By Andrew Soshnick, AAML

For years, the U.S. Tax Court (Tax Court) has vacillated regarding the practice of tax affecting under the income approach to valuation. Particularly, the discounted cash flow (DCF) method under the income approach has been the subject of intense scrutiny and divergence of opinion as to the propriety of tax affecting. A recent opinion from the Tax Court suggests that tax affecting is back in vogue for consideration and use by valuation analysts and approval by courts on an ad hoc, carefully considered basis.

Pierce v. Commissioner, T.C. Memo 2025-29 (April 7, 2025) involved a privately held business, Mothers Lounge, LLC (Mothers Lounge), an S corporation for tax purposes involved with mother and baby products, structured as a limited liability company and owned by a taxpayer husband and his wife. For estate planning purposes, in 2014 husband and wife each gifted 29.4% of their Mothers Lounge common stock to two irrevocable trusts and each sold a 20.6% interest in Mothers Lounge to a limited liability companies owned by the irrevocable trusts. In 2016, the Internal Revenue Service (IRS) challenged the values placed on IRS Form 709 as being lower than fair market value.

The Tax Court recounted a long and, at times, sordid history of Mothers Lounge and its owners that involved complex business travails, litigation and later infidelity by the husband that eventually led to the dissolution of the parties’ marriage. During tone of the periods of uncertainty and controversy, the husband and the wife banded together to attack succession planning for Mothers Lounge. When a 2016 notice of IRS audit arrived, the husband and the wife retained counsel and multiple business valuation experts.

On Sept. 19, 2018, the IRS issues notices of gift tax deficiencies to the husband and the wife in the amount of $4,824,160 and accuracy related penalties of $1,929,664. On the eve of trial, the wife settled her case and the husband’s case proceeded.

The husband and the IRS each relied on expert opinions to value the Mothers Lounge interests. The husband’s expert, who prepared and earlier 2017 and then a 2024 report, opined that the fair market value of Mothers Lounge as of the valuation date in his 2024 report was $18,678,000 before a 25% discount for lack of marketability and a 5% discount for lack of control. He valued the 29.4% gift interest at $3,913,000 and the 20.6% sale interest at $2,741,000. The husband also offered the expert testimony of a financial analyst and a rebuttal expert to the IRS expert’s rebuttal report. The IRS expert opined that the fair market value of Mothers Lounge as of the valuation date was $28,107,338 before a 30% discount for lack of marketability and 10% discount for lack of control on nonoperating assets. He valued the 29.4% gift interest at $5,784,421 and the 20.6% sale interest at $4,053,029.

Each expert applied the DCF method under the income approach to value Mothers Lounge, and the Tax Court agreed that was the proper approach and method to use. The Tax Court defined the DCF method as a method to determine the value of a business by adding the present value of projected cash flows for a discrete period, the present value of a business’s terminal value and the nonoperating assets of a business.

In its analysis, the Tax Court “easily” rejected the IRS expert’s projections as knockoffs of the husband’s expert’s 2017 report without any independent analysis. Functionally, that left the Tax Court to compare the husband’s expert’s 2017 and 2024 reports. After carefully weighing all evidence, the Tax Court found that the projections in the husband’s expert’s 2024 report were credible and were adopted to value Mothers Lounge.

Turing to tax affecting, there was little difference between the tax-affecting rates of the experts. The Tax Court noted that when the data used to value a pass-through entity such as an S corporation is largely based on the data of C corporations, a fictitious tax burden is often applied by valuation analysts to reduce earnings before calculating present value. The Tax Court went on to acknowledge that tax affecting has been narrowly applied by it when there is no adequate explanation of the necessity of tax affecting or when experts disagree as to the necessity but is applied when the record clearly sets out the need for tax affecting.

Here, the husband’s expert calculated the fictitious tax rate at 26.2% and the IRS expert calculated the fictitious tax rate at 25.8%, based primarily on the application of different individual tax rates. The IRS expert’s tax rate calculation lacked necessary supporting calculations to affirm its accuracy while the husband’s expert reasonably calculated the 26.2% individual tax rate by applying the graduated tax rates to Mother’s Lounge’s income.

The Tax Court further analyzed discount rate differences, terminal value differences, nonoperating assets differences, discount for lack of marketability differences and discount of lack of control differences between the experts. Ultimately, the Tax Court accepted (a) the husband’s expert’s forecasts as the related to the discrete period of operation and terminal value, $1,351,978 excess cash calculations, 25% discount for lack of marketability and 5% discount for lack of control and (b) the IRS expert’s 18% discount rate. In conclusion, the Tax Court indicated it would issue an appropriate order based on these determinations.

While Pierce is chock full of factual drama, evidentiary rulings, valuation variable choices and discretion, tax affecting comes into full view in this memorandum. In a clear voice, the Tax Court recognized that C corporation data applied to S corporation business valuations has different tax impact characteristics. Applying C corporation-level tax analysis, all else equal, overstates value by understating taxes paid at the personal level. Moreover, when competing experts agree on tax affecting, the Tax Court indicated that it would look favorably on applying this assessment if necessity is established. Pierce reviews prior tax affecting case precedent but elucidates in perhaps the clearest way to date the when, where, why and how to tax affect pass-through income. While wedged into a contentious factual setting with multiple complex issues and analyses, the memorandum offers guidance to attorneys and valuation analysts who are advocating for application of tax affecting. And for that, if nothing else, the tax affecting paradox is not so mysterious, esoteric and unreachable in divorce litigation and a welcomed development.