AI Case Brief
Generate an AI-powered case brief with:
Estimated cost: $0.001 - $0.003 per brief
Full Opinion
This estate tax case presents on appeal an issue of first impression in this circuit.
The issue is whether or not the Tax Court used the appropriate valuation methodology in computing the net asset value of CCC to determine the value of Jelke’s interest in CCC for estate tax purposes on the date of death. The Tax Court, adopting the Commissioner’s expert witness appraiser’s approach, allowed the estate only a partial $21 million discount for CCC’s built-in capital gains tax liability, indexed to reflect present value on the
Based upon the following historical overview, discussion, and precedential authority, we are in accord with the simple yet logical analysis of the tax discount valuation issue set forth by the Fifth Circuit in Estate of Dunn, 301 F.3d at 350-55, providing practical certainty to tax practitioners, appraisers and financial planners alike. Under a de novo review, as a matter of law, we vacate the judgment of the Tax Court and remand with instructions that it recalculate the net asset value of CCC on the date of Jelke’s death, and his 6.44% interest therein, using a dollar-for-dollar reduction of the entire $51 million built-in capital gains tax liability of CCC, under the arbitrary assumption that CCC is liquidated on the date of death and all assets sold.
I. FACTUAL BACKGROUND
Jelke died testate on March 4, 1999, in Miami, Florida. On the date of his death, CCC’s marketable securities had a fair market value of $178 million, plus a built-in contingent capital gains tax liability of $51 million on those securities. Combined with $10 million in other CCC assets, without regard to the tax liability, CCC’s net asset value totaled $188 million.
On the estate’s federal estate tax return filed December 6, 1999, Jelke’s 6.44% interest in CCC, held through his revocable trust, was included in his gross estate under Section 2031 at a value of $4,588,155. I.R.C. § 2031. The estate calculated this figure by reducing CCC’s $188 million net asset value by $51 million, or 100% of the built-in capital gains tax liability. It then applied a 20% discount for lack of control and a 35% discount for lack of marketability-
In his December 2, 2002, notice of deficiency issued to the estate, the Commissioner determined that Jelke’s estate owed
II. PROCEDURAL BACKGROUND
The estate filed a petition in Tax Court in March 2003, contesting the Commissioner’s $9,111,000 fair market value of Jelke’s 6.44% interest in CCC stock on the date of death. It claimed that the Commissioner had based his value on an incorrect net asset value of CCC, by declining to discount CCC’s net asset value of $188 million, by the $51 million in contingent built-in capital gains tax liability, accrued as of the date of death. The estate also claimed that the Commissioner undervalued the two additional discounts available to the estate, one for lack of marketability and one for lack of control.
After a two-day bench trial, the Tax Court rejected the estate’s position that CCC’s net asset value must be reduced dollar-for-dollar by the entire amount of the built-in capital gains tax liability under Estate of Dunn, 301 F.3d at 351-53, as the Estate of Dunn was a Fifth Circuit, not an Eleventh Circuit, case. It determined that a discount was available, but not one for 100%.
The Tax Court noted that a hypothetical buyer of 6.44% of CCC stock single-hand-edly would be unable to cause or force a liquidation of CCC. It stated that CCC’s long-term history of dividends and appreciation, with no immediate plans to liquidate (one trust continues until 2019), together with its low annual turnover of securities in the portfolio, belied the Estate of Dunn’s threshold, arbitrary assumption of complete liquidation on the valuation date. Further, the Tax Court distinguished Estate of Dunn on the fact that the Fifth Circuit in Estate of Dunn was valuing a majority, not a minority, shareholder interest as was present here. Also the company valued in the Estate of Dunn was primarily (85%) an operating company, unlike CCC, a 100% investment holding company.
Under the net asset valuation approach, the Tax Court adopted the Commissioner’s argument that the capital gains tax discount should be reduced to present value, as computed on an annualized, indexed basis, over the sixteen-year period it was expected to be incurred as the assets turned over.
This appeal follows.
