Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 25

Cost of Capital of Interests in Pass-through Entities

Introduction

Characteristics of PTEs

Gross Decision

Delaware Court Adjusts for Tax Differences

Family Law Court Adjusts for Tax Differences

Market Evidence of Value of Interests in PTEs

Cost of Capital for PTEs

Risks of Investments in PTEs

Summary

Additional Reading

INTRODUCTION

More and more entities are organized as pass-through entities (PTEs). Taxable income for federal income tax reporting purposes (and generally for state income tax reporting purposes as well) of PTEs is passed through to the owners of the entity. The entity itself does not pay the income taxes; rather, the entity acts as a conduit and the owners pay the income taxes directly.

Beginning with passage of the 1986 Tax Act, more and more businesses have been organized as PTEs. Of the 34 million business tax returns filed in 2009 (the latest year for which data are available), 32 million were PTEs, representing about 70% of the net business income, compared to about 25% in 1980.

In the 1990s, the rules on treatment of subsidiaries changed (so-called “check the box” tax return procedures), making it easier for larger and larger entities to be organized as PTEs. For example, in 2007, there were almost as many PTEs with annual revenues exceeding $50 million (15,360 PTEs) as there were C corporations with equivalent revenues. Large closely held companies organized as PTEs include Bechtel, the global construction and engineering firm, and Mars, the ...