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Valuation of an interest in an entity is the determination of what a hypothetical buyer would pay a hypothetical seller when purchasing that interest. Valuation is often a major issue in estate and gift tax returns, and the appropriateness of valuations reported by taxpayers on gift and estate tax returns has been litigated for years. Included within valuation is determining the impact of the built-in capital gains tax liability of the entity in determining what a hypothetical buyer would pay and what a hypothetical seller would accept in transferring a closely held business interest. The 11th U.S. Circuit Court of Appeals recently reversed the U.S. Tax Court by ruling that the value of a holding company is reduced by the entire built-in capital gains tax liability for federal estate tax purposes. Estate of Jelke v. Comm’r, No. 05-15549, 2007 U.S. App. Lexis 26477 (11th Cir. Nov. 15, 2007). The 11th Circuit joins the 5th Circuit in allowing a full reduction for built-in capital gains liability. Previously, the 2d and 6th circuits had both held that some discount for built-in capital gains liability is appropriate, but not a full reduction for built-in capital gains liability. The trend seems to be toward allowing a full reduction for built-in capital gains tax liability, but this issue may ultimately be resolved by the U.S. Supreme Court. Until relatively recently, no reduction was allowed for built-in capital gains tax liability when valuing a holding company for estate tax purposes. In 1935, the Supreme Court held that a Subchapter-C corporation did not recognize taxable income on the corporate level when making distributions of appreciated property to its shareholders. General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935). In response to this holding, Congress enacted I.R.C. � 311(a), which commonly became known as the General Utilities doctrine. Under � 311(a), a shareholder receiving appreciated distributed corporate property used the fair market value of the properties as his adjusted stepped-up basis. From 1935 to 1986, courts did not allow any discount for built-in capital gains tax liability unless a sale or liquidation was planned or imminent. Courts deemed any discount without a planned liquidation or sale to be speculative, remote and uncertain. See, e.g., Estate of Andrews v. Comm’r, 79 T.C. 938, 942 (1982); Estate of Piper v. Comm’r, 72 T.C. 1062, 1086-87 (1979); Cruikshank v. Comm’r, 9 T.C. 162, 165 (1947). The Tax Reform Act of 1986 made dramatic changes to the tax law and required the recognition of corporate-level capital gains upon distribution to shareholders. I.R.C. � 311(b). The Tax Reform Act of 1986 repealed the General Utilities doctrine and opened the door for courts to begin considering the impact of built-in capital gains tax liability upon the value of shares in the hands of corporate shareholders. In the area of estate and gift taxation, the repeal of the General Utilities doctrine would be replaced by consideration of the hypothetical willing buyer and seller. After a series of cases allowing some level of discount for built-in capital gains tax liability, in 2002 the 5th Circuit allowed a dollar-for-dollar reduction in value for built-in capital gains tax liability. Estate of Dunn, 301 F.3d 339 (5th Cir. 2002). At the time of her death, Beatrice Ellen Jones Dunn owned a 62.96% interest in the family-owned corporation engaged in the rental of heavy equipment. Dunn’s interest did not amount to a supermajority interest that could force a liquidation of the company, and the facts presented indicated that the company intended to remain in operation. The 5th Circuit held that a hypothetical willing buyer and seller, as distinguished from a strategic buyer, must always be assumed to immediately liquidate the corporation, which would trigger the tax on the built-in capital gains. In other words, the threshold assumption in determining fair market value is that liquidation will occur and the hypothetical willing buyer would decrease his offer accordingly. Thus, under Dunn, the discount for built-in capital gains tax liability is equal to 100%, and the reduction is dollar for dollar. The Dunn case is somewhat at odds with earlier decisions in the 2d and 6th circuits, which allowed some discount for built-in capital gains tax liability but not a dollar-for-dollar discount. The 2d Circuit did away with the requirement that a sale or liquidation of the company must be imminent or contemplated at the valuation date in order to support a discount for built-in capital gains tax. Eisenberg v. Comm’r, 155 F.3d 50, 57 (2d Cir. 1998). The Eisenberg case involved valuing a gift of closely held stock, and the court specifically acknowledged that no liquidation of the corporation or sale of its assets was imminent. The Eisenberg court concluded that a willing buyer would demand a discount to account for the fact that the capital gains tax would ultimately have to be paid. Dicta in the Eisenberg decision suggest that a dollar-for-dollar discount should not be used. However, the 2d Circuit did not spell out the precise methodology for valuing the underlying contingent tax liability. Instead, the 2d Circuit remanded the case to the Tax Court for calculation of an appropriate discount for the built-in capital gains tax liability. The 