The question of whether the Tax Court used the correct standard to determine fair market value is a legal issue. See Powers v. Comm’r, 312 U.S. 259, 260, 61 S.Ct. 509, 85 L.Ed. 817 (1941). We review de novo the Tax Court’s rulings on the interpretation and application of the tax code. See Estate of Blount v. Comm’r, 428 F.3d 1338, 1342 (11th Cir.2005) (citation omitted). The Tax Court’s findings of fact are reviewed for clear error. Id. Where a question of fact, such as valuation, requires legal conclusions, we review those underlying legal conclusions de novo. See Adams v. United States, 218 F.3d 383, 386 (5th Cir.2000). A determination of fair market value is a mixed question of fact and law: the factual premises are subject to a clearly erroneous standard while the legal conclusions are subject to de novo review. See Estate of Dunn, 301 F.3d at 348 (citations omitted). “The mathematical computation of fair market value is an issue of fact, but determination of the appropriate valuation method is an issue of law that we review de novo.” Id.
IV. DISCUSSION
A. Introduction
The issue in this case is, for estate tax purposes, the proper calculation of the magnitude of the discount for built-in capital gains taxes in valuing stock in a closely-held corporation on the date of death. A general overview of the applicable tax statutes, regulations and revenue rulings is appropriate.
1. The Tax Code and Treasury Regulations
Section 2031(a) provides that the value of a decedent’s gross estate shall be determined by including the value at the time of death of all property, real or personal, tangible or intangible, wherever situated. I.R.C. § 2031(a). Section 20.2031-1(b) provides that the value of every item of property includable in a decedent’s gross estate ... is its fair market value at the time of the decedent’s death. Treas. Reg. § 20.2031-l(b). The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.
2. Internal Revenue Service Guidelines
Revenue Ruling 59-60 provides the foundation for undertaking an analysis of a closely-held stock’s value. Rev. Rul. 59-60, 1959-1 C.B. 237.
The fair market value of closely-held securities also clearly depends upon the potential buying public’s estimate of the worth of the securities. Id. at § 3.02. The level of risk that a buyer will be willing to accept in purchasing stock of a closely-held company will directly impact the value of that stock. Id.
Revenue Ruling 59-60 states that “[t]he value of the stock of a closely-held investment or real estate holding company, whether or not family owned, is closely related to the value of the assets underlying the stock.” Id. at § 5(b). The net asset value method of valuation, which assumes that the value of the corporation is based upon the fair market value of its underlying assets, is in turn determined by applying the venerable willing buyer-willing seller test. Id. The net asset value method is the best method to use in valuing corporations that are essentially holding companies, while an earnings-based method applies to operating companies. Id.
B. Historical Overview of the Issue Presented on Appeal
1. The Law Prior to the Tax Reform Act of 1986
In General Utilities & Operating Co. v. Helvering, 296 U.S. 200, 56 S.Ct. 185, 80 L.Ed. 154 (1935), the Supreme Court held that a C corporation did not recognize taxable income at the corporate level on a distribution of appreciated property to its shareholders. Id. at 206, 56 S.Ct. 185. Congress responded to this holding, later to become known as “the General Utilities doctrine,” by enacting Section § 311(a).
With one exception during this fifty-one year period, ease law did not allow a discount for built-in capital gains tax liability when a sale or liquidation was neither planned nor imminent, as it was deemed by the courts to be too uncertain, remote or speculative.
The pre-1986 cases do not announce a rule of law that such taxes may never affect the value of stock, but that taxes will create an impact only when the taxpayers can prove that the assets will in fact be sold in the foreseeable short-term future, rather than held for long-term investment return. See Obermer v. United States, 238 F.Supp. 29, 35-36 (D.Haw.1964). The pre-1986 cases are now, however super-ceded by statute. See Tax Reform Act of 1986, Pub.L. No. 99-5U, § 631, 100 Stat. 2085.
2. The Tax Reform Act of 1986
The Tax Reform Act of 1986 (TRA 1986) made dramatic tax law changes. New rules were enacted to require the recognition of corporate-level gains on the distributions of appreciated property under Section § 311(b), thereby repealing the General Utilities doctrine and I.R.C. §§ 336 and 337. See I.R.C. § 311(b).
