By Stanley E. Bulua
Double Taxation Is Not Nice
It used to be that the tax on liquidation could be avoided at the corporate level and paid at the shareholder level. In the past, when valuing a C corporation, no discount was allowed for the potential tax on built-in gains of assets held by the C corporation. The thought was that the corporation could be liquidated after the sale of corporate stock and the tax avoided.
The IRS continued to hold this position, even after the 1986 tax act repealed the doctrine that permitted the avoidance of the tax at the corporate level. Two recent court cases challenged the IRS's position. A discount for the taxes on the built-in gains in a C corporation will be allowed in valuations for tax purposes.
For many years, the IRS has steadfastly held to the position that capital gains taxes on corporate level built-in gains cannot be taken into account for purposes of determining the transfer tax value of common stock in a closely held company. Interestingly, this position has found inconsistent support in the Tax Court for quite some time.
Tax Court Position Before General Utilities
In Estate of Cruickshank [9 TC 162 (1974)], which predated the repeal of the General Utilities doctrine, the Tax Court held that a discount for potential capital gains tax at the corporate level was not justified where there is no evidence that either--
* liquidation of the corporation was contemplated, or
* liquidation could not have been consummated without the imposition of a corporate level capital gains tax.
In subsequent decisions predating the repeal of General Utilities [e.g., Ward v. Comm'r, 87 TC 78 (1986), and Estate of Piper v. Comm'r, 72 TC 1062 (1979)], the Tax Court continued to disallow a reduction for the potential capital gains tax liabilities at the corporate level where there was no evidence that a tax-triggering event, such as a liquidation or sale of the corporation's assets, was imminent.
The Impact of General Utilities. Because prior to the repeal of General Utilities it was almost always possible to liquidate a corporation free of capital gains tax, the foregoing second condition for ignoring the tax generally applied. Now that a C corporation can no longer distribute appreciated assets to its shareholders, whether in a liquidating or nonliquidating context, without incurring a capital gains tax on such built-in gain, the second condition is no longer applicable. Accordingly, the only issue for consideration is whether such capital gains tax liability is too speculative to be valued as of the date of the transfer where no liquidation, sale, or other distribution by the corporation is planned. Although this change in the law relating to the taxation of corporate liquidations presented the IRS with an opportunity to change its position on allowing discounts for built-in capital gains, the IRS continued to adhere to its original position.
IRS Position After General Utilities. The position of the IRS after repeal was articulated in Technical Advice Memorandum 9150001, which involved the proper estate tax valuation of stock in a real estate holding company that held depreciated residential and commercial properties. It was represented in the ruling that no liquidation of the corporation was currently planned.
The taxpayer in the ruling argued that the net asset value of the decedent's stock should be discounted to reflect the potential capital gains tax that would be payable if the estate beneficiaries liquidated the corporation. The taxpayer argued for the application of standard valuation principles, which define "fair market value" as "the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge or relevant facts" [Regulations section 20.2031-1(b)]. The taxpayer therefore asserted that a willing buyer would not pay the full value of the underlying assets for the stock, but would adjust the price offered to reflect the potential liability. Finally, the taxpayer argued that in view of the amendments to IRC sections 336 and 337 mandating a capital gains tax upon liquidation of a corporation, the older cases relied on by the IRS were no longer on point and a discount should be allowed.
The IRS rejected the position of the taxpayer, citing the second prong of Cruickshank. It took the position that the liquidation of the corporation was speculative and reasoned that there was no guarantee that a hypothetical willing buyer would desire to purchase the stock with an objective to liquidate the corporation such that the capital gains tax would factor into its calculation of purchase price. In the IRS's view, the prior decisions disallowing a discount were primarily grounded on the speculative nature of the liquidation and, therefore, the repeal of General Utilities did not have an impact on their reasoning.
Recent Court Cases
Two recent decisions in this area, one by the Tax Court and the other by the Second Circuit Court of Appeals, have handed the IRS a major loss. As a result of these decisions, the IRS has decided it will no longer take the position that a discount for built-in capital gains taxes is not allowable as a matter of law. Accordingly, the area of conflict in the future between the IRS and taxpayers in valuing the stock of a C corporation for transfer tax purposes will involve the determination of the appropriate amount of the discount for these built-in capital gains taxes.
The Tax Court Ruling. In Estate of Davis [110 TC 35 (1998)], the question presented was the proper valuation of shares in a holding company owned by Artemus Davis, one of the founders of Winn-Dixie stores. The IRS, the estate, and their respective experts all agreed that the first step in determining the fair market value of each of the two 25-share blocks that Davis gifted to his sons was to determine, as of the date of the gift, the fair market value of the holding company's assets and the total of its liabilities. All of the parties agreed with the resulting valuation. However, the parties disagreed over what discounts should be applied and to what extent. The estate, the estate's experts, and the IRS's expert all agreed that a discount should be made to reflect the built-in capital gains tax. They did not agree on the amount of the appropriate discount. The IRS disagreed with its own expert and asserted, based primarily upon pre-1986 case law, that a discount for the built-in capital gains tax was contrary to Federal tax law.
