S corporations are so-called pass through entities. The company itself pays no income taxes. Instead, the shareholders pick up their share of business earnings and put them on their own tax returns. This is big savings compared to the double taxation common with the C corporations.
Pre-tax or after-tax earnings for your business valuation?
When valuing a private company formed as an S corporation, the key question is whether to use the pre-tax or after-tax earnings as your basis. Business appraisers differ in their approach.
One scenario – business valuation for acquisition
An argument in favor of using after-tax earnings in your business valuation is that it puts the S corporation on an equal footing with companies paying income tax. Successful S corporations are often bought by larger competitors organized as C corporations. In this case using a reasonable corporate tax rate makes sense. Note that imputing 35% or higher income tax to the company will certainly affect your business valuation result.
Another case – valuation for buy-sell agreements and partner buyout
A different scenario is a partner buyout valuation. The block of shares is likely to be bought by the remaining business owners who will pay only individual taxes. In this case valuing the company on the pre-tax earnings basis is the right thing to do.
Since S corporations tend to be smaller and usually riskier than their C corporation counterparts, the discount rates tend to run higher. This has the effect of reducing business value even if the company is valued on the higher pre-tax earnings basis.