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The valuation discount for potential capital gains tax.

Two recent court decisions should prove to be landmark cases in the valuation of closely-held corporations for estate and gift tax purposes. In Irene Eisenberg v. Commissioner,[1] the Tax Court found that the gift tax value of stock in a closely-held corporation should not be discounted to reflect capital gains taxes that would be owed if real estate owned by the corporation were sold. In the appeal which was decided August 18, 1998,[2] the Second Circuit vacated and remanded the decision of the Tax Court, stating that the taxpayer's adjustment for potential capital gains tax liabilities was appropriate. In Estate of Artemus D. Davis,[3] the Tax Court awarded a $9 million discount for the built-in capital gains tax in addition to a lack of marketability discount of $19 million and a minority interest discount of 15% on the gift tax value of two gifts made by the decedent to his two sons.

These cases have important implications for those involved in valuations, because the decisions indicate a marked change from past litigation where the taxpayer had discounted net asset value for potential capital gains tax. In both the Eisenberg and Davis cases, the discount was awarded even though no liquidation or sale of the corporation or its assets was planned at the time of the gifts.

Background

In the past, the Tax Court has repeatedly held that no reduction in the value of closely-held stock to reflect potential capital gains tax is warranted where a liquidation or a sale of the corporation's assets is purely speculative. The seminal case in this regard is Estate of Cruikshank v. Commissioner,[4] where the taxpayer held stock in a closely-held corporation which was an investment holding company. The basis for valuation was the value of the underlying assets. The question answered by the Court was whether the value should be reduced by amounts of commissions, stamp taxes and capital gain taxes which would be payable if the assets were sold. The Court held

. . . the costs of disposal like broker's commissions are not a proper deduction. Still less do we think a hypothetical and supposititious liability for taxes on sales not made nor projected to be a necessary impairment of existing value. We need not assume that conversion into cash is the only use available to an owner, for property which we know would cost him market value to replace.

Other frequently cited cases where the Court allowed no reduction for potential capital gains tax include Gallun, McTighe, Robinson, Piper, Andrews, Ward, Luton, Ford, and Gray.[5] (See Table 1). The taxpayers in all of these cases requested a reduction in stock value equal to the full amount of the capital gains taxes that would have been due upon liquidation of the respective corporations. The Court denied each of those requests where there was no evidence that a liquidation or sale of assets was planned or even contemplated or that the full amount of capital gains taxes could not have been avoided. The avoidance of capital gains tax was based upon the General Utilities doctrine. Under the General Utilities doctrine, a corporation could avoid recognition of gain on the distribution of appreciated property to its shareholders. With the Tax Reform Act of 1986 (TRA), corporations are now required to recognize gain on the distribution of appreciation property except in certain limited circumstances.

District Court Allows Reduction for Capital Gains Tax

Two district court decisions occurred before the repeal of the General Utilities doctrine and allowed a reduction in value for potential capital gains taxes. In both of these decisions, the potential capital gains tax was included with other factors which reduced the value of the stock. In Obermer,[6] the District Court of Hawaii allowed a reduction of 33 1/3% from adjusted book value for several factors adversely affecting book value. These factors included (1) the personal holding company status, (2) the existence of outstanding debentures, (3) the built-in capital gains tax which would result when stock was sold to retire the debentures, (4) the equally divided control, (5) probable special selling expenses, and (6) the uniqueness of the stock.

In Clark,[7] the District Court allowed a reduction for potential capital gains tax in determining the gift tax value of shares of stock in a closely held corporation. However, the Court did not consider the potential capital gains tax to be a separate discount. The Court noted:

While it is appropriate to consider capital gains tax liability as a factor an investor might consider, there is no absolute right as a matter of law for plaintiffs to separately deduct such hypothetical tax liability from the value of the assets of the corporation.

