BIG tax as a valuation factor.

In Est. of Dunn, 5th Cir., 8/1/02, rev'g and rem'g TC Memo 2000-12, the Fifth Circuit bolstered the argument that C corporations should consider potential built-in gain (BIG) tax in valuing their stock. Prior cases have held that C corporation holding companies should consider BIG, but the discount in holding company cases has generally not been at the full 34% corporate tax rate. C corporations operating an active business, not valued on an asset-value basis, generally would not require a BIG adjustment.

In Est. of Davis, 110TC 530 (1998), the Tax Court allowed a 15% discount on net asset value (NAV) for potential capital-gain tax. The corporation was a holding company with a large block of publicly held stock with substantial BIG. Because a hypothetical buyer could buy the same publicly traded stock on the open market without exposure to capital-gain tax, a discount was applied to the equity value.

The same principle--a discount for BIG--was applied in Eisenberg, 155 F3d 50 (2d Cir. 1998) (a real estate holding company) and Est. of Jameson, 267 F3d 366 (5th Cir. 2001) (a timberland holding company).

The corporation in Dunn leased equipment. The block of shares being valued represented 62.96% of the outstanding stock. The corporation had 134 employees and was an operating business. Even though it was profitable, the corporation's return on equity was less than the return on alternative safe investments.

The IRS advocated a valuation approach based on NAV without a reduction for potential BIG tax. The taxpayer's expert advocated a value comprised of 50% of the earnings-based value and 50% of the NAV, as determined by including a 34% reduction of the assets' potential inherent gain. (The company was located in Texas; thus, state income tax was not a factor.)

The Tax Court arrived at a value weighted as 65% NAV and 35% earnings-based value. It reduced the NAV by 5% of the approximately $7.1 million BIG. The court reasoned that a potential stock buyer would not necessarily liquidate the company, but might buy the stock with a view toward entering into a different line of business. Further, the likelihood of liquidation was rather low.

The Fifth Circuit ultimately assigned an 85% weight to the earnings-based value and 15% to the NAV. Within the asset-based value, the court rejected the Tax Court's 5% BIG adjustment and used a 34% reduction. It reasoned that the asset-based approach should not consider the likelihood of liquidation in determining the corporation's NAV. In effect, the BIG tax is an integral part of the corporation's value in an asset-based value approach.

The Service's continued rejection of BIG adjustments appears to have been dealt another blow in Dunn. Since the repeal of the General Utilities doctrine, closely held C corporations have few options to mitigate the corporate-level tax on BIG. When NAV is considered in determining value, Dunn provides support that BIG tax should be considered in full, not reduced by an estimate of the likelihood of liquidation.

FROM CECIL MCPHERRON, CPA, MST, ANDERSON & WHITNEY, P.C., GREELEY, CO