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NEW JERSEY COURT USES VALUATION DISCOUNT TO PUNISH “BAD BOY”

Introduction Richard and Steven Parker are brothers who ran a flower business in Scotch Plains, New Jersey.  Richard is the President of Parker Interior Plantscapes (“PIP”), which installs and services plants and flowers in commercial settings.  Steven is the President of Parker Wholesale Florists (“PWF”), which is a garden center.  Each are vice presidents of […] More...

Dell Appraisal Spawns a Multitude of Valuation Approaches

February 2017 | Issue 84 Introduction A Delaware Chancery appraisal case involving computer company Dell Inc. gave rise to a multitude of valuation measurements.  It is instructive to see how the court sorted through them in coming up with its final appraisal conclusion.  The case is In re Appraisal of Dell Inc., 2016 Del. Ch. LEXIS […] More...

Future Expected Investment Strategy Determines Value of FLP Interest

January 2016 | Issue 83 The estate of Helen P. Richmond held a 23.44% interest in Pearson Holding Co. (“PHC”), a family investment company.  The estate valued this holding at $3,150,000, later adjusted to $5,046,000.  The IRS valued it at $7,330,000.  This difference of opinion was aired in US Tax Court in a case called Estate […] More...

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Tax Court Recognizes Full Valuation Discount for Capital Gains

September 2010 | Issue 48

In Estate of Marie J. Jensen v. Commissioner, T.C. Memo. 2010-182, (August 10, 2010). Judge Vasquez allowed an estate to deduct from the value of a corporation, 100% of the latent or “trapped in” capital gains tax that would be payable if the corporation were to be liquidated.

The IRS had determined a $333,000 deficiency against the Estate of Marie J. Jensen. The Estate owned an 82% interest in Wa-Klo, a closely-held C corporation. Wa-Klo’s principal asset was a 94 acre waterfront parcel in New Hampshire. Both the Estate and the IRS agreed that the company should be valued by valuing its assets and liabilities. Wa-Klo’s net asset value was $3,772,000 before deduction of a discount for built-in long-term capital gains tax. The federal LTCG liability was $1,133,000. The Estate felt it was entitled to deduct its portion of the entire amount. The IRS was willing to countenance a discount for LTCG of only $490,000. The difference of opinion on this issue accounted for the lion’s share of the deficiency.

The IRS’s Arguments

The IRS’s expert contended that the Estate was entitled to a discount for trapped capital gains tax of only $490,000, which represented about 50% of the total gains tax, and about 13% of Wa-Klo’s net asset value. It based this conclusion in part on an analysis of six closed-end funds. The expert found that built-in capital gains exposure for the six funds ranged from 10.7 to 41.5% of net asset value. The expert then sought to correlate exposure to capital gains tax to market price discounts. He found that two of the funds with the highest capital gains tax exposure were selling at a premium to net asset value. On the basis of these findings he concluded that he was “unable to find a direct correlation, at least up to 41.5% of net asset value, between higher exposure to built-in capital gains tax and discounts from net asset value.”

The IRS’s expert also pointed out that there were ways a buyer can avoid or at least defer capital gains taxes, such as a Sec. 1031 like-kind exchange transaction, or conversion to an S corporation.

He concluded than that the Estate was entitled to a capital gains tax deduction only to the extent that the gain exceeded 41.5% of total net assets.

The Estate’s Arguments

The Estate argued that it should receive a reduction in the valuation of Wa-Klo equal to 100% of the amount of the built-in capital gain tax.

In addition to legal arguments based on recent decisions (Estate of Dunn v. Comm., Estate of Jelke v.Comm.), the Estate argued that the IRS’s reliance on closed-end fund data was misplaced. The Estate also felt it inappropriate to assume that a hypothetical buyer would rely on “alternate methods” such as Sec. 1031 transactions or conversion to an S corporation to avoid the tax.

The Court’s Analysis

The Court pointed out that with the repeal of the General Utilities doctrine, a hypothetical willing buyer would be likely to be willing to pay less for the shares of a corporation having a contingent capital gains tax liability than for one that did not have such a liability. The issue is how much less.

The Court agreed with the Estate’s contention that closed-end funds are not comparable to Wa-Klo for purposes of calculating a discount. Closed-end funds invest in a variety of sectors, while Wa-Klo’s assets consist primarily of a single parcel of real estate. Furthermore, valuation discounts of closed-end funds are attributable to several factors, including supply and demand, fund performance, and liquidity.

The Court concluded that, based on the record, a present value approach is arguably applicable to determine the estate’s discount for the built-in LTCG tax. The Court calculated the future value of the land and improvements using an appreciation rate of 5% per annum over 17 years (the average estimated life of the depreciable assets). He then calculated the estimated LTCG tax payable 17 years hence, and discounted that amount back to the present at the same 5% discount rate. This produced a present value for the LTCG tax liability of $1,233,000. He repeated the same calculation utilizing a 7.75% appreciation and discount rate, producing a present value of $1,264,000. The Court noted that repeating the calculation at a discount rate of zero also produces approximately the same present value.

Since these values were close to the $1,133,000 requested by the Estate, the Court accepted the Estate’s value for the discount. In effect, the proper discount for adjusting the value of a C corporation for the LTCG tax liability, in this case, is the current amount of the liability.