By John J. Barton, CPA, ASA
The Federal Court of Appeals, Eleventh Circuit, reversed the Tax Court’s decision regarding the Estate of Frazier Jelke III1 on Nov. 15, 2007. Business appraisers, especially those performing valuations for the purposes of estate and gift tax, will be pleased with the prospect of taking a 100 percent, dollar-for-dollar discount for trapped-in capital gains when valuing C corporations. But don’t push this too far. The Jelke decision does not shed any light on trapped-in gains in pass-through entities and it does not necessarily apply to C corporations outside the Eleventh Circuit.
First, I will review the trapped-in capital gain controversy. After the repeal of the General Utilities Doctrine in 1986, C corporations became susceptible to double-taxation in a transaction scenario. For example, assume a C corporation that owns long-term real estate is sold. The real estate has a cost basis of $1 million and a fair market value of $10 million. Also, assume the land is the only asset, and the land value equals the business value. In this case, the C corporation would have to pay capital gains tax on the $9 million gain. The net proceeds after the gains tax would be distributed to the shareholder, who would then be taxed on the gain between his basis and the proceeds. This double taxation motivated most small, closely held companies to set themselves up as either S corporations, partnerships, or LLCs, which are taxed only once, at the shareholder level.
Business appraisers have argued that the double-taxation disadvantage represents a separate marketability issue in a fair market value appraisal. Any buyer who acquires the stock of the C corporation in the above example would recognize that he or she is assuming a trapped-in gain at the corporate level, and negotiate a lower sale price accordingly. In the estate and gift tax arena, however, the IRS argued against this position on two points: the tax law allows avoidance since a C corporation can change to an S corporation and liquidate after 10 years; and liquidation is speculative, and an actual sale that would trigger the gains tax may not occur for years after the valuation date. In the Jelke case, the estate deducted the full $51 million gain from a preliminary value indication, then also deducted a 20 percent discount for lack of control and a 35 percent discount for lack of marketability. The IRS deducted a partial $21 million discount, assuming a sale 16 years in the future and discounting the future gain to present value. The Tax Court, relying on the speculative nature of the trapped-in gain issue, sided with the IRS.
The Federal Appeals Court, in a strongly worded 2-1 decision, rejected the Tax Court’s decision in Jelke. Using reasoning that the valuation community has relied on for many years, as well as prior decisions,2 the Appeals Court found that since the fair market value standard requires the assumption of a transaction, it is not possible to assume that the gains tax would be paid at some indiscriminate point in the future. Although not specifically stated by the Appeals Court, it is also true that even if one accepts the reasoning of post-dating the gains tax, it is financially and logically impossible that a current tax liability would be identical to the tax liability five, 10, or 20 years later.
Remember, Jelke only applies to C corporations. If the subject company is a partnership, the IRS’s rejection of a discount for trapped-in capital gains has generally held, since partnerships have the option of taking a 754 election in a transaction. In the case of a sale and a 754 election, the inside basis of the partnership’s assets is raised to match the cost basis of the transferee in the transferred partnership interest - the outside basis - for the benefit of the transferee. Although it is argued that a basis for a trapped-in gain discount also exists for partnerships, that argument is not as sound for C corporations, and is beyond the scope of this article.
Similarly, S corporations can avoid the trapped-in gains scenario because the buyers and sellers have the option to take a 338(h)(10) election, which treats a stock sale as if it were an asset sale so the buyer is able to write up the depreciated assets to current value. Similar to partnerships, the valuation community has argued that an additional discount for trapped-in gains should be allowed for S corporations. Those arguments, which are also beyond the scope of this article, have not been widely tested in the courts.
In closing, practitioners should be aware that Jelke does not signal a Wild West of marketability discounts in stock valuations. The Tax Court and the Appeals Court have a history of not suffering fools when it comes to appraisal support for such discounts. If separate discounts for trapped-in gains, market-ability, and control are applied, care should be taken that each is supported separately from the other.
1 Estate of Frazier Jelke III et al. v. Commissioner, No.05-15549 (15 Nov. 2007)
2 Estate of Eisenberg v. Commissioner, 155 F. 3d 50, 57 (2d Cir. 1998); Estate of Davis v. Commissioner, 110 T.C. 530 (1998); Estate of Dunn v. Commissioner, 301 F.3d 339 (5th Cir. 2002)
John J. Barton, CPA, ASA, is president of Brandywine Valuation Consultants LLC. He can be reached at jbarton@bwvaluations.com.
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