Prior to the repeal of the General Utilities doctrine by TRA 1986, no corporate tax would have been required to be paid and no discount would have been allowed. TRA 1986 required recognition of corporate-level gains and losses on liquidating sales and on distributions of corporate property.
With the repeal of the doctrine, courts began to recognize the possibility that a discount related to the capital gains taxes incurred should be allowable. Due to the taxpayer’s inability to receive a step-up in basis to fair market value on the valuation date after TRA 1986, 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.
3. Post-TRA 1986 until Estate of Davis in 1998
Although subject to the 1986 legislation, as late as 1991, the Commissioner continued to adhere to his pre-1986 position that no capital gains discount was permitted on distributions of closely-held corporate stock, ignoring the fact that a corporate-level income tax now would be incurred upon its liquidation. See I.B.S. Tech. Adv. Mem. 91-50-001 (1991) (the Commissioner will continue to adhere to his historical rule against allowing a capital gains tax discount).
From 1986 to 1998, taxpayers were unsuccessful in their arguments that the repeal of the General Utilities doctrine made it difficult to avoid capital gains at the corporate level, and that, therefore, ipso facto a discount for built-in capital gains should be allowed. See Estate of Bennett v. Comm’r, 65 T.C.M. (CCH) 1816, *12 (1993); Estate of Ward v. Comm’r, 87 T.C. 78, 104, 1986 WL 22156 (1986) (no discount as there was no evidence that liquidation is imminent or even contemplated). The courts continued to adhere to the rigid position that the highly speculative nature of the tax mandated that its present value be zero. See Estate of Luton v. Comm’r, 68 T.C.M. (CCH) 1044 (1994).
C. Historical Evolution of Precedential Case Law on the Issue on Appeal
1. Estate of Davis — The Tax Court Case
Then, in 1998, twelve years after the TRA 1986 was enacted, the Tax Court began to relax its historical stance in keeping with the “new” statute.
No liquidation of the holding company or sale of its assets was planned or contemplated on the valuation date. No tax was due and owing on the valuation date. Estate of Davis, 110 T.C. at 530. Nevertheless, citing section 5(b) of Rev. Rul. 59-60, 1959-1 C.B. at 242-43, the Tax Court determined, under an economic reality theory, that a hypothetical buyer and seller would not have agreed on that date on a stock price that took no account of the corporation’s built-in capital gains tax.
The Tax Court permitted discounts in Estate of Davis, both for a lack of market
The Commissioner’s position was beginning to erode. The stage was set for other courts to become involved.
2. Estate of Eisenberg and Estate of Welch — The Circuit Courts of Appeal Cases
In Estate of Eisenberg v. Comm’r, 74 T.C.M (CCH) 1046 (1997), the donor gave away shares of stock in her closely-held corporation. She owned all 1,000 shares in a corporation whose only asset was a commercial office building. Id. at *1. The corporation’s only activity was renting office space in the building to clients. There were no plans to sell the building or liquidate the corporation. Id.
Nevertheless, the donor sought to reduce the value of the gifted shares of the closely-held corporation to account for the fact that, if its asset was sold, the sale would trigger a tax gain to the corporation. Estate of Eisenberg, 74 T.C.M. at *2. The Tax Court, notwithstanding the repeal of the General Utilities doctrine, and still citing its pre-1986 cases, declined to allow the tax discount to the donor on the basis that it was unlikely that a hypothetical buyer would want to liquidate the corporation or sell its underlying assets on the transfer date. Id. at *4. “[T]he primary reason for disallowing a discount for capital gains taxes in this situation is that the tax liability itself is deemed to be speculative,” therefore, its discount value should be zero. Id.
The Second Circuit Court of Appeals disagreed. Eisenberg v. Comm’r, 155 F.3d 50, 57 (2d Cir.1998). Buoyed by the Tax Court’s own recent decision in Estate of Davis, the Second Circuit concluded that, although no liquidation of the corporation or sale of corporate assets was imminent or contemplated at the time of the gift, the requirement of an imminent sale was unnecessary. Id. It was the opinion of the court that a willing buyer would demand a discount to take account of the fact that, sooner or later, the tax would have to be paid.
