Taxpayer victory in the battle over built-in capital gains tax

No two ways about it: Built-in capital gains tax is an economic reality for C corporations. Recent Tax Court rulings have forced the IRS to concede that hypothetical investors consider imbedded tax liabilities when buying and selling C corporations.

Whether valuators should apply dollar-for-dollar or discounted reductions for built-in capital gains tax liabilities remains the subject of debate, as the case Estate of Jelke v. Commissioner shows.

Case background - When Frazier Jelke III died in 1999, he owned 6.44% (or 3,000 shares) of Commercial Chemical Co. (CCC). After divesting its chemical manufacturing operations in 1974, CCC operated as an asset-holding C corporation that maintained a diversified portfolio consisting primarily of large-cap domestic stocks, such as Exxon, General Electric, Hewlett-Packard, Microsoft and PepsiCo.

Both the IRS and the estate agreed that the undiscounted net asset value of CCC was approximately $188 million, excluding its $51 million built-in capital gains tax liability. But they differed substantially in their estimates of the value of Jelke’s interest in CCC.

The estate asserted that the value was roughly $4.6 million, including a dollar-for-dollar reduction for the capital gains tax liability, a 20% minority interest discount and a 35% marketability discount. Using more conservative valuation adjustments, the IRS calculated the value at about $9.1 million.

If CCC had sold off its assets when Jelke died, the company would have incurred a $51 million capital gains tax bill. In light of CCC’s intention to continue as a going concern, the IRS argued that the prospective tax liability should be discounted to $21 million to reflect the time value of money and CCC’s low asset turnover rate.

On appeal - The estate argued its position before the Eleventh Circuit Court of Appeals. The appellate court recognized that a hypothetical investor could “just as easily venture into the open marketplace and acquire an identical portfolio of blue-chip domestic and international securities as those held by CCC ... without any risk of exposure to the underlying [capital gains] tax liability lurking within CCC due to its low cost basis in the securities.”

Accordingly, the estate was awarded a dollar-for-dollar discount for CCC’s entire built-in capital gains tax liability, applying logic similar to that expressed in Estate of Dunn. (See page 5.) The court noted that “it is more logical and appropriate to value the shares of CCC stock on the date of death based upon an assumption that a liquidation has occurred, without resort to present values or prophesies.”

Issues at stake - According to West’s Federal Taxation, built-in capital gains tax is “applied to any unrealized gain attributable to appreciation in the value of an asset (e.g., real estate, cash basis receivables, goodwill) or other income items while held in the C corporation.”

Before Congress passed the Tax Reform Act of 1986 (TRA 1986), C corporations could avoid paying capital gains tax using various tax loopholes, such as corporation liquidations. Accordingly, the Tax Court historically refused C corporation discounts for built-in capital gains tax.

TRA 1986 eliminated the loopholes, making the capital gains tax liability less speculative. It also encouraged C corporations to pursue valuation discounts for built-in capital gains tax liabilities. But it wasn’t until 1998 that taxpayers were successful.

Case law summary - Jelke provides an in-depth discussion of the history of capital gains tax issues as presented before the Tax Court, including:

Estate of Davis. In a major turning point in legal precedent, the Tax Court recognized that a hypothetical buyer or seller would not have accepted a value that “took no account of [the corporation’s] built-in capital gains tax.”

If sold, the donor’s holding company would have incurred approximately $27 million in capital gains tax. The court allowed a partial $9 million reduction (combined as part of the discount for lack of marketability), even though no corporate liquidation or asset sale was imminent on the valuation date.

Estate of Eisenberg. The Second Circuit Court of Appeals overturned a Tax Court decision that disallowed a discount for built-in capital gains tax. Specifically, the appellate court stated, “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.”

Estate of Jameson. This case dealt with the mag-nitude of the built-in capital gains tax discount, rather than the taxpayer’s legal right to claim it. The Fifth Circuit Court ruled that the Tax Court’s determination of the built-in capital gains tax decision was flawed, stating: “Any reasonable, willing buyer would consider the company’s low [tax] basis in determining a purchase price.”

Estate of Dunn. This landmark case awarded a dollar-for-dollar reduction in value for the built-in capital gains tax liability. Dunn substantially altered the Tax Court’s fair market value test. The Fifth Circuit held that, as a matter of law, “liquidation must always be assumed when calculating an asset [value] under the net asset value approach.”

Stay tuned - Though encouraging for taxpayers, Jelke is just one victory in the ongoing built-in capital gains saga. Addressing attendees of the 2007 American Institute of Certified Public Accountants (AICPA) Business Valuation Conference, Tax Court Judge David Laro speculated that Jelke might wind up before the U.S. Supreme Court. (As of this writing, the IRS is in the process of appealing the Jelke decision.) And one dissenting judge in Jelke called the appellate court’s practical, dollar-for-dollar methodology the “rule of least effort.”

It’s likely that cases in other jurisdictions or with different fact sets may turn out differently. Valuators who understand the ins and outs of built-in capital gains can help taxpayers support their discounts and withstand IRS scrutiny.