The Valuation Discount for Potential Capital Gains Tax
Earles, Melanie J., The National Public Accountant
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, 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, 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, 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.
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, 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. (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, 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. …