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Estate of Jensen Gets the Full BIG Discount

By : Ori Bash, ASA

In Jensen v. Comm’r, TC Memo 2010-182, the estate prevailed on the discount for the Built-in-Gains (“BIG”) tax when determining the fair market value (“FMV”) of the estate’s interest in a company that primarily held real estate. The Jensen case, along with others, directs appraisers to calculate the BIG tax discount using a “dollar-for-dollar” approach. 

Historical Context

The debate over BIG tax liabilities took form after the General Utilities doctrine, which allowed for the complete avoidance of corporate-level capital gains through tax free liquidation, was repealed in the Tax Reform Act of 1986. Initially, arguments in Eisenberg1 and Davis2 focused on rejecting BIG tax liability in its entirety based principally upon the prospective liquidation test or a deferral/avoidance strategy through an S corporation election. In both of these cases, it was ultimately ruled that a BIG tax liability is a real detriment to value. Shortly thereafter, in an IRS announcement3, the Service conceded on this issue by recognizing that FMV can be reduced for a BIG tax liability when sufficient evidence for the computation of the discount is provided. Accordingly, in future court cases, the BIG tax liability argument shifted gears from a matter of existence to that of magnitude. Dunn4 and Jelke5 were huge victories for the taxpayer as the dollar-for-dollar approach for BIG tax liability was applied on appeal. Dunn set precedent for applying a dollar-for-dollar approach under a net asset value method, while Jelke ruled in favor of the dollar-for-dollar approach due to its simplicity and transparency. In Litchfield6, since both experts utilized a present value analysis, the dollar-for-dollar approach was not considered by the Court. However the taxpayer’s expert’s stronger evidence resulted in a significant BIG tax liability.

Background

The decedent held 164 shares (an 82 percent interest) of common stock in Wa-Klo, Inc., a closely held C corporation whose principal asset was a 94-acre waterfront real estate parcel that was utilized as a summer camp for girls. In 2003, the decedent created a revocable trust that held the aforementioned shares of Wa-Klo. At issue was the magnitude of the BIG tax liability, as the parties had already agreed on a lack of marketability discount of 5 percent and no lack of control discount.

Expert Testimony

The taxpayer’s expert valued the subject interest using the adjusted book value method and applied a dollar-for-dollar approach for the BIG tax liability. An earnings-based approach was not applied as: (i) Wa-Klo did not generate substantial cash flows from its operations, (ii) the best use of Wa-Klo could be derived from the sale of its assets due to the Company’s poor historical operating performance, (iii) there was substantial value in the appreciated value of Wa-Klo’s underlying assets, and (iv) the estate’s 82 percent interest in Wa-Klo was a controlling interest.

The respondent’s expert also solely relied upon the adjusted book value method for the subject interest. However, with respect to the BIG tax liability, the Service’s expert applied an unorthodox approach in which closed-end fund data was analyzed for exposure to BIG taxes. Based upon the closed-end fund data, the respondent’s expert concluded that, only BIG tax exposure in excess of 41.5 percent of net asset value, should be given consideration on a dollar-for-dollar basis7. The respondent’s expert also discussed possible avoidance methods of the BIG tax such as engaging in a Section 1031 exchange or by converting a C corporation to an S corporation and waiting out the required 10-year holding period. The respondent’s expert’s report did not, however, discuss if either of the BIG tax avoidance options were viable options in the case of a hypothetical willing buyer of the subject interest.

The Court’s Response
In its opinion, the Court cites Dunn, Jelke, and Litchfield, among others. Petitioner had argued that the Court should apply the approach of these prior opinions. However, the Court stated, “we decline to speculate how the Court of Appeals for the Second Circuit may hold in the future” and proceeded to resolve the valuation question based on the arguments and analyses presented.

The Court rejected the Service’s expert’s analysis of the closed-end fund data, stating that the Wa-Klo stock is not comparable to the closed-end fund data because of: (i) the lack of diversity of Wa-Klo’s underlying assets compared to that of the closed-end funds, (ii) the other factors (supply and demand, manager or fund performance, investor confidence or liquidity) affecting closed-end fund discounts, and (iii) the inconclusive nature of studies on the effects of unrealized capital gains on closed-end fund discounts. The Court also rejected the respondent’s analysis of the methods for avoiding the BIG tax for the subject interest.

Finally, the Court performed its own calculation of the BIG tax liability by using a present value analysis with similar inputs to those applied by the Court in Litchfield (post-mortem appreciation rates, depreciation, asset turnover, and discount rate). In particular, the Court projected future appreciation of the property and then discounted the resulting cash flows back to the present using the same rate8. The Court’s range of values for the BIG tax liability (with its selected assumptions) slightly exceeded that of the taxpayer’s expert under the dollar-for-dollar approach. This present value approach gave the Court added comfort, as it ultimately sided with the taxpayers’ BIG tax liability determination.

FINAL COMMENTARY

In a departure from Dunn with respect to methodology, the Court also considered a present value analysis under an adjusted net asset value method. Luckily for the taxpayer, the assumptions selected by the Court in the present value analysis resulted in a BIG tax liability that was just slightly higher than that of a dollar-for-dollar approach. After the Court rejected the Service’s expert’s analysis of the closed end fund data, it naturally gravitated towards the evidence provided by the taxpayer’s expert in favor of the dollar-for-dollar BIG tax liability. Jensen is another victory for dollar-for-dollar BIG discounting, which seems to be becoming the norm.

1. Eisenberg v. Comm’r T.C. Memo 1997-483 and Eisenberg v. Comm’r 155 F.3d 50,54-55 (2d Cir. 1998). 
2. Estate of Davis v. Comm’r 110 T.C. at 530, 538 (1998) 
3.1999-4, I.R.B.4 
4. Dunn v. Comm’r 301 F.2d 339 (August 1, 2002) 
5. Estate of Jelke III v. Comm’r Tax Court No. 3512-03 (November 15, 2007) 
6.Estate of Litchfield v. Comm’r T.C. Memo 2009-21 (2009) 
7.Based on a very small sample, the Service’s expert essentially found no correlation between the closed-end fund discounts and built-in gains. The data-set included funds with built-in capital gains up to 41.5 percent of net assets. The Court found this analysis unconvincing, as would, we believe, most experts.
8. Needless to say, if the DCF method is applied correctly, such an analysis will almost always “bring back” a very similar value as the dollar-for-dollar.

Ori Bash, ASA, is a Vice President at Pluris Valuation Advisors LLC and resides in our Palo Alto, California office. He performs valuation services for estate and gift tax, corporate and personal income tax, fairness opinions, financial reporting, and other purposes. Mr. Bash has valued common stock, preferred stock, debt instruments, carried interests, intangible assets, minority interests in passive asset holding entities, and fractional interests in real property.

Pluris has offices in New York and Palo Alto, and specializes in illiquid, complex, and distressed securities, and business valuations.

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