February 2009 | Issue 33
In Estate of Marjorie deGreeff Litchfield v. Commissioner; T. C. Memo. 2009-21; No. 15882-05 (Jan. 29, 2009), the Tax Court (Swift) upheld valuation discounts employed by the estate to reflect potential capital gains tax liabilities built into the portfolios of two family investment holding companies.
The decedent, Marjorie deGreeff Litchfield, died on April 17, 2001. Her estate included minority interests in two closely-held family-owned corporations, Litchfield Realty Co. (LRC) and Litchfield Securities Co. (LSC).
Both the estate and the IRS had agreed that the proper approach to valuing these two companies was to begin with the net asset value of the assets held in each company, and then to apply appropriate valuation discounts to each to account for built-in capital gains taxes, minority interest, and lack of marketability.
The assets of LRC consisted primarily of farmland and securities, with a total value of $33 million. At the valuation date, LRC had a built-in capital gain (BIG) of $29 million (86.7 % of assets). LSC’s assets were securities with a net asset value of $ 53 million. LSC had a built-in capital gain of $39 million (73.8 % of assets).
Estate Approach to BIG
In calculating his discount for built-in capital gains tax, the estate’s expert projected holding periods and sales dates for LRC’s and LSC’s appreciated assets. He estimated the appreciation for the assets during the holding periods until the estimated sales dates and calculated the capital gains taxes that were estimated to be due upon the sale of the appreciated assets on the projected sale dates. He then discounted the projected taxes to the valuation date and subtracted the present value of the projected capital gains taxes from the net asset values of LRC and of LSC. The use of this method produced a discount for built-in gains taxes of 17.4 % for LRC and 23.6 % for LSC.
IRS Approach to BIG
The IRS expert also made projections of future holding periods for the companies’ assets. He then assumed a capital gains tax rate effective at the end of the holding period and calculated the capital gains tax due on the assets (without having calculated any appreciation on the assets). He then discounted the capital gains tax back to the valuation date. Treating the present value of the capital gains tax as a liability, he subtracted them from net assets. This method produced a discount for built-in gains taxes of only 2 % for LRC and 8 % for LSC.
The Court’s Analysis
The Court ended up accepting the estate’s discounts for built-in gain. It was influenced in part by the fact that the estate’s expert had taken greater pains in estimating future rates of asset turnover, consulting with management rather than simply utilizing historical turnover rates.
The Court also pointed to the fact that the IRS expert did not allow for the appreciation of assets during the holding period in calculating taxes, noting; “a hypothetical buyer of LRC and LSC stock would attempt to estimate this extra corporate level tax burden on holding-period asset appreciation and would include the extra cost … in a built-in capital gains discount.”
It would appear, once again, that a thorough-going and logical approach to calculating built-in capital gains tax liability can carry the day in court.