The following article is adapted and reprinted from the M&A Tax Report, Vol. 11, No. 3, October 2002, Panel Publishers, New York, NY.


By Robert W. Wood

I know, this sounds like a stupid question. The plain truth is that virtually all businesspeople, and financial markets, will take into account inherent tax liability in valuing a company. But will the Internal Revenue Service? Specifically, if you must value a C corporation which will face the inevitable corporate level tax inherent in a post-General Utilities repeal liquidation, should that inherent corporate tax be considered? The issue often arises for estate tax purposes, in other contexts.

While the markets will certainly take this built-in tax liability into account, is anyone surprised that the Internal Revenue Service takes a very harsh view? Not likely. Fortunately, an appellate court recently slapped down the Service, calling the Service's attitude on this point a "red herring." The appellate court also knocked the Tax Court, all but calling it an automaton for adopting the Service's red herring view like, to mix metaphors, like a lemming.

Corporate Valuation Malaise

In Estate of Beatrice E. Dunn, et al. v. Commissioner, No. 00-60614, Tax Analysts Doc. No. 2002-17949, 2002 TNT 151-6 (5th Cir., Aug. 1, 2002), the estate tax return included 493,000 shares of a closely-held company, Dunn Equipment, Inc. The estate tax return reported the fair market value of those shares at $1.6 million. The IRS assessed a deficiency, determining that the fair market value of the stock was $2.2 million. There were various discounts in question, but the one of greatest interest was whether it was appropriate to discount the value of the stock to consider the value of the corporation's assets. Specifically in question was whether it was appropriate for the valuation to account for the built-in tax liability the corporation would face.

The Fifth Circuit said that no one could dispute that if Dunn Equipment had sold all of its properties, the corporation would have incurred a 34% federal tax rate on the gain, regardless of whether the gain would be labeled as ordinary income or capital gain. The court then went on to say that given this clear rate of tax, the appropriate question was the method to employ in accounting for this inherent tax liability when valuing the corporation's assets. The court acknowledged that this task of valuing assets should not be confused with the ultimate task of valuing the stock (and it is that latter point that is relevant for estate tax purposes).

The estate engaged an expert who took the position that the assets of the corporation would have to be treated as if they had been sold, so that the full 34% corporate tax rate would be applied to all gain. That would have reduced the fair market value of the company dollar for dollar. If a willing buyer were to purchase the block of stock held by the decedent, then regardless of whether thereafter that buyer could and would cause a sale of the corporate assets (either in liquidation or not), the value of the corporation would be the value of the assets less all costs (including corporate tax) that would be incurred. The estate's expert argued convincingly that it was simple math. The value of the company was reduced by the amount of tax, and this had to be considered in calculating the asset-based value of the corporation. What did the IRS say in response?

The Fifth Circuit characterized the Commissioner's argument as the diametric opposite. The IRS' position was that no reduction for this inherent corporate tax liability should be permitted. The Commissioner grounded this contention "solely on the assertion that liquidation was not imminent or even likely." The Tax Court blithely accepted this notion. The Tax Court found that there was no imminent liquidation (something the Fifth Circuit characterized as a red herring).

However, the Tax Court vacillated a bit, concluding that only if the hypothetical willing buyer of the decedent's block of stock intended to liquidate the company in the short term — which the holder of that block of stock could not force acting alone — would that buyer seek a substantial reduction in purchase price to take the tax into account. The Tax Court then got even more convoluted in its analysis, talking about buyers alternatives to liquidation and then even went into the present value of a future tax liability.

All its musings concluded, the Tax Court concluded that the asset-based value of Dunn Equipment should be reduced by only 5% for potential tax costs. The Tax Court presumably felt it was throwing the taxpayer a bone, not allowing the full 34% corporate tax rate the corporation would have to pay when it sold its assets, but allowing a 5% accommodation for future potential tax costs.

Successful Appeal

The taxpayer estate was hardly satisfied, and appealed to the Fifth Circuit. There, the taxpayer had a much more receptive ear. The Fifth Circuit flatly stated that the Tax Court had made a fundamental error, and that the Tax Court's belly flop was reflected in some of the Tax Court's statements. For example, the Tax Court said that for purposes of an asset-based analysis of corporate value, a fully informed willing buyer of corporate shares would not seek a substantial price reduction for built-in tax liability, absent that buyer's intention to liquidate. Huh?