For the first time since the enactment of TRA 1986, the mandate by the Commissioner and the Tax Court of an imminent sale or liquidation, notwithstanding the
The issue is not what a hypothetical willing buyer plans to do with the property, but what considerations affect the fair market value of the property he considers buying. While prior to the [TRA 1986] any buyer of a corporation’s, stock could avoid potential built-in capital gains tax, there is simply no evidence to dispute that a hypothetical willing buyer today would likely pay less for the shares of a corporation because of a buyer’s inability to eliminate the contingent tax liability.
Eisenberg, 155 F.3d at 57.
“Further, we believe, contrary to the opinion of the Tax Court, since the General Utilities doctrine has been revoked by statute, a tax liability upon liquidation or sale for built-in gains is not too speculative in this case.” Id. at 58. The Second Circuit vacated and remanded the Tax Court decision for recalculation.
There is dicta in Eisenberg to suggest, however, that it would be incorrect to conclude that the full amount of the potential capital gains tax should be used. Id. at 58 n. 15.
In 2000, the trend continued and moved to a different circuit. See Estate of Welch v. Comm’r, (unpublished) 208 F.3d 213 (6th Cir.2000).
The Tax Court denied the decedent’s estate a tax discount on the basis that the estate failed to prove that liquidation of the corporations’ assets was likely to occur on the valuation date. Id. at *3. The
Relying upon the rationale of the Second Circuit in Estate of Eisenberg, the Sixth Circuit found the Tax Court’s judgment disallowing any discount in any amount erroneous as a matter of law and remanded to the Tax Court for a hearing. Id. at *5. The court was instructed to determine what a hypothetical, willing buyer would likely pay for the Estate of Welch stock on the valuation date, considering all the facts and circumstances at the time, including the built-in capital gains tax on the corporation’s real estate.
While neither the Second Circuit in Estate of Eisenberg, nor the Sixth Circuit in the Estate of Welch, seemed keen on granting a 100% discount, neither court prescribed a specific alternative approach either as to the amount of the reduction or a method by which to calculate it. Now that taxpayers have historically prevailed on this issue and are entitled to a discount as a matter of law, the issue shifts to the amount of the discount to be allowed.
3. The Fifth Circuit In Estate of Jame-son and Estate of Dunn — A Further Shift in Emerging Case Law
By 2001, the issue presented itself squarely in the Fifth Circuit. In Estate of Jameson v. Comm’r, 267 F.3d 366 (5th Cir.2001), the decedent owned 98% of the stock of her predeceased husband’s closely-held operating company. Id. at 367. The company was both an operating timber company and an investment company. Id. at 367-69.
The Tax Court, based on its recent decision in Estate of Davis, concluded that some discount for built-in capital gains should be acknowledged. Estate of Jameson, 267 F.3d at 371. Using a net asset valuation approach, the Tax Court allowed a partial discount based upon the court’s estimate of the net present value for the capital gains tax liability on the timber property that would be incurred as the timber was cut, over a nine-year period.
Relying on the Second Circuit case of Estate of Eisenberg, the Fifth Circuit in the Estate of Jameson concluded that the Tax Court had clearly erred in crafting its own valuation method. Id. at 371. The method was flawed because it was based upon the Tax Court’s conclusive assumption that a strategic, not a hypothetical, buyer would continue to operate the company for timber production. Id. at 371-72.
The Fifth Circuit determined that the first, or economically rational, purchaser of the stock cannot be presumed to operate the company. Estate of Jameson, 267 F.3d at 371-72. The rational economic actor or willing buyer would have to take into account the consequences of the unavoidable, substantial built-in tax liability
Citing internally inconsistent assumptions within the Tax Court opinion, the Fifth Circuit vacated the judgment and remanded the case back to the Tax Court. The instructions given were that the Tax Court reconsider the amount of capital gains on the operating timber property, and, to consider and allow a discount for the built-in capital gains on the investment property. Estate of Jameson, 267 F.3d at 372.
A year later, the Fifth Circuit went one step further in Estate of Dunn v. Comm’r, 301 F.3d 339 (5th Cir.2002). At the time of her death, Mrs. Dunn owned a majority 62.96% of the stock of a family-owned corporation engaged in the rental of heavy equipment. The family company also managed certain commercial property as an investment. Id. at 347.