The net asset value was reduced by 40% which was due to several factors limiting the price the stock would bring in the open market. These factors included (1) no ready market for the shares, (2) a trapped-in capital gains tax liability on the investment portfolio, (3) the minority interest status of each of the gifts, (4) the possibility of a tax liability because of accumulated earnings, (5) the lack of professional management for the investment portfolio, and (6) no reasonable expectation that the income of the corporation would increase dramatically.

IRS Position on Capital Gains Discount

The Internal Revenue Service (IRS) has alerted its appeals officers to watch for "hidden" discounts in a variety of pro-taxpayer strategies. In its new handbook on valuation for appeals officers,[8] the IRS states that a discount for prospective capital gains tax is speculative and unwarranted, unless the taxpayer can show that liquidation of the corporation is imminent.

In a 1991 letter ruling,[9] the IRS stated that no discount for potential capital gains taxes would be allowed in determining the estate tax value of 69.4% of the stock in a closely held real estate holding company. The decedent's estate contended that a willing buyer would not pay the full value of the underlying assets, but would consider the capital gains tax payable upon disposition of the assets and adjust the price he would be willing to pay accordingly. The estate noted that no liquidation was planned.

The taxpayer argued that TRA '86 amendments to sections 336 and 337 of the Code made it a virtual certainty that if the corporation were liquidated, a capital gains tax would be imposed at the corporate level.

The taxpayer's position was that this change in the law justified the allowance of a discount for potential taxes. The Service cited some of the previously mentioned cases (Cruikshank, Ward, Andrews, Piper, McTighe, and Gallun), noting that the Court's disallowance of the discount in these cases was not due to the nonrecognition provisions of sections 336 and 337 prior to TRA 86, but rather to the speculative nature of the liquidation itself.

The Eisenberg Case

In Eisenberg, the IRS determined deficiencies totaling $61,735 attributable to the disallowance of the taxpayer's application of discounts to the value of gifts made during 1991, 1992 and 1993. Before the gifts, the petitioner, Irene Eisenberg, held 100% of the outstanding common stock of Avenue N Realty Corp., a subchapter C corporation. Over three transfer dates, Ms. Eisenberg gave all of her shares of Avenue N Realty Corp. to her son and two grandchildren. The principal asset of the corporation was a building, which was leased to third parties. The corporation's only income was from renting the property.

The IRS agreed with the taxpayer that the net asset value method was appropriate for the valuation of the stock, and both sides agreed on the fair market value of the property. There was further agreement that the corporation would have recognized capital gains of $530,500, $402,094 and $402,892 on the three gift dates if the property had been disposed of in a taxable disposition. The taxpayer argued that a hypothetical willing buyer of the stock would have discounted the fair market value of the stock because of the inherent income tax liability. Thus, the taxpayer reduced the fair market value of the stock by the full amount of capital gain taxes that would have been incurred if the corporation had sold the property on the transfer dates. The IRS argued that a hypothetical buyer might indefinitely defer taxes by purchasing the corporate stock and continuing the business of leasing the property through the corporate form. The IRS noted that there are several transactions in which the corporation might transfer the property to a new corporation in exchange for the new corporation's stock and avoid the recognition of gain.[10]

The Court cited Ward (1986), Piper (1979), Andrews (1982), Robinson (1977), and Cruikshank (1947). The taxpayer argued [TABULAR DATA FOR TABLE 1 OMITTED] that many of these cases have lost their vitality as a result of the Tax Reform Act of 1986 which repealed the General Utilities doctrine. Both the taxpayer and the IRS acknowledged that there was no plan of liquidation. The Tax Court agreed with the IRS, noting that a discount for potential costs of sale or liquidation is inappropriate where the sale or liquidation itself is purely speculative.

The Second Circuit Position

The Second Circuit disagreed with the Tax Court's view that the critical point in the case was the lack of any indication of an imminent liquidation, stating, "The issue is not what a hypothetical willing buyer plans to do with the property, but what considerations affect the fair market value of the property he considers buying" The Second Circuit also denied the appropriateness of citing cases which had been decided before the General Utilities doctrine was repealed:

Now that the TRA has effectively closed the option to avoid capital gains tax at the corporate level, reliance on these cases in the post-TRA environment should, in our view, no longer continue.