The Fifth Circuit had a nice response to this Tax Court myopia: "This is simply wrong: it is inconceivable that, since the abolition of the General Utilities doctrine and the attendant repeal of [the liquidation provisions of the Code], any reasonably informed...buyer [would insist that] the latent tax liability of assets held in corporate solution be reflected in the purchase price of such stock."

The Tax Court found that this would be a dollar-for-dollar reduction in the case of the Dunn Equipment stock, so that a 34% discount was correct. Indeed, the Fifth Circuit noted that since it was trying to determine the asset-based value of the corporation, it would assume — as it must — that the willing buyer is purchasing the stock to get the assets! The Fifth Circuit held, "as a matter of law that the built-in gain tax liability of this particular business' assets must be considered as a dollar-for-dollar reduction when calculating the asset-based value of the corporation."

Likely Liquidation?

The Fifth Circuit was not through with thrashing the Tax Court or the IRS. The appeals court went on to consider the likelihood of liquidation, something used by the Tax Court in its methodology. Switching from its pejorative "red herring" appellations, the Fifth Circuit then went on to say that considering the likelihood of liquidation was a "quintessential mixing of apples and oranges." Considering the likelihood of a liquidation was silly considering that the fact that the assets would be sold was a foregone conclusion if the asset-based test was to have any meaning.

By definition, the court said, the asset-based value of a corporation is grounded in the fair market value of its assets. That value, in turn, must be determined by applying the venerable willing buyer and willing seller test. This test contemplates a consummation of purchase and sale with the assets being valued. If there were any doubt which way the wind was blowing, the Fifth Circuit settled it by saying:

"It is axiomatic that an asset-based valuation starts with the gross market (sales) value of the underlying assets themselves, and, as observed, the Tax Court's finding in that regard is unchallenged on appeal: when the starting point is the assumption of sale, the "likelihood" is 100%!"

Much of the opinion reads a little like a castigating memo from an executive to an underling. Consider this crisp quote:

"Bottom line: the likelihood of liquidation has no place in either of the two disparate approaches to valuing this particular operating company."

Is That Your Final Answer?

The Fifth Circuit refers glowingly to another case it recently decided, Estate of Jamison v. Commissioner, 267 F.3d 366 (5th Cir. 2001). In Jamison, the Fifth Circuit had considered a "similarly misguided application of the built-in gains tax factor by the Tax Court." The Fifth Circuit in Estate of Dunn noted that in Jamison it reversed and remanded with instructions for the Tax Court to reconsider its valuation of the timber property in question there, by using a more straightforward capital gains tax reduction.

In Dunn Equipment's case, the Fifth Circuit spelled it out painfully clearly: valuing the underlying corporate assets is not the equivalent of valuing the stock on the basis of its assets, but is merely one preliminary exercise in that process. Therefore, advised the Fifth Circuit, the threshold assumption in conducting the asset-based valuation approach must be that the underlying assets would indeed be sold. The sale must be to a fully informed and willing buyer, and that determination then becomes the basis for the company's asset-based value. That value, according to the appellate court, must include consideration of the tax implications of those assets as owned by that company.

Serving almost as a ten foot nail into a coffin already full of nails, the Fifth Circuit said that the Tax Court view had to be rejected as legal error, and that determination of the value of Dunn Equipment must include a reduction equal to 34% of the taxable gain inherent in those assets. Furthermore, the Fifth Circuit reiterated that any factually determined "real world" likelihood of liquidation is simply not a factor effecting the built-in tax liability when conducting the asset-based approach.

Me, Too

Estate of Dunn isn't the only case to mess with the Service on this issue. In Estate of Artemus D. Davis v. Commissioner, 110 T.C. 530 (1998), the Tax Court held that in valuing two minority blocks of common stock of a closely held corporation, the court could properly consider the corporation's built-in gain tax as of that valuation date. The corporation had built-in gain tax by virtue of the 1986 repeal of the General Utilities doctrine. Despite such authority, the government continues to argue that potential capital gains taxes should not be considered in such circumstances. In Irene Eisenberg v. Commissioner, 155 F.3d 50 (2d Cir. 1998), acq., 1999-4 I.R.B. 4, the Justice Department argued that it was inappropriate to reduce the value of corporate stock that Irene Eisenberg gave to family members in 1991-1993 by the amount of potential capital gains taxes.

