax posture, and the assumptions used. The shareholder-level rates apply in any no-income-tax state, but the entity-level tax does not, as Wyoming and Nevada have no corporate income tax, and this table does not apply in Texas, where a franchise tax at the entity level applies to S corporations as well as C corporations. The actual SEAM calculation is sensitive to several interacting tax-rate inputs, and even a small inconsistency among them can materially change the result.

Choosing the Delaware Approach or the SEAM

One subtracts and one multiplies, but the two methods are aimed at the same target, and given the same assumptions, they generally give the same answer. However, there are important differences.

The Delaware approach in Kessler runs on three inputs — a corporate rate, an individual rate, and a dividend rate. The SEAM runs on many more: the entity-level corporate tax, a PTE-level state tax, the individual/ordinary rate, the capital gains rate, the dividend rate, and the payout ratio. While the state taxes and the QBI deduction could be applied in the Delaware model by adjusting the applicable tax rates, there is no way to shoehorn into the Delaware approach the consideration of payout ratio and retained earnings (and capital gains on the value derived from those retained earnings). Kessler’s illustration assumed full distribution as a modeling convenience.

On the other hand, the SEAM accounts for payout ratio and retained earnings. A C corporation’s reinvested earnings compound against only the 21% entity layer, plus any applicable state taxes, because the shareholder-level tax is deferred. A PTE’s reinvested earnings are taxed to the owner every year. Where a company retains and reinvests earnings over time, a C corporation shareholder’s ability to defer the shareholder-level tax until sale can create a compounding advantage that a single-year comparison like the table above doesn’t capture.

There are also scenarios where the C corporation shareholder never pays the shareholder-level tax. An owner who simply holds until death may escape the shareholder-level tax entirely: under the basis step-up of I.R.C. § 1014, the shareholder’s heirs take the stock at its date-of-death value, and the deferred gain on a lifetime of retained earnings disappears. There may also be a basis to eliminate the shareholder-level tax before death for certain qualified small business stock under I.R.C. § 1202.

While SEAM is the more complete model, there are scenarios where non-operating assets can overstate the SEAM effect. In certain cases, we have seen redundant assets (i.e., cash, marketable securities, land, etc.) swept in along with operating value and impacted by the SEAM multiple. To avoid this, the SEAM should be applied only to the value of business operations, before redundant assets are added back and debt is subtracted.

In sum, there can be significant differences between the Delaware approach and the SEAM. The SEAM is the more complete model, but close cooperation with your business valuation professional and attorney is imperative to ensure that your interests are protected.

Caveat: The figures above depend on today’s 21% corporate rate, the QBI deduction, and current dividend and capital-gains rates, etc. When Congress changes any of them, the premium will change too — and a model, or a quoted rate, built on the old law is outdated the day the new law takes effect. Further, this blog post is not tax advice. There may be limitations on retained earnings in C corporations. See I.R.C. § 531. Do not rely on this blog post for tax matters. Check with your CPA or tax attorney.

Why This Matters in Florida

No reported Florida appellate decision appears to have decided how, or even whether, to tax-affect a PTE’s earnings in a determination of fair value in dissolution or appraisal proceedings. Florida courts may be more amenable to the Delaware approach, but in the right case, a court may be convinced to adopt the SEAM methodology.

Florida courts generally look to Delaware corporate law as persuasive. See Williams v. Stanford, 977 So. 2d 722, 727 (Fla. 1st DCA 2008). Especially so where Florida law is underdeveloped, as it is in interpreting “fair value.” See, e.g., Boettcher v. IMC Mortgage Co., 871 So. 2d 1047, 1052 (Fla. 2d DCA 2004) (“Research discloses no reported Florida cases interpreting the term ‘fair value’ as used in the dissenters’ rights statute.”). A Florida judge asked to value a PTE may, therefore, be pointed to Kessler, and the Delaware approach carries a certain comfort. The Delaware approach has also received significant support in other jurisdictions. See Bernier v. Bernier, 873 N.E.2d 216 (Mass. 2007); Raley v. Brinkman, 621 S.W.3d 208 (Tenn. Ct. App. 2020); Pierce v. Commissioner, T.C. Memo 2025-29, 2025 WL 1057782 (T.C. 2025).

But the SEAM is the more complete tool. It models retained earnings as well as distributions, and it states every assumption where it can be tested. And Florida’s slate is blank — no Florida appellate court has adopted Kessler, and nothing obligates a Florida court to follow the Delaware approach over the sharper instrument. In an appropriate case, it will be the job of the attorney and business valuation expert to explain why the SEAM is the better tool for the job.

Conclusion

Whether a business is taxed as a PTE or a C corporation can substantially change its value. Yet, the fact that no Florida authority exists on the subject suggests that perhaps the issue flies under the radar more often than it should. Don’t let that happen to you. Get counsel and a valuation professional that can maximize your chance of getting fair value.