The Davis Case

On November 2, 1992, Artemus Davis gave each of his two sons a gift of 25 shares (25.77%) of ADDI&C, which was primarily a holding company for Davis' assets. ADDI&C also had some cattle operations, but its predominant asset was 1,020,666 shares of Winn-Dixie stock. The taxpayer, the IRS and all of their expert witnesses agreed that the net asset value of ADDI&C on the valuation date was $80,140,269 (before application of any discounts).

The taxpayer and all of the valuation experts, including the expert for the IRS, agreed that the net asset value should be reduced by applying a discount for the built-in capital gains tax. The IRS rejected their opinions, stating that an adjustment attributable to ADDI&C's built-in capital gains tax was contrary to federal tax law. The IRS cited the established line of cases where no reduction for projected capital gains taxes had been allowed. Two reasons were offered by the IRS for the decisions of those cases. First, prior to 1986, Code sections 336 and 337 allowed the tax-free liquidation of a corporation, so the projected liability was so speculative as to be irrelevant. Second, the repeal of those provisions in 1986 did not foreclose the possibility of avoiding capital gains taxes at the corporate level. A subchapter C corporation can convert to a subchapter S and avoid recognition of any gain, if the corporation retains the assets for a period of ten years from the date of conversion. The Court rejected the IRS position that ADDI&C could have avoided all of the built-in capital gains tax by electing S corporation status and by not selling any of its assets for ten years thereafter.

As of the valuation date, the built-in capital gains tax relating to all of ADDI&C's assets was $26,686,614. The taxpayer and one of the taxpayer's experts argued that the net asset value should be reduced by the full amount of the tax. The Court rejected their position stating

. . . where no liquidation of ADDI&C or sale of its assets was planned or contemplated on the valuation date, the full amount of ADDI&C's built-in capital gains tax may not be taken as a discount or adjustment in determining the fair market value . . .

The Court concluded that some adjustment for the built-in capital gains tax should be part of the lack of marketability discount and chose $9 million, a number between two amounts calculated by the IRS expert and one of the estate's experts.

A 1998 Decision Denying Capital Gains Tax Discount

In Estate of Pauline Welch,[11] the decedent was a minority stockholder in two closely-held corporations. The valuation date for estate tax purposes was the date of death, March 18, 1993. To determine the value of the decedent's shares, the estate deducted a 34% discount for built-in capital gains taxes from the value of the real estate and then deducted a 50% minority interest discount before calculating the per share value of each corporation. The IRS and the estate agreed on the fair market value of the decedent's interest before the application of any discounts. There had been a subsequent stock sale on March 4, 1994 at a per share price equal to the per share price shown on the estate's federal tax return. The estate argued that the sale was indicative of what a willing buyer would have paid for the stock given the inherent income tax liability in the real property.

The Tax Court sided with the IRS, allowing the 50% minority interest discount, but disallowing a discount for built-in capital gains tax. The Court disregarded the subsequent sale on March 4, 1994, stating that the sale was between related parties and that the sales price was determined solely by referencing the reported amount on the estate's tax return. The disallowance of the built-in capital gains tax discount seemed to stem from the subsequent condemnation of the real property of both corporations by the government. On June 20, 1994, the real estate of both corporations was sold to the Metropolitan Government of Nashville and Davidson County, Tennessee due to condemnation proceedings. Both corporations made elections on their 1994 federal tax returns not to recognize gain realized from the compulsory or involuntary conversion of property,[12] and both corporations purchased replacement property within the replacement period. The Court noted that a section 1033 election was available to the estate on the valuation date, and the estate had presented no evidence that either corporation considered recognizing the built-in capital gain and foregoing the election. In an ominous note to its decision, the Court stated, "We also note that a corporation's recognition of built-in capital gains is far from certain, even in the absence of special nonrecognition provisions such as section 1033. A corporation's NOL carrybacks and carryovers can limit or extinguish any potential recognition of built-in capital gain for up to 19 years."