The Eisenberg decision should be widely read by both estate planners and corporate tax practitioners-making the case a kind of curious melting pot for those on both sides of the aisle. The Eisenberg case arose out of Mrs. Eisenberg's transfer of shares in her corporation to her children. The sole asset of the corporation was a parcel of rental real estate located in Brooklyn. The question was whether the value of the stock (here, for gift tax purposes) should be reduced to reflect the inherent tax in the corporation's assets, even though it was acknowledged by the taxpayer that no realization event triggering the payment of the tax was imminent.

Interestingly, one of the stipulations in the case was the speculative nature of the timing of the taxable event. The corporation stipulated with the government that it did not have plans to liquidate, distribute or sell its building. However, being advised by tax planners, in making the calculation of the gift of shares, Mrs. Eisenberg reduced the value of the shares given by the tax the corporation would incur if it were liquidated, or if it distributed or sold its real estate.

The Tax Court held that this reduction in value could not be taken. The Tax Court hung its hat on the fact that there was no evidence that such a liquidation or sale was likely to occur. After all, the taxpayer had stipulated that there was no current plan to sell or liquidate. Indeed, a drafter of corporate minutes might take an implicit note of advice from this, since ostensibly it is never clear when just the right offer may come along and when a corporation may sell assets generating a corporate level gain!

Second Circuit Opens Doors

Since Mrs. Eisenberg was defeated in the Tax Court, she took her dispute to the Second Circuit Court of Appeals. The Second Circuit reviewed the history of such valuation discounts, noting that before the 1986 change in Subchapter C, the courts uniformly disallowed discounts attributable to inherent tax liabilities. The reasons the courts gave for these early disallowances were: (1) the tax was considered too speculative, and (2) the existence of former Section 337 (which allowed a corporate liquidation with no corporate level tax), the tax could easily be avoided.

Given anti-General Utilities regime that has been the Service's mantra since 1986, the Second Circuit felt that the Service could not have it both ways. Reliance on these cases, said the Second Circuit, was no longer appropriate. The critical point, said the court, was not that there was no indication that a liquidation was imminent, but that there was no evidence introduced by the IRS to dispute the fact that a willing buyer of stock would pay less because of the inherent tax liability inside this C corporation.

Accordingly, the Second Circuit vacated the Tax Court's decision. The Second Circuit held in principle that an adjustment for the potential tax should be taken into account in valuing stock, even though no liquidation of the corporation is planned. The same conclusion held for the situation where there is no sale or distribution of assets planned by the corporation.

Now that this concept has been recognized, one must assume that even more aggressive gift tax strategies will be developed. After all, the concept of gifting shares where there is no contemplated corporate liquidation, or where there is a contemplated sale or liquidation, occurs all the time. In Eisenberg, the Second Circuit validated the notion that the sometimes crushing corporate tax liabilities that would be paid on a sale or liquidation do reflect the value of the shares given. Whether or not there is an immediate (or even eventual) plan to make a sale or liquidation, should not prevent a valuation discount.

Valuation Methods

One nettlesome question remaining is exactly how one goes about valuing stock where there are tax liabilities involved. In Estate of Artemus D. Davis v. Commissioner, 110 T.C. 530 (1998), the taxpayer was successful in convincing the Tax Court that there should be a valuation discount to take the built-in gain tax into account. The Tax Court agreed with the estate (and with the expert witnesses) that a hypothetical willing seller and willing buyer of the stock would have taken into account the tax in negotiating the price, even though a liquidation or sale of the company's assets was not planned or contemplated on the valuation date. After all, at some point down the road, the tax would have applied.