As Texas corporate law required a 66.66% interest in the voting shares to affect a liquidation, with 62.9%, Mrs. Dunn did not own a “supermajority,” or 66.6%, that could force a liquidation. Id. The facts further indicated that the family company planned to remain viable and in operation for some time.
Using a willing buyer-willing seller fair market value test, the Tax Court in the Estate of Dunn, while agreeing with the Commissioner’s argument that the tax was certainly speculative, still agreed to discount the stock price by 5% of the built-in capital gains as a matter of law. Id. at 347. This holding was in response to the existence of a very small possibility that a hypothetical buyer would liquidate the company. The 5% discount was in lieu of the 34% reduction sought by the taxpayers. Id. The Tax Court concluded that it was much more likely that a hypothetical buyer would continue to operate the company. Id.
The Fifth Circuit disagreed emphatically with the Tax Court. In the Estate of Dunn, under a net asset valuation approach, the Fifth Circuit determined value by totaling the corporation’s assets and subtracting its liabilities. It held that a hypothetical willing buyer-willing seller' must always be assumed to immediately liquidate the corporation, triggering a tax on the built-in gains.
Turning to the proper amount of the discount, the Fifth Circuit concluded that the value of the assets must be reduced by a discount equal to 100% of the capital gains liability, dollar for dollar.
4. Cases After the Estate of Dunn
In 2004, the Fifth Circuit in Estate of Smith v. Comm’r, 391 F.3d 621 (5th Cir.2004), was asked to decide the issue of whether or not, for estate tax purposes, the value of a decedent’s individual retirement accounts (IRAs), containing marketable stocks and bonds, should be reduced by the amount of potential income tax liability of the beneficiaries upon distribution from the accounts. Estate of Smith, 391 F.3d at 626. While acknowledging the recent trend of considering potential tax liability in valuation cases, the Fifth Circuit declined to extend Estate of Davis and its progeny, including the Estate of Dunn, to the valuation of IRAs held by a decedent.
Most recently, in Estate of McCord v. Comm’r, 461 F.3d 614 (5th Cir.2006), another Fifth Circuit case, the “trend” continues. The case presented an issue of
In Estate of McCord, the Commissioner asserted in a notice of deficiency that donor taxpayers had understated the fair market value of their gifted partnership interests on their gift tax returns. Id. at 621. The Commissioner claimed that this error resulted from the donor taxpayers’ discounting the fair market value of those gifted interests by the mortality-based, ac-tuarially-calculated present value of the donees’ assumed obligations for additional estate taxes. Id.
Finding no error in undervaluation, the Fifth Circuit in Estate of McCord, citing Estate of Dunn, stated:
For purposes of our willing buyer/willing seller analysis, we perceive no distinguishable difference between the nature of the capital gains tax and its rates on the one hand and the nature of the estate tax and its rates on the other hand. Rates and particular features of both the capital gains tax and the estate tax have changed and likely will continue to change with irregular frequency; likewise, despite considerable and repeated outcries and many aborted attempts, neither tax has been repealed. Even though the final amount owed by the Taxpayer as gift tax on their January 1996 gifts to non-exempt donees has yet to be finally determined (depending, as it does, on the final results of this case), we are satisfied that the transfer tax law and its rates that were in effect when the gifts were made are the ones that willing buyer would insist on in applying in determining whether to insist on, and calculate a discount for § 2035 estate tax liability.
Estate of McCord, 461 F.3d at 630.
The Fifth Circuit thereby extended the rationale of Estate of Davis to a gift tax case involving contingent estate taxes.'
D. Applying the Fifth Circuit Estate of Dunn Rationale to the Present Appeal
Juxtaposed against the backdrop of this emerging case law, the question before the Tax Court in this case, and now before us, is what was the value of Jelke’s 6.44% interest in CCC on March 4, 1999? Which dollar figure do we use to discount the fair market value of CCC’s securities for built-in capital gains on March 4, 1999? Is it dollar-for-dollar, as the estate contends, under the rationale set forth in 2002 by the Fifth Circuit in the Estate of Dunn, or $51 million? Or is it the