In light of the Davis and Eisenberg decisions, an appeal of the Tax Court's decision in Welch seems possible. In its arguments for disallowance of a discount for built-in capital gains tax, the IRS contended that the estate failed to show that the condemnation of the properties was foreseeable on the valuation date. (Legislative action to condemn the property was not taken until August 12, 1993, five months after the valuation date.) Subsequent events which affect the value of the property can be taken into account only if they are reasonably foreseeable on the valuation date.[13]

Conclusion

The recent Davis and Eisenberg court decisions provide support for lowering some estate and gift tax values through the use of a capital gains tax discount. However, one note of caution is offered. In both Davis and Eisenberg, the Court did not conclude that the value should be reduced by the full amount of the potential capital gains tax. In Davis, the Tax Court only allowed 34% of the total built-in capital gains tax to be included as part of the reduction in value, and the Court concluded that it was properly accounted for as part of the lack of marketability discount. In Eisenberg, the Second Circuit stated that it would be incorrect to conclude that the full amount of the potential capital gains tax should be subtracted from what would otherwise be the fair market value of the real estate. Instead, the Court noted that it was only addressing how potential tax consequences may affect the fair market value of the gifted shares of stock in contrast to the fair market value of the real estate. The IRS has taken the position that a reduction for the full amount of the built-in capital gains tax would only be appropriate when liquidation or sale of the assets is imminent. Nonetheless, these two recent court decisions are a welcome change for those involved in valuing closely-held entities. Davis and Eisenberg signal the willingness of the courts to accept some reduction in value for potential capital gains tax even when there is no plan to sell the assets or liquidate the corporation.

References

1. Irene Eisenberg v. Cam., CCH Dec. 52,321, 74 T.C.M. 1046 (1997).

2. Irene Eisenberg v. Com., 98-2 USTC ??60,322.

3. Estate of Artemus D. Davis v. Com., CCH Dec. 52,764, 110 T.C. 35 (1998).

4. Estate of Frank A. Cruikshank v. Com., CCH Dec., 15,941, 9 T.C. 162 (1947).

5. Edwin A. Gallun v. Comm., 33 T.C.M. 1316 (1974); Estate of Frederick J. McTighe, 36 T.C.M. 1655 (1977); Estate of G.R. Robinson, 69 T.C. 222 (1977); Estate of William T. Piper, 72 T.C. 1062 (1979); Estate of Woodbury G. Andrews, 79 T.C. 938 (1982); Charles W. Ward v. Comm., 87 T.C. 78 (1986); Estate of William F. Luton, 68 T.C.M. 1044 (1994); Estate of Ray A. Ford, 66 T.C.M. 1507 (1993), 53 F.3d. 924 (1995) affirmed; Estate of Jewell E. Gray, 73 T.C.M. 1940 (1997).

6. Nesta Obermer v. United States, 65-1 USTC ??12,280, 238 F. Supp. 29 (D. Haw. 1964).

7. W. G. Clark, Jr. v. United States, 75-1 USTC ??13,076, E.D.N.C. (May 16, 1975).

8. IRS Valuation Training for Appeals Officers Coursebook, CCH, Inc., 1998.

9. CCH IRS Letter Ruling Report No. 772, LTR 9150001 (August 20, 1991).

10. Code Sec. 351 and 355.

11. Estate of Pauline Welch v. Com., CCH Dec. 52,689, 75 T.C.M. 2252 (1998).

12. Code Sec. 1033(a)(2).

13. Nathan P. Morton v. Comm., CCH Dec. 51,979, 73 T.C.M. 2520 (1997).

Melanie J. Earles, DBA, CPA, Assistant Professor of Accounting, Department of Accounting and Business Law Tennessee Technological University, Cookeville, TN
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Date:Jul 1, 1999
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