The Tax Court rejected the position of the IRS and adverted to the contradictory position taken by the IRS in its answering brief. In that brief the IRS conceded that even if a sale or liquidation was not contemplated, a discount would be appropriate if there was no possibility of avoiding the corporate level capital gains tax. The IRS argued, however, that although the holding company would have been required to pay tax on the appreciated value of its assets if they were distributed to its shareholders or sold to a third party, this tax could have been avoided. The action needed was for the company to convert to a subchapter S corporation and wait 10 years before the assets were sold.
IRC section 1374, enacted at the time General Utilities was repealed, instituted the 10-year waiting period before gains on sales of assets previously held in a C corporation could pass through to shareholders of the S corporation and escape a corporate tax. The law was intended to close the loophole of C corporations with built-in gains converting to S corporations and immediately selling those assets.
The Tax Court took issue with the S corporation argument advanced by the IRS. It concurred with the argument advanced by one of the estate's experts that the assumption that the holding company would have been able to make an S election and thereby avoid the corporate level tax was not based upon the reality of the marketplace. Such a conversion would have significantly restricted the universe of potential buyers of the stock because of the limitations on S corporation shareholders. And it was unlikely that a hypothetical buyer would be interested in purchasing stock in an S corporation whose assets could not be sold for 10 years without incurring a corporate level tax.
Based on the foregoing, the Tax Court concluded that there was no mechanism by which the holding company could avoid the corporate level tax and that a hypothetical willing buyer would have to agree on a price for the stock which reflected the built-in capital gains tax. The court, however, found that since no liquidation or sale was imminent, the amount of the discount should not be the full amount of such tax. In addition, the discount for the tax consequences should be part of the lack of marketability discount that the parties agreed should be applied in the valuation process.
Finally, in reaching a determination as to the proper amount of the discount to be applied to the transferred shares, the court relied upon the methodology of the taxpayer and IRS experts. Although not specifically explained in the opinion, it would appear that the discount was based upon marketplace assumptions as to the likely time frame that a buyer of corporate stock would consider holding the assets of a company prior to sale. It will therefore become very important in future disputes with the IRS to validate the discount with an expert appraisal supported by empirical evidence of the period of time after the purchase of stock a hypothetical buyer would still take the contingent capital gains tax into account.
The Second Circuit Decision. In Eisenberg v. Comm'r [82 AFTR 98-5173 (2nd Circuit)], the Second Circuit reached substantially the same conclusion as the Tax Court in Davis. Here, the issue was how to value the stock of a C corporation that owned a commercial building in New York City and leased it to third parties. The corporation had no plans to liquidate or to sell or distribute the building at the time the taxpayer, who owned all of its common stock, made gifts of stock to her children and grandchildren.
The taxpayer reported the gift by valuing the net assets of the corporation and reducing such value by the full amount of the capital gains tax that would have been incurred had the corporation liquidated or sold its assets.
The IRS assessed a deficiency based upon its determination that no discount should be allowable. The Tax Court sided with the IRS, finding that the capital gains tax was too speculative to be considered because no tax-triggering event such as a liquidation or sale of the corporation's assets was contemplated.
The Second Circuit disregarded the reasoning of the Tax Court and of the line of old cases upon which its decision was based. It held that as a result of the repeal of the General Utilities doctrine, a tax liability upon liquidation or sale for built-in capital gains was not too speculative. As in Davis, the court underscored that a potential buyer of the corporate stock would most likely pay less for the shares of a corporation because of the buyer's inability to eliminate the contingent tax liability. In support of this statement, the court cited a 1994 empirical study that concluded that a large majority of buyers of a private, closely held corporation would negotiate a lower purchase price due to the existence of a contingent tax liability on the value of the corporation's appreciated assets. The Second Circuit then remanded the case to the Tax Court to determine the appropriate discount for the built-in capital gains tax. In making this determination, the court suggested in a footnote that, where the number of potential buyers that can avoid or defer the tax is small, the fair market value of the shares might be only slightly above the value of the real estate net of taxes.
The IRS has announced its acquiescence in the holding of the Eisenberg case. Accordingly, it will follow the holding of the Second Circuit that a discount for potential capital gains tax liabilities may be applied in valuing closely held stock.
Responding to the New Approach
These recent decisions and the announced IRS position with regard to a discount for potential capital gains liabilities highlight a new approach to the valuation of shares of a C corporation with appreciated assets. Individuals that have previously reported gifts of stock, or estates owning such stock, for which the statute of limitations has not run, should consider amending their gift or estate tax returns to achieve the benefit of this discount. Furthermore, preparers of gift or estate tax returns reflecting the transfer of such stock should discuss with their clients the ability, under current law, of taking a discount for the potential capital gains tax liabilities. It is incumbent upon taxpayers to back up any such discount with an expert appraisal that employs a methodology that takes into account what a willing buyer would pay a willing seller for stock of a corporation with a built-in tax associated with the liquidation or sale of its underlying assets. As in other valuation disputes, the battleground will now shift to the underlying theories and analyses of the appraisers hired by the parties. *
Stanley E. Bulua is an attorney in private practice in Scarsdale, N.Y., specializing in tax, trust and estate planning, and elder law.
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