6th Circuit, in an unpublished decision cited by the 11th Circuit in Jelke, continued the trend established by the Eisenberg court. Estate of Welch v. Comm’r, No. 98-2007, 2000 U.S. App. Lexis 3315 (6th Cir. March 1, 2000). In Welch, the Tax Court had denied any discount for built-in capital gains tax liability despite the fact that the property was subject to condemnation and sale shortly after the decedent’s death. The 6th Circuit reversed and instructed the Tax Court to determine what a hypothetical willing buyer would likely pay for the stock, given all of the facts and circumstances including the built-in capital gains tax liability. As with Eisenberg, the 6th Circuit included dicta in the opinion suggesting that a dollar-for-dollar reduction was not appropriate. ‘Estate of Jelke’ The 11th Circuit recently jumped into this issue, siding firmly with the 5th Circuit’s prior holding that a dollar-for-dollar reduction in value for the built-in capital gains tax liability is the proper approach to setting a value on shares of a holding company for federal transfer tax purposes. In Jelke, the 11th Circuit relied heavily on the decision of the 5th Circuit in Dunn. The court rejected the lesser discounts contemplated by the 2d and 6th circuits. Frazier Jelke III died testate on March 4, 1999, in Miami. The decedent owned a 6.44% stock interest, consisting of 3,000 shares, in a closely held investment holding company. The holding company, Commercial Chemical Co. (CCC), held appreciated marketable securities, and was owned by Jelke and several irrevocable trusts benefiting various family members. The value of the securities owned by CCC consisted of blue-chip and domestic equities, and the market values for all were readily available. The underlying securities owned by CCC had a value of approximately $178 million, with built-in contingent capital gains tax liability of $51 million. CCC owned $10 million in other assets. The 11th Circuit, in a case of first impression in the circuit, addressed the estate tax valuation of the 6.44% stock interest. The estate took the position on the federal estate tax return that a hypothetical willing buyer and seller would reduce CCC’s $188 million net asset value by the $51 million contingent capital gains tax liability, and arrive at a $137 million value for CCC. In valuing the 6.44% interest owned by Jelke, the estate then applied a 20% discount for lack of control and a 35% discount for lack of marketability. In applying this methodology, the estate asserted that the 6.44% interest had a fair market value of $4,588,155. Not surprisingly, the Internal Revenue Service (IRS) initially took the position that no discount was available for the built-in capital gains tax liability in CCC, and applied more “reasonable” discounts for lack of control and lack of marketability. In applying this methodology, the IRS asserted that the 6.44% interest had a fair market value of $9,111,000, and that the estate owed an estate tax deficiency in the amount of $2,564,772. At the Tax Court level, the estate and the IRS agreed upon the value of the underlying assets owned by CCC. They also agreed that some form of discount should be applied for the built-in capital gains tax liability. However, the estate and the IRS disagreed upon the proper valuation of that discount. The estate argued for a dollar-for-dollar discount for the built-in capital gains tax liability. The IRS argued that the built-in capital gains tax liability should be indexed based upon the historical rate of sales of securities by CCC and discounted to its present value using the average rate of return for the portfolio. The Tax Court rejected the estate’s position that a dollar-for-dollar discount for built-in capital gains tax liability should be applied to CCC’s net asset value. The Tax Court noted that Jelke’s interest was a minority interest and that a hypothetical buyer could not force a liquidation event. The Tax Court accepted the arguments of the commissioner that a capital gains tax discount should be reduced to present value. In calculating the present value, the Tax Court took into account the average turnover period on a historical basis for securities owned by CCC. Thus, the Tax Court determined that the discount for built-in capital gains tax liability should be $21 million, instead of the $51 million advocated by the estate. The hypothetical willing buyer The 11th Circuit, after reviewing the historical development of the discount for built-in capital gains tax liability discussed above, turned to this critical question: Would a hypothetical willing buyer and seller value the 6.44% interest using a dollar-for-dollar reduction for the full $51 million in contingent capital gains tax liability, or would the capital gains tax liability be indexed over a 16-year period in a present-value calculation? The court contemplated the arguments of the estate that the present-value approach is incomplete and inconsistent, by not accounting for increasing capital gains tax liability over the 16-year period. The court also contemplated the arguments of the IRS commissioner that the threshold “assumption of liquidation” was unreasonable and unrealistic, when a minority shareholder has no ability to force a liquidation. In answering these questions, the 11th Circuit reviewed its recent decision in Estate of