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Case in Point – Issue 4 - Big Break: Calculating the Discount for Tax Liability on Built-in Gains

Contact: David Politziner

January 24, 2012

When it comes to determining tax liability based on the value of a business, a taxpayer’s best friend may well be the discounts that can be applied to reduce the value of the business’ assets. This includes the discount for built-in gains (BIG) tax liability. Although the BIG discount is largely accepted by the IRS and the U.S. Tax Court, there’s disagreement over how the amount of the discount should be calculated.

Circumstances dictate approach 

Both the Fifth and Eleventh U.S. Circuit Courts of Appeals have reversed the Tax Court to adopt dollar-for-dollar offsets for the capital gains tax that would be realized upon the immediate sale of an appreciated asset. This method often is used when valuing real estate or other holding companies that rely on the net asset value (NAV) approach. The theory is that to recognize value under the asset approach, an asset has to be sold, so the actual current sale is presumptive.

At first glance, it might appear that the Tax Court prefers to calculate the BIG discount using a present value (PV) approach — which considers when assets will actually be sold and determines the PV of the tax liability at that time. A recent Tax Court case, however, suggests that the court’s preferred approach depends on the particular circumstances of the case.

Dollar-for-dollar? 

In Estate of Jensen, the court assessed the value of a decedent’s 82% interest in a C corporation, Wa-Klo, which held appreciated real estate and improvements used as a summer camp. The expert witnesses for the estate and the IRS both used cost-based valuation approaches to calculate an NAV for Wa-Klo of about $3.8 million, before reductions for lack of marketability and BIG discounts.

If the assets were sold on the date of death, the BIG tax liability would have been approximately $1.1 million. No sale or liquidation of the business or its assets was imminent or planned at that time, though.
 
Nonetheless, the estate applied a dollar-for-dollar BIG discount of $1.1 million, based on the assumption that the assets would be sold. The IRS countered with a discount of about $500,000. It calculated this amount by comparing the Wa-Klo shares to closed-end funds, which are commonly subjected to BIG discounts.

Doing the math 

The Tax Court rejected the IRS’s approach, finding that the funds weren’t comparable to the shares. The court also criticized the IRS expert’s failure to account for the likelihood that the value of Wa-Klo’s assets would increase — along with the BIG tax — and for the time value of money.

But the Tax Court didn’t accept the estate’s figure, either. Instead, it performed its own PV analysis, based on a holding period of 17 years (the assets’ remaining useful life), over which the assets would continue to appreciate. The court ran two scenarios, assuming equal discount and growth rates under each: 5% in one, 7.725% in the other. It came up with PV for the BIG tax liability of $1.23 million and $1.26 million, respectively.

Because the estate’s discount was in the same range as its own calculations and the estate didn’t argue for a higher amount, the Tax Court ultimately accepted it. However, the court expressed a preference for the PV approach under the facts of the case.

Facts matter 

When determining the proper BIG discount, taxpayers can’t assume that the Tax Court will apply one approach over the other at all times. If the facts of the case drive the court to opt for the PV approach, though, an experienced valuation professional can help your client provide the court with the proper holding period and discount and growth rates.

Case in Point - Issue 4

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