Valuing closely held stock for estate and gift tax purposes.

The courts and IRS agree: Potential capital gains reduce stock value.

CPAs who work with estates know that, if a decedent owned stock of a closely held business at his or her death, the value of the stock generally must be determined if an estate tax return will be filed. The value for such purposes is the date-of-death fair market value (FMV) (or, if an election is made under IRC section 2032, the FMV on the "alternative valuation date," six months later). The same is true for gifts of closely held stock--the FMV on the date of the gift must be determined for gift tax purposes.

BACKGROUND

The valuation issue is not much of a problem when stock is publicly held because a CPA can readily obtain the date-of-death (or date-of-gift) FMV from a newspaper or broker and multiply it by the number of shares owned or gifted. However, closely held stock usually does not have a readily ascertainable FMV: There may be only a few shares, they may not be widely traded (and, indeed, may never have been traded), and only a few family members may be holding them. In addition, other factors may apply, such as applicable discounts and premiums that affect FMV--for example, owning a minority or controlling block of shares--and the availability to an estate of the section 2057 qualified family-owned business deduction. While revenue ruling 59-60, 1959-1 CB 237, outlines the general approach to valuing closely held stock for estate and gift tax purposes, it also states that the determination of FMV depends on the facts and circumstances.

Normally, expert appraisers are hired by tax advisers to value the stock; sometimes, if the IRS does not agree with the value reported on the return, litigation ensues. Thus, when the courts and IRS agree that certain reductions in closely held stock value are permissible, CPAs should take notice.

Recently, the Second Circuit Court of Appeals held that the per-share valuation can be reduced for potential capital gains on corporate liquidation, or on a distribution or sale of its capital assets (for example, real estate). The IRS later acquiesced, agreeing such a reduction is valid. The Sixth Circuit later weighed in with an opinion of its own. A review of these rulings illuminates the thinking on this issue.

SECOND CIRCUIT

In Irene Eisenberg (155 F.3d 50, 2d Cir. 1998, revk'g and remd'g TC Memo 1997-483), the taxpayer owned all 1,000 shares of a corporation whose sole asset was a commercial building it rented out. The taxpayer gave shares of the corporation to her son and two grandchildren in 1991, 1992 and 1993: In valuing the stock for gift tax purposes, she reduced the FMV by the full capital gains tax she would have incurred in the event of corporate liquidation, or a sale or distribution of the building, even though, at the time of the gifts, the corporation had no such plans.

The IRS disagreed with the gift tax valuation, contending solely that the value of the stock could not be reduced for potential capital gains tax. The taxpayer petitioned the Tax Court, which held against her.

The court reasoned that firmly established precedent dictated no reduction in stock value for potential capital gains tax in the absence of evidence that a corporate liquidation--or a sale or distribution of capital gain assets--was likely to occur. In the court's view, such tax liability was purely speculative. Further, the taxpayer failed to show that a hypothetical buyer would purchase the corporation with an eye towards liquidation or selling assets so that the potential capital gains tax liability would be a material or significant concern.

The taxpayer appealed the decision; the Second Circuit held that she was entitled to reduce stock value for potential capital gains tax liabilities, even though no liquidation, or asset sale or distribution, was contemplated by the corporation when the stock was gifted. According to the court, such a reduction takes into account whether a hypothetical willing buyer of the stock, having reasonable knowledge of the relevant facts, would take some account of the tax consequences of contingent built-in capital gains in making a sound valuation of the property.

The IRS later acquiesced in Eisenberg (see IRB 1999-4, 4); it agreed that the FMV can be reduced, for estate or gift tax purposes, by the potential capital gains tax liability. However, the IRS requires the taxpayer (for gift tax purposes) or the estate (for estate tax purposes) to offer sufficient evidence as to the computation of the discount.

SIXTH CIRCUIT

In Estate of Pauline Welch (6th Cir., 3-1-00, rev'g and remd'g TC Memo 1998-167), an unpublished opinion, the court held that an estate could present evidence of the appropriate amount a hypothetical willing buyer and seller would consider as a discount or adjustment in valuing the stock, based on the built-in capital gains on the corporation's real estate.

In Welch, the taxpayer had owned minority interests in two closely held corporations; at her death, the stock passed to her children. The value of the stock on her estate tax return was reduced for the capital gains tax liability on the corporate real estate and for the decedent's minority interests. The IRS disputed the reduction for capital gains taxes; the estate appealed.

The Sixth Circuit, explicitly adopting an Eisenberg analysis, held that such valuation reduction was available; it further held that the corporations' option to defer capital gains tax under section 2033, for real estate potentially subject to condemnation, did not bar a valuation discount for estate tax purposes. The Sixth Circuit thus reversed and remanded the case to the Tax Court for a hearing on the price a hypothetical buyer would pay for the stock.

COMPLIANCE STRATEGY

CPAs working with gift and estate tax valuation issues for closely held stock should keep these decisions and the IRS's acquiescence in mind when computing closely held stock FMVs on estate or gift tax returns. Because the IRS agrees a discount is appropriate, it does not matter whether the taxpayer or estate is located within the jurisdiction of the Second or Sixth Circuits; the principle applies nationwide. However, a CPA should attach a disclosure statement to the estate or gift tax return detailing the capital gains tax liability computation that reduced the stock valuation.

--Lesli S. Laffie, JD, LLM Technical Editor, The Tax Adviser