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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."

The Court also favored the dollar-for-dollar approach because it reduces the need for judicial resources to be used to "wade through a myriad of divergent expert witness testimony... [This approach] has the virtue of simplicity."

Finally, the Court said that "[t]his 100% approach settles the issue as a matter of law, and provides certainty that is typically missing in the valuation arena."

The Dissent
Judge Carnes dissented vigorously from the majority opinion. He felt that the use of the simple arbitrary assumption that the assets were liquidated at the time of death led to a less accurate value determination. In the instant case, it ignored the time value of money benefit arising from the projected deferral of the payment of the taxes. In his words, "the buyer could not reasonably expect the seller to agree to a price that ignored completely the time value of money."

Impact on Appraisals
This is the second appeals court decision to have employed a 100% deduction for built-in gains tax. The other is Dunn v. Commissioner (5th Circuit, August 1, 2002). In both of these cases, the 100% deduction approach was applied solely to the asset-based method of valuation. Since CCC was an investment holding company, the asset-based method was the only valuation method employed. In the Dunn case, both the income approach and the asset approach were used. The 100% tax deduction calculation was applied only to the asset approach.

The use of an arguably "arbitrary" valuation approach by the Court in this case resulted in an outcome that was favorable to the taxpayer. It is not difficult to imagine, however, that the adoption and employment of other similar valuation "shortcuts," and giving to them the force of law could in other instances lead to outcomes that might be less welcome to taxpayers.

The material presented in the Hempstead E-Letter should not be construed as definitive legal, accounting, financial, or business advice nor should it be acted upon without consultation with legal or other professional counsel.