In business valuation, the correct term is tax-affected, not tax-effected. “Affect” is the verb meaning to influence or change something, and when a valuation professional reduces a pass-through entity’s projected earnings by a hypothetical corporate tax, they are changing those earnings. The past participle is “tax-affected,” and the process is “tax affecting.” Every major Tax Court opinion and IRS guidance document on the subject uses those forms. “Tax-effected” turns up in casual conversation and occasional drafts, but it does not appear in the professional literature.
Why the Spelling Carries Weight
This is not just a grammar preference. The term appears in formal appraisal reports, Tax Court proceedings, IRS examination files, and shareholder litigation. Appraisers, attorneys, and judges who work in business valuation use “tax-affected” consistently. A written report that says “tax-effected” signals unfamiliarity with the field at exactly the moment credibility matters most, whether that is on cross-examination, in an IRS conference, or in front of a judge weighing competing expert opinions.
What Tax Affecting Is
Tax affecting is a valuation adjustment applied to pass-through entities such as S corporations, partnerships, and LLCs. These businesses do not pay federal income tax at the entity level. Profits flow through to the owners’ personal returns, and the owners pay tax individually. C corporations, by contrast, pay a 21 percent corporate tax before any distribution to shareholders.
The problem shows up when an appraiser needs to value a pass-through business. Most of the market data used to build valuation models comes from publicly traded C corporations, whose reported earnings are already reduced by corporate taxes. Feeding pre-tax pass-through earnings into a model built on after-tax C corporation data produces a mismatch. Tax affecting closes the gap by applying a hypothetical entity-level tax to the pass-through’s earnings so the comparison is consistent. Without the adjustment, a valuation can overstate the business’s worth by a wide margin.
In practice, appraisers reduce projected earnings by a hypothetical corporate rate, often 21 percent, and run that adjusted figure through a discounted cash flow or capitalization of earnings method. Several models exist for the adjustment. The S Corporation Economic Adjustment Model, sometimes called the Van Vleet Model, was introduced in 2002 and attempts to capture the full range of tax differences between S and C corporations, including shareholder-level capital gains taxes. A different approach came out of the 2006 Delaware Chancery Court decision in Delaware Open MRI Radiology Associates v. Kessler, which used a lower assumed entity-level rate under narrow conditions.
Where the Term Comes Up
You are most likely to see “tax-affected” in writing in a few settings:
- Estate tax filings, where a decedent’s interest in a closely held pass-through business must be reported at fair market value on Form 706 under Regulations sections 20.2031-2 and 20.2031-3.1Internal Revenue Service. Instructions for Form 706
- Gift tax reporting on Form 709, when business interests are transferred and require a fair market value determination.
- Divorce proceedings, when marital assets include a closely held business and the court needs a professional valuation.
- Shareholder buyouts and disputes, where the applicable standard is often “fair value” rather than “fair market value,” and whether tax affecting fits depends on the jurisdiction and the facts.
Is Tax Affecting Even Allowed?
A reader checking the spelling is often also checking whether the adjustment itself is on solid ground. It is, with caveats.
For years the Tax Court refused to permit tax affecting. The line started with Gross v. Commissioner (T.C. Memo. 1999-254), where the court reasoned that S corporations do not pay entity-level tax, so reducing their earnings by a hypothetical corporate tax was inappropriate. The IRS leaned on Gross during examinations for the better part of two decades.
The position began to move in 2019. In Kress v. United States, a federal district court accepted tax affecting in a case involving Green Bay Packaging, where all three experts on both sides applied the adjustment. That same year, in Estate of Jones v. Commissioner (T.C. Memo 2019-101), the Tax Court itself allowed tax affecting when supported by credible expert testimony. In Estate of Cecil v. Commissioner (T.C. Memo 2023-24), experts for both the taxpayer and the IRS agreed the entity’s projected cash flows should be tax-affected. The court wrote that “there is not a total bar against the use of tax affecting when the circumstances call for it,” while adding it was “not necessarily holding that tax affecting is always, or even more often than not, a proper consideration.”
The IRS default remains skeptical. Its Job Aid for valuation analysts states that “absent a compelling showing that unrelated parties dealing at arm’s length would reduce the projected cash flows by a hypothetical entity level tax, no entity level tax should be applied in determining the cash flows of an electing S Corporation.”2Internal Revenue Service. Valuation of Non-Controlling Interests in Electing S Corporations – A Job Aid for IRS Valuation Analysts The Job Aid also treats personal income taxes paid by S corporation shareholders as “not relevant in determining the fair market value of that interest.” It is not an official IRS position and cannot be cited as legal authority, but examiners use it as a roadmap.
The practical takeaway matches the terminology point: use the right word, and back the adjustment with fact-based analysis. Tax affecting is permissible when the appraiser can show why a hypothetical arm’s-length buyer would treat the earnings that way, and a boilerplate application without that support is still vulnerable on audit or in court.
Quick Reference
- Verb form: tax affect (to apply a hypothetical entity-level tax to pass-through earnings).
- Past participle and adjective: tax-affected (as in “tax-affected earnings” or “tax-affected cash flows”).
- Gerund and noun form of the process: tax affecting.
- Incorrect: tax effect, tax-effected, tax effecting.
If a draft appraisal, brief, or expert report crosses your desk with “tax-effected,” treat it as a red flag and ask the author to correct it before the document leaves the office.