CA-11 Allows Discounts to Corporation's Stock for Entire Built-In Capital Gains Tax
In Estate of Jelke, III,1 the Eleventh Circuit (with a dissenting opinion) reversed the Tax Court and held that in valuing the stock of a C corporation for estate tax purposes, the net value of the assets of the corporation may be reduced dollar-for-dollar for the entire built-in capital gains tax liability of those assets.
At the time of his death, Frazier Jelke, III, owned 6.44% of the stock of a closely held, family-owned C corporation investment holding company which owned appreciated, marketable securities. The primary investment objective of the corporation was long-term capital growth, which resulted in low asset turnover and large unrealized capital gains. As of Jelke's date of death, there were no plans to sell a significant portion of the corporation's portfolio of marketable securities or to liquidate the corporation.
On the estate tax return, the estate valued the corporation by reducing the net asset value of the corporation's assets by the full amount of the built-in capital gains tax liability that would have been incurred if all the assets of the corporation were sold on Jelke's date of death. In addition, the estate claimed discounts for lack of control and lack of marketability. The IRS audited the estate tax return, and the estate challenged the IRS's determination in Tax Court.
In the Tax Court, the IRS contended that the value of the corporation's assets should be reduced by an amount based on the present value of the built-in capital gains tax liability discounted to reflect when it was expected that the capital gains tax would be incurred—that is, over a period of 16 years. The IRS also contended that discounts smaller than those claimed by the estate were more appropriate for lack of control and lack of marketability. The Tax Court agreed with the IRS regarding the appropriate amount of the discount for the built-in capital gains tax. In addition, the Tax Court allowed a 10% discount for lack of control and a 15% discount for lack of marketability.
The Eleventh Circuit held in favor of the taxpayer, vacated and remanded the Tax Court's decision, and allowed a dollar-for-dollar discount to net asset value for the built-in capital gains taxes of the corporation's assets. The Eleventh Circuit's decision was based on the decision of the Fifth Circuit in Estate of Dunn.2 In Dunn, the decedent owned 62.96% of the stock of a family-owned Texas corporation engaged in the rental of heavy equipment and also in the management of certain commercial property as an investment. Texas law required a supermajority of a 66.66% interest in the voting shares to effect a liquidation of a corporation. Hence, the decedent could not force a liquidation of the corporation. Moreover, there were no plans to liquidate the corporation.
The Tax Court in Dunn allowed the stock price to be discounted by 5% of the built-in capital gains. While the Tax Court held that it was more likely that a hypothetical buyer would continue to operate the company, the Tax Court permitted some discount because it found that there was a very small possibility that a hypothetical buyer would liquidate the company.
On appeal in Dunn, the Fifth Circuit reversed the Tax Court. The Fifth Circuit held that as a matter of law under the net asset valuation approach, liquidation of the corporation must always be assumed. The Fifth Circuit labeled as a “red herring” the fact that no liquidation was imminent or even likely. With respect to the amount of the discount, the Fifth Circuit in Dunn concluded that the value of the corporation's assets must be reduced by a discount equal to 100% of the capital gains tax liability. The court relied on the assumption that, in a net asset valuation context, the hypothetical buyer is predisposed to buy stock to gain control of the company for the sole purpose of acquiring its underlying assets. This, in turn, triggers a tax on the built-in gains, and therefore, the Dunn court held that the discount should be 100% of the capital gains tax liability.
The Eleventh Circuit in Jelke agreed with the Fifth Circuit in Dunn that in applying the net asset valuation approach, it is to be assumed that a liquidation takes place on the decedent's date of death and that this assumption is to be used regardless of whether the decedent possessed a majority or a minority interest in the corporation. The Eleventh Circuit stated that the approach advanced by the IRS requires the courts “to either gaze into a crystal ball, flip a coin, or, at the very least, split the difference between the present value calculation projections of the taxpayers on the one hand, and the present value calculation projections of the Commissioner, on the other.”
The Eleventh Circuit recognized that the approach it adopted would be subject to criticism. Nevertheless, the court believed its approach was better since it (1) provides certainty and finality to valuation, (2) bypasses the unnecessary expenditure of judicial resources being used to wade through a myriad of divergent expert witness testimony, (3) has the virtue of simplicity, (4) provides a practical and theoretically sound foundation as to how to address discount issues, and (5) would be a welcome road map for those in the judiciary who are not formally trained in valuation.
Finally, the Eleventh Circuit stated that the approach it adopted mimics the marketplace and recognizes the reality of the depressing economic effect that lurking taxes have on the market selling price. The court stated that common sense dictates that a willing buyer would not pay the same price for identical blocks of stock—one purchased outright in the marketplace with no tax consequences, and one acquired through the purchase of shares in a closely held corporation with significant built-in tax consequences.
While the approach adopted by the Eleventh Circuit in Jelke has the appeal of being a bright-line test, it ignores—as pointed out by the dissent—the fact that no rational seller would accept a price that subtracted the entire amount of the future tax liability as though it were due immediately, when that liability will almost certainly be spread out over future years instead. This aspect undercuts to a great extent the analysis of the majority's holding and highlights the arbitrary nature of its holding. Because other circuits,3 at least in dicta, appear to believe that some—but not a full—discount for built-in capital gains taxes is allowable, if the IRS continues to litigate this issue (as most likely will be the case) this issue may ultimately be decided by the Supreme Court. This case is certainly not the ultimate resolution of this issue.
1 100 AFTR 2d 2007-6694, 507 F3d 1317, 2007-2 USTC ¶60552 (CA-11, 2007).
2 90 AFTR 2d 2002-5527, 301 F3d 339, 2002-2 USTC ¶60446 (CA-5, 2002).
3 See Estate of Eisenberg, 82 AFTR 2d 98-5757, 155 F3d 50, 98-2 USTC ¶60322 (CA-2, 1998); and Estate of Welch, 85 AFTR 2d 2000-1200, 208 F3d 213, 2000-1 USTC ¶60372 (CA-6, 2000).
Frank S. Baldino is an attorney at Lerch, Early & Brewer in Bethesda, Maryland who practices in the areas of estate planning and probate administration and who co-chairs the firm's Estate Planning and Probate Group. He has extensive experience in the areas of estate planning, charitable giving, estate planning for non-U.S. citizens, tax planning with respect to retirement plans and stock options, asset protection planning, business succession planning and estate and trust administration. Frank may be contacted at 301-657-0715 or firstname.lastname@example.org.