However, even if one agrees that a corporate tax liability must give rise to a discount, there can be questions how such a discount can apply. Indeed, in Eisenberg, the Tax Court decision was vacated, and the matter had to go back to the Tax Court for a determination of just what discount was appropriate. And, in Estate of Artemus D. Davis, the Tax Court rejected the estate's contention that the full amount of the built-in capital gains tax should be subtracted from the net asset value of the corporation in arriving at the appropriate valuation figure. The Tax Court held that where no liquidation or asset sale was contemplated as of the valuation date, it was inappropriate for the full amount of the tax to be allowed at a discount. Instead, the Tax Court in Estate of Artemus D. Davis adopted a somewhat waffling approach that some portion of the tax could be taken into account in valuing each block. The discount, according to the Tax Court in Estate of Artemus D. Davis, should be part of the lack of marketability discount.

Whoa Nelly...

Even though the IRS has been defeated in these valuation cases — and the Service eventually acquiesced in Eisenberg (1999-4 I.R.B. 4) — taxpayers hardly have carte blanche to apply a full tax discount to transferred shares. Indeed, it would seem appropriate to acknowledge from time to time that transfers of stock may be made in a mileau where there is a mere possibility of sale, or there are in fact plans to sell or liquidate the company (or at least some of its assets). Where there is truth to such recitations, they may bolster the discount, and even may have the IRS agreeing that a discount is appropriate. After all, these cases only arise in the context of litigation-the IRS wants to see a plan (or at least a substantial possibility) that a sale or liquidation will occur before it will grant a discount without being forced to do so by a court.

These issues are not little, given the dollar volume and numbers of shares of stock that are transferred annually. The IRS long fought (and largely lost) the question whether minority discounts should be considered when gifts of closely held stock were made. In the context of family companies, perhaps an even better argument can be made that the potential capital gains or built-in gains taxes that could be levied on a sale or liquidation of the business must be considered.

However, it would seem that the Service is sometimes disingenuous in these valuation disputes. In Estate of Artemus D. Davis v. Commissioner, 110 T.C. 530 (1998), for example, the taxpayer was arguing both for a blockage discount pursuant to SEC Rule 144, and also for a built-in gains tax discount to the shares. The Tax Court noted (seemingly with some mirth) that the IRS argued against both valuation discounts, but that the IRS' own expert witness supported the built-in gain tax discount!

In Artemus D. Davis, Tax Court Judge Chiechi (who can be notoriously, shall we say, firm) agreed with the estate and the expert witnesses that a hypothetical willing seller and willing buyer of the stock would have taken into account the tax in negotiating the price, even though a liquidation or sale of the company's assets was not planned or contemplated on the valuation date. Nonetheless, the Tax Court has not made it clear precisely how the valuation discount should be applied. The court in Estate of Artemus D. Davis rejected the estate's intention that the full amount of the built-in capital gains tax should be subtracted from the net asset value of the corporation in arriving at the appropriate valuation figure. The Tax Court held that where no liquidation or asset sale is contemplated as of the valuation date, it was inappropriate for the full amount of the tax to be allowed as a discount.

Rather, Judge Chiechi held that the discount for some portion of the tax should be taken into account in valuing each block. The discount, the court held, should be part of the lack of marketability discount. Two of the experts involved in this case included $8.8 million and $10.6 million, respectively, of the built-in capital gains tax as part of this lack of marketability discount. Concluding that valuation was not an exact science, the Tax Court included $9 million of the anticipated tax in the discount.

Dunning the Service?

Students of valuation methodology will doubtless want to read the lengthy and interesting opinion in Estate of Dunn, the latest offering in the Eisenberg and Davis triple crown. There is, after all, a good discussion in Dunn of the weight of various approaches (cash flow, earnings, etc.). Still, what seems most significant is the solid thrashing the Tax Court and the Service took in Dunn when it comes to the significant built-in gain tax liability that C corporations clearly have. There is no discussion, incidentally, of the Section 1374 built-in gain tax applicable to S corporations during their first ten years of S status. Presumably the same rationale would apply, though. Thus, Estate of Dunn would presumably be helpful to valuing an S corporation subject to the built-in gain tax as well.

Should Built-In Tax Liability Be Taken Into Account In Valuing a Company?, Vol. 11, No. 3, The M&A Tax Report (October 2002), p. 1.