Discounting Built-In Capital Gains Tax Liability for Closely-Held Businesses


The recent case of  Estate of Richmond v.Commissioner , T.C. Memo 2014-26 (2014), could present some opportunities for estate planners.  The case also presented a valuation methodology not employed by either the taxpayer or the IRS and litigators should take heed in preparing their expert to present valuations of built-in capital gains tax (BIGC tax) discounts.

In  Estate of Richmond, the Tax Court was asked to rule on a valuation dispute.  In this case, the valuation dispute centered around the proper discount to apply for a BIGC tax with respect to stock held in a family holding company, Pearson Holding Company (PHC).  The main assets of PHC were publicly traded stock.  PHC was established in 1928, and pursued investments meant to maximize dividends. It thus shunned selling any stock holdings in order to avoid paying any capital gains tax.  The result was that the stock holdings turn over, where all of the assets are completely sold off and replaced, every 70 years.  That meant that at the time of Ms. Richmond’s death, 87.5% of the value of the holding company was appreciated stock, and if sold, capital gains tax would be due on that portion. In addition, PHC was organized as a corporation, meaning that any capital gains would be paid at the appropriate corporate income tax rate, and not the lower rate applicable to individuals, as well as being taxable to the individual shareholders. The prickly part of the issue is how these future tax obligations impact the value of PHC’s shares, and the amount of discount, if any, for those obligations.

While the facts in Estate of Richmond may be reminiscent of a by-gone era, or possibly an indication of what is to come, the court is quick to point out that the issue of how to account for BICG tax in asset valuations, particularly among closely held companies, is still an issue among the circuits and within each circuit.

In determining the proper discount to be applied as a result of the potential BICG tax, the Tax Court was faced with choosing between two different methodologies that have resulted in a split in the circuit courts.  The first methodology employed by the Fifth and Eleventh Circuits would apply a 100% discount for taxes due on the assumption that all of the assets would be hypothetically liquidated on the decedent's date of death.  The Fifth Circuit applied this methodology in Estate of Dunn v. Commissioner, 301 F.3d 339, 353 (5th Cir. 2002), rev'g and remanding T.C. Memo 2000-12.  The Eleventh Circuit had applied this methodology in Estate of Jelke v. Commissioner, 507 F.3d 1317 (11th Cir. 2010), vacating and remanding T.C. Memo 2005-131. 

Neither the Second Circuit nor the Sixth Circuit have employed this 100% discount.  See Estate of  Eisenberg v. Commissioner, 155 F.3d 50 (2d Cir. 1998), vacating and remanding T.C. Memo. 1997-483; Estate of Welch v. Commissioner, 208 F.3d 213 (6th Cir. 2000), rev'g and remanding without published opinion T.C. Memo. 1998-167.  Similarly, the Tax Court has also held that the a 100% discount was inappropriate.  See e.g., Estate of Davis v. Commissioner, 110 T.C. 530 (1998); Estate of Jensen v. Commissioner, T.C. Memo. 2010-182.

For a summary of the discounts applied to selected cases, see the Estates, Gifts and Trusts Portfolios: 831 T.M.: Valuation of Corporate Stock, Worksheet 1.

Pursuant to §7482(b)(1)(A), the Richmond case would be reviewable on appeal by "the United States court of appeals for the circuit in which is located * * * the legal residence of the petitioner."  To the extent the estate "reside[s]" where its co-executors reside or where the will was probated, the Richmond case would be reviewed on appeal by the Court of Appeals for the Third Circuit.  As the Third Circuit hasn't ruled on this issue, the Richmond court was not bound by the Golson rule to adopt any previous methodology employed by the previous circuit court cases. 

The facts of the case were not in dispute.  PHC was incorporated in 1928.  As of December 2005, the month that Ms. Richmond died, PHC had 2,338 shares of common stock outstanding.  Ms. Richmond owned 23.44% of PHC.  The total net value of the stock owned by PHC was $52.1 million.  Therefore, with no discounts, Ms. Richmond's 23.44% share would be valued at $12.2 million.  However, both the estate and the IRS agreed that the estate would be entitled to three discounts - a lack of control (LOC) discount, a lack of marketability (LOM) discount, and built-in capital gains discount.  Although the estate and the IRS differed with respect to the proper discounts for LOC and LOM, the main issue involved the discount for the BICG tax.

The estate originally valued the decedent's interest in PHC at $3,149,767, using a capitalization-of-dividends method.  However, apparently realizing that the Tax Court would not adopt the capitalization-of-dividends method, the estate also offered a net asset valuation model at the Tax Court whereby it applied the 100% discount methodology employed by the Fifth and Eleventh Circuits.  This resulted in an overall valuation of $4.7 million, which included a lack of marketability and a lack of control discount as well.

In its notice of deficiency, the IRS valued decedent's interest in PHC at $9.2 million, but did not specify the valuation method utilized.  At trial, the IRS applied a lack of control discount of 6%, and another 36% discount for both the lack of marketability and the BICG tax, and only applied this discount after it had applied the lack of control discount.  The BICG discount amounted to 15%.  The resulting value of Ms. Richmond's 23.44% was thereby reduced to $7.3 million.

