Erickson Partners, LLC | Dallas, Texas Business Valuation Services Firm

The 2005 Jelke v. Commissioner decision has been described as “poor” for the taxpayer (by Shannon Pratt in the BVU) and frustrating for the appraiser. The Tax Court declined to follow the leading case, Estate v. Dunn (5th Cir. 2002), and adopt a dollar-for-dollar discount for a holding company’s built-in capital gains tax liability. After receiving the disappointing result in Jelke, the taxpayers almost did not want to appeal, according to their original appraiser, Will Frazier (see BVWire #62-3). “Their advisors and I had to beg them.”

But they ended up hiring attorney John Porter (Baker Botts, Houston), “a good choice on their part,” Frazier said. (Porter led the reversal of McCord v. Comm’r by the Fifth Circuit in 2006.) The effort evidently paid off, as the Eleventh Circuit opinion provides an exhaustive but excellent review of precedent in support of its decision. We’ve abstracted the case in some detail to give appraisers a full understanding of the context for the Jelke decision and its ultimate findings.

A long, slow path to ‘economic reality’

After a brief recitation of the facts—the decedent owned a minority (6.44%) interest in a closely held investment company that owned marketable securities—the Court began with Revenue Ruling 59-60, “the focal point for the proper method of valuing closely held securities.” Given the close relationship between the values of the stock of a holding company and the underlying assets, Rev. Ruling 59-60 recommends the net asset value method, which in turn relies on the “venerable willing buyer-willing seller test.”
The Court turned to tax law next. Prior to the Tax Reform Act of 1986, the federal tax code and case law permitted C corporations to distribute appreciated property to shareholders without incurring income tax at the corporate level. Courts generally did not permit a discount for built-in capital gains tax liability unless a sale or liquidation was either planned or imminent, deeming the discounts to be too speculative.

The Tax Reform Act made “dramatic” changes, requiring the recognition of corporate-level gains on distributions of appreciated property. Because an individual shareholder/taxpayer would no longer receive a step-up in basis to fair market value on the valuation date (e.g., at a decedent’s death for estate tax purposes), the Court explained, “it now became more important than ever for a taxpayer to be able to quantify his or her loss in value of the stock due to inherent capital gains tax liability in the corporation.”

But despite tax reform, the IRS steadily refused to allow a capital gains discount. Courts, while recognizing the “possibility” that a discount for the capital gains taxes could be allowed, adhered to the “rigid” position that the highly speculative nature of the tax mandated that its present value be zero. Then along came Estate of Davis (1998). Citing Rev. Ruling 59-60 and “economic reality theory,” the Tax Court held that a hypothetical buyer and seller would take some account for imbedded capital gains tax. Rather than permit a separate discount, however, the Tax Court attributed approximately one-third of the allowed marketability discount to the contingent capital gains liability.

IRS position ‘beginning to erode’

Davis“set the stage” for other courts to being to make inroads into the IRS position. In the 1998 Estate of Eisenberg, the Second Circuit concluded that a willing buyer and seller would negotiate a discount to account for the tax liability, despite no imminent liquidation or sale.

[T]here is simply no evidence to dispute that a hypothetical willing buyer…would likely pay less for the shares of a corporation because of [the] buyer’s inability to eliminate the contingent tax liability. …Further, we believe…a tax liability upon liquidation or sale for built-in gains is not too speculative.

But language in Eisenberg and Estate of Welch (6th Cir. 2000) suggested that while a discount was permissible, it need not be on a dollar-for-dollar basis. While neither circuit court “seemed keen on offering a 100% discount,” the Jelke opinion observed, each failed to prescribe a specific approach to calculate its magnitude. Disputes between the IRS and taxpayers began to focus on the appropriate valuation method and amount of the reduction. In Estate of Jameson (2001), the decedent owned 98% of a closely held interest that operated both a timber and an investment company. Applying a net asset valuation, the Tax Court allowed a partial discount for the capital gains tax liability on the timber property, incurred over the timber harvest. But it permitted no discount on the investment property, assuming a hypothetical buyer would continue operations.

On appeal, the Fifth Circuit disagreed with the presumption that a strategic, not a hypothetical, buyer would continue to operate the company for timber production. An “economically rational buyer” would account for the consequences of the unavoidable, substantial built-in tax liabilities, especially given the company’s low basis in the investment property. It instructed the Tax Court to reconsider the amount of capital gains on the timber operations and to calculate a discount for the contingent liability on the investment property.

