JELKE DECISION SETS NEW VALUATION STANDARD

Background
In Estate of Jelke v. Commissioner (T.C. Memo. 2005-131), the Tax Court circumscribed the amount that a taxpayer could deduct for a $51 million built-in capital gains tax liability in valuing the stock of Commercial Chemical Company, a C corporation which held appreciated assets. The Court allowed a deduction of only $21 million. The haircut was applied to the tax liability in order to reflect the fact that the built-in gain tax would be incurred at various dates in the future and therefore that it needed to be discounted to the present by an amount calculated to reflect the time value of money.

The Appeal
Taxpayer appealed this decision to the 11th Circuit Court of Appeals. In a recent decision, Estate of Jelke v. Commissioner (November 15, 2007), the appeals court, in a split decision, approved the use of a 100% "dollar-for-dollar" reduction for the entire built-in capital gains tax liability in valuing the company, thus overturning the Tax Court's prior allowance of only a partial discount.

The subject company, Commercial Chemical Company (CCC), was a pure investment holding company. It was a closely-held company, with the Estate holding a 6.44 % interest. In arriving at its conclusion that the entire tax liability should be deducted for purposes of valuation, the Court reflected on the thought processes of a potential buyer of the stock.

"In our case, why would a hypothetical willing buyer of CCC shares not adjust his or her purchase price to reflect the entire $51 million amount of CCC's built-in capital gains tax liability? The buyer could just as easily venture into the open marketplace and acquire an identical portfolio of blue chip domestic and international securities as those held by CCC. Yet the buyer could accomplish this without any risk exposure to the underlying tax liability lurking within CCC due to its low cost basis in the securities."

The Court was not deterred in its approach by the fact that a 6.44% shareholder could not single-handedly bring about a liquidation of the company. Said the Court;

"This distinction is not persuasive to us. We are dealing with hypothetical…willing buyers and willing sellers. As a threshold assumption, we are to proceed under the arbitrary assumption that a liquidation takes place on the date of death. Assets and liabilities are deemed frozen in value on the date of death and a 'snap shot' of value taken. Whether or not a majority or a minority interest is present is of no moment in an assumption of liquidation setting."

The Court criticized prior approaches to analyzing built-in gains tax liability, which required predictions of when the tax payments would occur. The downside of this approach, it said, is that it requires "a type of hunt-and-peck forecasting by the courts." [Read More]