In the end, the Tax Court adopted the IRS's BICG discount of 15%, however, the court relied on a different methodology in arriving at that percentage.

The respective positions of the Court and the parties can be summarized in the following chart:

 

Tax Court

IRS

Estate

Net Assets of PHC

$52,114,041

$52,114,041

$52,114,041

Less: BICG discount (T.C. 15%, Estate 100%)

-7,817,106

0

-18,113,083

NAV of PHC

44,296,935

52,114,041

34,000,958

23.44% interest in NAV

10,383,202

12,215,531

7,696,825

Less: LOC Discount (T.C. 7.75%)

-804,698

 

 

Less: LOC Discount (IRS 6%)

 

-732,932

 

Less: LOC Discount (Estate 8%)

 

 

-637,586

23.44% Int. Less LOC discount

9,578,504

11,482,599

7,332,239

Less: BICG discount (IRS - 15%)

 

-1,722,389

 

Less: LOM discount (T.C. 32.1%)

-3,074,700

 

 

Less: LOM discount (IRS 21%)

 

-2,411,345

 

Less: LOM discount (Estate  35.6%)

 

 

-2,610,277

Value of Decedent’s interest in PHC

6,503,804

7,348,864

4,721,961

The Tax Court first declined to use the estate's original capitalization-of-dividends methodology, noting that it was entirely based upon estimates of the future and ignored concrete and available data of value.  The court noted that the net asset valuation methodology is the preferred method used by courts.

With respect to the proper discount for the BICG tax, the Tax Court in Richmond began by dismissing the 100% discount approach employed by the Fifth and Eleventh Circuits.  According to the court, the 100% discount approach is "plainly wrong" in a case like Richmond.  The court noted that the $18.1 million BICG tax which the estate sought to deduct from the value could be deferred to the future by retaining appreciated stock.

The court then looked to the IRS's 15% discount for the BICG tax.  This amounted to a $7.8 million overall discount for PHC.  While the court found this discount to be "reasonable," it found the IRS's methodology to be problematic.  As a result, the court adopted the 15% discount but for reasons different than those advanced by the IRS.  The court noted that the discount should be applied at the entity level, rather than at the individual level (after the LOC discount).

The IRS's expert had determined that there should be a dollar-for-dollar discount for the tax exposure once the BICG exceeds 50% of value of the assets.

The Tax Court noted that the IRS could point to no data backing up this methodology.  Instead, the Tax Court simply calculated the discount by using the present value cost of paying of the BICG tax in the future.  The court noted that the IRS declined to use this approach because PHC's unusual turnover rate of selling stock, i.e., it would take 70 years before all the stock had been sold and all the built-in gain had been taxed. However, according to the Tax Court, a hypothetical buyer would not use the 70 year holding period, i.e., it would sell the stock more quickly than the 70-year trend currently used by PHC.  The Tax Court noted that the IRS's expert had indicated that normal turnover rate would be 20 to 30 years - and that rate was not rebutted by the estate.  Therefore, the court found a normal 20 to 30 year turnover rate to be reasonable.  Using different discount rates to calculate the present value of the BICG tax over 20 to 30 years, the Tax Court calculated a potential discount of $5.6 million to $9.5 million.  The court noted that the IRS's $7.8 million valuation falls comfortably within this range and adopted the IRS's $7.8 million BIGC discount.

Planning and Litigation Opportunities

As the Richmond case illustrates, anyone planning on litigating their case before the Tax Court should take heed of the methodology employed by the Richmond decision.  In the end, the court used a present value of the BICG tax to calculate the BICG tax discount.  In so doing, the court accepted a 20-30 year turnover rate for the sale of stocks.  Was this the correct turnover rate?  The court merely relied on the IRS's expert because the taxpayer did not contest it.  Perhaps, using the present value analysis, an expert could argue for a shorter holding period, or could come up with other factors that would create a larger discount.  See, e.g., Estate of Jensen v. Commissioner, T.C. Memo 2010-182 (Tax Court used a 17 year period to calculate BICG discount).  As the chart above illustrates, the calculation of the discount could mean millions of dollars to your client.

However, possibly the biggest planning opportunity lies in selecting an appropriate executor.  The court specifically declined to follow the 100% discount methodology applied by the Fifth and Eleventh Circuits.  Had the court followed this methodology, the BIGC discount would have been approximately $2.4 million greater.  Pursuant to the Golson rule, the Tax Court would be required to employ the 100% discount methodology for any case which is appealable to the Fifth or Eleventh Circuits.  As stated above, and as Judge Gustafson notes in the Richmond case, under §7482(b)(1)(A), appellate review of a Tax Court decision would be in the circuit where the petitioner resides.  For an estate, that would mean the location in which the will was probated or where the executor or executors resided.  If a particular estate has a factual scenario like Richmond, perhaps choosing an executor in the Fifth or Eleventh circuit is the way to go.