Blount v. Comm’r, 428 F.3d 1338 (11th Cir. 2005), in which it concluded, “To suggest that a reasonably competent business person, interested in acquiring a company, would ignore a $3 million liability strains credulity and defies any sensible construction of fair market value.” Id. at 1346. The court concluded that a hypothetical buyer “could just as easily venture into the open marketplace and acquire an identical portfolio of blue chip domestic and international securities as those held by CCC . . . without any risk exposure to the underlying tax liability lurking within CCC due to its low cost basis in the securities.” Jelke, 2007 U.S. App. Lexis 26477, at *41. It emphasized that valuation involves a hypothetical willing buyer, not a strategic buyer. The court concluded that the precise valuation methodology first set forth in Dunn provides certainty and finality in valuation, “as best it can.” Id. at *46. The Jelke court selected the dollar-for-dollar reduction for built-in capital gains tax liability in valuing closely held stock in an attempt to mimic the marketplace and to place a practical, transactional overlay in the valuation context of a hypothetical willing buyer and willing seller. It did so to settle this aspect of valuation as a matter of law, and to provide certainty to taxpayers. The current trend in case law addressing built-in capital gains tax liability for federal estate tax purposes is clearly that of allowing a dollar-for-dollar reduction. The 11th Circuit concluded that the Tax Court did not clearly err in applying discounts for lack of control and lack of marketability. The 11th Circuit affirmed without further discussion the findings of the Tax Court, which applied a 10% discount for lack of control and a 15% discount for lack of marketability. A vigorous dissent The dissent, in a biting and occasionally sarcastic opinion, vigorously protested applying a dollar-for-dollar reduction for contingent capital gains tax liability and advocated strongly instead for an indexing of the contingent liability reduced to its present value. The dissent, after quoting then-Vice President Theodore Roosevelt in his speech on the strenuous life, argued that “the majority gives in to the judicial equivalent of the doctrine of ignoble ease.” Id. at *50. Because Jelke could not have forced a liquidation, the dissent argued that the only reasonable expectation would be that the company would continue to operate as it had in the past, resulting in an average turnover of 5.95% of its assets on an annual basis. Agreeing in full with the Tax Court, it found that with the average turnover rate, 100% of the capital gains tax liability would be incurred over a 16.8-year period, and, when discounted to present value assuming an average rate of return of 13.2%, this liability would produce a $21 million reduction of the net asset value of CCC. The dissent argued that no hypothetical seller would agree to a full reduction for built-in capital gains tax, which will almost certainly be spread out over a period of years, when that price completely ignores the time value of money. It further argued that no rational being would elect to pay a $51 million tax liability today when it could, instead, be spread out over 16.8 years. It also argued that the majority ignored the rate of return on a $51 million investment declining at a rate of 5.95% per year and ignored the time value of money. The dissent asserted that the arbitrary assumption of full liquidation adopted by the majority will lead to similar arbitrary assumptions in the name of simplicity in other areas of law, such as in calculating lost future earnings awards in a tort cases. The dissent concluded with the statement “I dissent from the majority’s perilous delusion.” Id. at *68. As is obvious from the opinion in Jelke, the two approaches in calculating a discount for the built-in capital gains tax liability for federal estate tax purposes can produce significant differences in the amount of the reduction. Under the dollar-for-dollar approach adopted by the 11th Circuit, the reduction was $51 million, while under the approach adopted by the Tax Court and advocated by the dissent, the reduction was only $21 million. Taxpayers in the 5th and 11th circuits can take comfort in the fact that the full built-in capital gains tax liability will reduce, dollar-for-dollar, the net asset value of an entity being valued for federal estate tax purposes. Taxpayers in other circuits, however, may continue to see the approach adopted by the Tax Court and the dissent in Jelke. This seems particularly likely for the 2d and 6th circuits, which have case law implying that a full reduction is improper. The issue of the impact of built-in capital gains tax liability on the value a hypothetical willing buyer is willing to pay to a hypothetical willing seller remains somewhat unsettled. If the IRS continues to litigate the value of discounts for built-in capital gains tax liability, the proper methodology may ultimately be resolved by the U.S. Supreme Court. Mary C. Downie is a partner in the Chicago office and the wealth planning group at Reed Smith, concentrating in sophisticated estate and tax planning, complex estate and trust administration, and estate and trust litigation. She can be reached at [email protected].

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