Dunn ushers in new valuation era

A year later, the Fifth Circuit went a step further in Estate of Dunn. The decedent owned a majority (62.2%) interest in a family corporation that rented heavy equipment, but lacked a supermajority, two-thirds interest that could force liquidation under Texas law. Because the family also planned to keep running the company, the Tax Court approved a 5% discount for built-in capital gains, reflecting the “small” possibility that a hypothetical buyer would liquidate.

This time, the Fifth Circuit disagreed “emphatically.” A hypothetical buyer and seller must always be assumed to liquidate the corporation immediately upon the valuation date, triggering a tax on the built-in gains. The “likelihood is 100%,” the Fifth Circuit said, and the appropriate amount for the discount was equal to 100% of the capital gains liability, dollar for dollar.
This decision substantially altered the Tax Court’s fair market value test, according to the Jelke opinion. “An era of valuation certainly had begun.” While the Fifth Circuit declined to extend Dunn to the valuation of imbedded tax liability in a decedent’s IRA, it approved discounts for contingent estate taxes related to gifted partnership interests in Estate of McCord (2006).

Majority favors practicality, precision

This evolving case law provided the backdrop for the questions in the Jelke appeal. Given the minority interest at stake and the unlikelihood of liquidation, the IRS urged the Eleventh Circuit to ratify the Tax Court’s acceptance of a present value of the $51 million capital gains liability, indexed over a sixteen-year period (the likely time when the assets would be sold), or $21 million. The estate claimed this approach was both inconsistent and incomplete, given the likelihood that the underlying securities would change over time. It urged the application of Dunn and the certainty of a dollar-for-dollar discount—and the Court agreed.
In our case, why would a hypothetical willing buyer…not adjust his or her purchase price to reflect the entire $51 million? The buyer could just as easily venture into the open marketplace and acquire an identical portfolio of blue chip domestic and international securities…without any risk exposure to the underlying tax liability.

The Tax Court’s distinction between the majority interest at stake in Dunn and the minority interest in Jelke was not persuasive. “We are dealing with hypothetical, not strategic, willing buyers and sellers,” the Court observed. This led to its threshold, “arbitrary” assumption that a liquidation takes place on the date of death, freezing all assets and liabilities at that time. Whether a majority or minority interest is present “is of no moment.”

The Court also rejected any distinction based on Dunn’s consideration of an interest that held operating as well as investment assets, which led the Fifth Circuit to apply an earnings-based valuation to the operations side (weighted 85%), and a net asset valuation to the investment side (15%). In Jelke, the company was solely an investment holding company, so the Dunn analysis applied only to the net asset valuation with no need for weighting. More importantly, the Tax Court’s present value approach was “fluidly ethereal,” requiring courts to “gaze into a crystal ball, flip a coin, or at the very least, split the difference” between the respective approaches of the taxpayer and the IRS.

“We think the approach set forth by the Fifth Circuit in [Dunn] is the better,” the Court held, in a three-to-one decision. By calculating the estate tax based on a “snapshot of valuation” on the date of death, the simple, logical Dunn rationale provides “practical certainty to taxpayers, appraisers and financial planners alike.” It is a “welcome road map for those in the judiciary,” the Court added, “not formally trained in the art of valuation.” Finally, the dollar-for-dollar approach relieves courts from spending time and resources having to “wade through a myriad of divergent expert witness testimony, based on subjective conjecture and divergent opinions.”

Notably, the Court declined to rule on the Tax Court’s determination of discounts, finding no error in the assessment of a 15% lack of marketability discount and 10% for lack of control.

A strong dissent

Like the Dunn panel, the Jelke majority anticipated that critics in the business appraisal community might call their methodology unsophisticated and overly simplistic. In assuming this risk, it quoted the Fifth Circuit’s observation in Dunn that opposite oversimplification on the methodology spectrum lies “over-engineering.”

[Our] economic reality approach mimics the marketplace and places a practical, transactional overlay upon the proverbial willing buyer-willing seller analysis. It allows the issue to conform to the reality of the depressing economic effect that the lurking taxes have on the market selling price.

A lone dissenting judge decried the adoption of the “rule of least effort.” “The majority gives in to the judicial equivalent of the doctrine of ignoble ease,” the dissent wrote, citing Theodore Roosevelt’s philosophy on the “strenuous life.” The Tax Court’s “real value approach” may not be perfect, and it depends on certain arguable assumptions—such as past rates of liquidation. But it produces a more accurate result than the majority’s arbitrary assumption method, the dissent argued, “because it more closely reflects the economic interests of those who control the company.”

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